Thrown for a Yield Curve
By MARK HULBERT
Published: December 18, 2005
ALAN GREENSPAN, the Federal Reserve chairman, raised more than a few eyebrows in November when he said in testimony before the Joint Economic Committee of Congress that there was no need to worry that the yield curve had flattened and was close to inverting. The yield curve, he said, has lost its ability to forecast recessions.
As is the case with many other issues, economists are all over the map on this one. But many are not as sanguine as Mr. Greenspan about recent interest rate trends. And even many who are sympathetic to his argument say that the statistical evidence for it is weak.
The yield curve, of course, refers to the difference between short-term and long-term interest rates. Most of the time, longer-term rates are higher than shorter-term ones. But occasionally this relationship is turned on its head - a phenomenon that economists call an inverted yield curve.
Many standard economics textbooks report that an inverted curve is a leading indicator of an imminent economic slowdown. The traditional reasoning goes something like this: when short-term rates are relatively high, demand for loans slackens, weakening the economy. And bond traders, collectively seeing so many signs of an impending economic slowdown, have already driven down longer-term rates in anticipation of an eventual loosening of short-term credit.
The statistical support for this indicator looks impressive. Arturo Estrella, an economist at the Federal Reserve Bank of New York, contends that an inverted yield curve "has predicted essentially every U.S. recession since 1950 with only one 'false' signal."
At first blush, there is no evidence that the indicator is losing its touch. It worked like a charm, for example, in forecasting the economy's most recent recession. According to the National Bureau of Economic Research, the widely recognized arbiter of when recessions begin and end, that recession began in March 2001. The yield curve went negative the previous summer.
Mr. Estrella and Frederic S. Mishkin, a professor of banking and financial institutions at Columbia University, have built an econometric model that relates various levels of the yield curve with the probability of a recession within 12 months. With the rate on 10-year Treasury notes now just about half a percentage point higher than that for three-month Treasury bills, for example, the researchers' model calculates a 10 to 15 percent probability of a recession within the next year. That probability would grow to about 25 percent is the difference in rates disappeared, and would grow even further if the curve inverted, meaning that the short-term rate was higher than the longer-term one.
The track record of the yield curve helps to explain why it is among the factors in the index of leading economic indicators maintained by the Conference Board, the nonprofit business research organization. This past summer, the board conducted a review as to whether the yield-curve indicator should continue as part of the index. Its answer was yes. Ken Goldstein, a Conference Board economist, says his group's research "does not show that the yield curve has lost its predictive power."
So what is there to debate about the yield curve, given its apparently impressive forecasting record? One reason to be tentative, many economists say, is that monetary conditions have changed markedly. In comments echoed by several other economists interviewed for this column, Mr. Goldstein speculated that if a recession followed an inverted yield curve today, it would be for reasons other than those that led to economic slowdowns after the curve inverted in previous decades.
In the high-inflation years of the late 1970's and early 80's, for example, inverted yield curves resulted from the Federal Reserve's aggressive monetary braking. By contrast, the Fed's rate increases over the last two years have been very gradual, and have occurred in the context of low inflation expectations.
Apparently that was at least part of what Mr. Greenspan had in mind when he said that the yield curve had lost its forecasting power. He told members of the Joint Economic Committee that "the markets have become far more complex" than they were in previous decades.
Robert F. Stambaugh, a finance professor at the Wharton School of the University of Pennsylvania, offered another reason to be tentative: there have been few recessions over the last 50 years - just nine, according to the National Bureau of Economic Research. Even if the world were not so different today, Professor Stambaugh argues, this sample size is not big enough to support much confidence in any statistical conclusions.
NOTE that these doubts about methodology do not support Mr. Greenspan's confident assertion that the yield curve has lost its forecasting ability. Instead, they suggest that economists need to be cautious in drawing any conclusion about the yield curve's significance. According to John H. Cochrane, a finance professor at the University of Chicago, the small sample size makes it very difficult "to determine what the relationship in the first place was between an inverted yield curve and recessions, much less to know if that relationship may have changed recently."
Dan Seiver, an emeritus professor of economics at Miami University of Ohio and now a visiting professor of economics and finance at San Diego State University and the University of San Diego, said that while Mr. Greenspan has been an exemplary chairman, he might have been motivated by considerations other than economic theory in saying that an inverted yield curve does not portend a recession. Mr. Greenspan is "on the way out, and has a vested interest in wanting everything to appear to be perfect as he leaves," Professor Seiver said.
Mark Hulbert is editor of The Hulbert Financial
Digest, a service of MarketWatch. E-mail: strategy@nytimes.com.
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