Reckoning the Odds of Recession

How likely is it that there will be a recession in the next 12 months? Well, now you can find out for yourself with Political Calculations' latest tool, which does the math developed by the Federal Reserve Board's Jonathan Wright in The Yield Curve and Predicting Recessions (HT: James Hamilton's Econbrowser, where the specific formulation used in the following tool was outlined).

In the tool below, enter the current bond yields for the 10-Year Treasury Bond and the 3-Month Treasury Bond. You'll also need to enter the Federal Funds Rate. The tool will determine the probability of a recession occurring in the next 12 months from the spread between the treasury bonds and factoring in the Federal Funds Rate, according to Wright's Model B:

Update (22 September 2006): We've developed a tool for visualizing the odds that will help you quickly determine where we are in terms of recession risk!

Update (15 November 2006): We've provided some guidance on how to make the recession call!

Bond Yield and Federal Funds Rate Data
Input Data	Values
10-Year Treasury Bond Yield (%)
3-Month Treasury Bond Yield (%)
Federal Funds Rate (%)

Probability of Recession in Next 12 Months
Calculated Results	Values
Probability of Recession (%)

Using this model, a combination of two factors greatly increases the likelihood of a recession:

1. An inverted yield curve (a negative spread produced when the 10-year treasury bond yield rate drops to be lower than the 3-month treasury's yield).
2. A high federal funds rate.

How well will this method work in predicting future recessions? Time will tell, but for now, James Hamilton reports that it does appear to be a factor in setting the Fed's policy:

According to Model B, the low values for the spread that we saw last summer were not a source of concern for future economic activity because a fed funds rate below 4% was so low by historical standards. Research like this seems to have played a role in Fed Chair Ben Bernanke's assessment that

I would not interpret the currently very flat yield curve as indicating a significant economic slowdown to come, for several reasons. First, in previous episodes when an inverted yield curve was followed by recession, the level of interest rates was quite high, consistent with considerable financial restraint. This time, both short- and long-term interest rates--in nominal and real terms--are relatively low by historical standards.

As for James Hamilton's assessment of the Fed's recession predicting model:

... if we accept Model B at face value, a couple more 25-basis point bumps by the Fed would put the funds rate at 5.25% and likely push the spread into negative territory. From the table above, that starts to make a recession look like a pretty good possibility.

Think Bernanke wants to take that gamble? I'm betting he won't.

We here at Political Calculations are hoping (not betting) he won't.