The Yield Curve as a Predictor of Economic Growth
April 2011
Covering March 25, 2011–April 22, 2011
Highlights

April  March  February 
3month Treasury bill rate (percent) 
0.06

0.09

0.11

10year Treasury bond rate (percent) 
3.41

3.29

3.60

Yield curve slope (basis points) 
335

320

349

Prediction for GDP growth (percent) 
1.0

1.0

1.0

Probability of recession in 1 year (percent) 
0.9

0.9

0.7

Overview of the Latest Yield Curve Figures
Over the past month, the yield curve became steeper, as long rates increased, resuming a trend that had been broken in the previous month. Short rates edged down yet again. The threemonth Treasury bill rate moved further into the singledigit range, to 0.06 percent (for the week ending April 22), down from March’s 0.09 percent, and February’s 0.11 percent. The tenyear rate increased to 3.41 percent, up from March’s 3.29 percent, but still below February’s 3.60 percent. The slope increased 15 basis points, giving back about half of the drop between February and March, and now stands at 335 basis points.
Projecting forward using past values of the spread and GDP growth suggests that real GDP will grow at about a 1.0 percent rate over the next year, the same forecast as March and February. The strong influence of the recent recession is leading toward relatively low growth rates, with a steady beat of 1 percent predictions. Although the time horizons do not match exactly, the forecast comes in on the more pessimistic side of other forecasts, although, like them, it does show moderate growth for the year.
Using the yield curve to predict whether or not the economy will be in recession in the future, we estimate that the expected chance of the economy being in a recession next April is 0.9 percent, essentially unchanged since March, but up slightly from February’s 0.7 percent. Although our approach is somewhat pessimistic about the level of growth expected over the next year, it is more optimistic about the chances of the recovery continuing.
The Yield Curve as a Predictor of Economic Growth
The slope of the yield curve—the difference between the yields on short and longterm maturity bonds—has achieved some notoriety as a simple forecaster of economic growth. The rule of thumb is that an inverted yield curve (short rates above long rates) indicates a recession in about a year, and yield curve inversions have preceded each of the last seven recessions (as defined by the NBER). One of the recessions predicted by the yield curve was the most recent one. The yield curve inverted in August 2006, a bit more than a year before the current recession started in December 2007. There have been two notable false positives: an inversion in late 1966 and a very flat curve in late 1998.
More generally, a flat curve indicates weak growth, and conversely, a steep curve indicates strong growth. One measure of slope, the spread between tenyear Treasury bonds and threemonth Treasury bills, bears out this relation, particularly when real GDP growth is lagged a year to line up growth with the spread that predicts it.
Predicting GDP Growth
We use past values of the yield spread and GDP growth to project what real GDP will be in the future. We typically calculate and post the prediction for real GDP growth one year forward.
Predicting the Probability of Recession
While we can use the yield curve to predict whether future GDP growth will be above or below average, it does not do so well in predicting an actual number, especially in the case of recessions. Alternatively, we can employ features of the yield curve to predict whether or not the economy will be in a recession at a given point in the future. Typically, we calculate and post the probability of recession one year forward.
Of course, it might not be advisable to take these number quite so literally, for two reasons. First, this probability is itself subject to error, as is the case with all statistical estimates. Second, other researchers have postulated that the underlying determinants of the yield spread today are materially different from the determinants that generated yield spreads during prior decades. Differences could arise from changes in international capital flows and inflation expectations, for example. The bottom line is that yield curves contain important information for business cycle analysis, but, like other indicators, should be interpreted with caution. For more detail on these and other issues related to using the yield curve to predict recessions, see the Commentary “Does the Yield Curve Signal Recession?” The Federal Reserve Bank of New York also maintains a website with much useful information on the topic, including their own estimate of recession probabilities.