Jerome Powell and friends have a new recession model.
Federal Reserve policy makers were presented with a new recession indicator, according to minutes released Thursday.
The discussion comes as the flattening of the so-called yield curve has raised fears about the health of the economy, since an inverted curve is often a leading indicator of a downturn.
Read Caroline Baum: To invert or not to invert? That is the Fed’s question
Minutes of the two-day meeting ending June 13 revealed this discussion:
“Participants also discussed a staff presentation of an indicator of the likelihood of recession based on the spread between the current level of the federal funds rate and the expected federal funds rate several quarters ahead derived from futures market prices. The staff noted that this measure may be less affected by many of the factors that have contributed to the flattening of the yield curve, such as depressed term premiums at longer horizons. Several participants cautioned that yield curve movements should be interpreted within the broader context of financial conditions and the outlook, and would be only one among many considerations in forming an assessment of appropriate policy.”
The description seems to match a paper released June 28, titled, “(Don’t Fear) The Yield Curve.”
That paper, by Fed staffers Eric Engstrom and Steven Sharpe, says there are better recession indicators than the spread between the 10-year TMUBMUSD10Y, -0.23% and the 2- TMUBMUSD02Y, -0.63% Treasury note.
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Instead, they advocate looking at what they called a near-term forward spread. They suggest looking at the difference between the current implied forward rate on Treasury bills six quarters from now, and the current yield on a 3-month Treasury bill TMUBMUSD03Y, -0.31% .
They point out the spread is similar to the slope of fed funds expectations that can be derived from a survey of economists.
When the near-term forward spread is negative, it signals that investors expect the Federal Reserve to ease monetary policy in the near term, the authors point out. And why would this be? Because of a slowing or decline in economic activity.
So what does this newfangled indicator have to say about current odds of a recession in the next year? About a 15% chance — which isn’t that much different from what the yield curve suggests.
That said, the Fed’s new indicator did put greater odds on the last two recessions occurring, as can be seen in the chart.