A Fed paper puts “significant” odds on the economy sinking into another recession within two years.
The paper, written by a visiting scholar at the Federal Reserve Bank of San Francisco and a grad student at the University of California at Davis, uses data from the Leading Economic Index prepared by the Conference Board.
Fed scholar Travis Berge, who is a professor at the University of California at Davis, and his grad student Oscar Jorda caution that the Conference Board index itself is “no better than a coin toss” in predicting economic turning points beyond 10 months.
But by tweaking the data, the researchers say they are able to determine that that the chance of recession is rising — and looks much higher if you ignore an indicator that is highly sensitive to the Fed’s low-rate policy.
The researchers ran three experiments using the leading indicators data – one using the 10 index components, and two others each excluding one indicator. In one case they excluded data on the stock market, in another information on the shape of the so-called yield curve tracking interest rates over time.
That test excluded the most bullish current indicator. The spread between the fed funds rate and the Treasury bond interest rate is relatively steep now, which typically points toward an economic expansion.
But the researchers throw that variable out, reasoning that the Fed’s embrace of near-zero interest rates makes a steep yield curve a foregone conclusion.
Without the steep yield curve, a reading of the leading indicators suggests that “a recessionary relapse is a significant possibility sometime in the next two years,” the researchers write.
Of course, none of this is cast in stone. “Any forecast 24 months into the future is very uncertain,” Berge and Jorda write. They add, almost on cue, that “policies that are adopted today could play a decisive role in shaping the pace of growth.”
The publication comes as officials at the Federal Reserve meet to consider how they’ll respond to signs that the economic recovery is weakening. Few economists expect to see the Fed take any action when its regular meeting ends tomorrow, but it is fashionable lately to say that the central bank will soon have to buy more assets to stave off deflation.
In any case, Berge and Jorda find that the risk of a recession appears apt to rise next year under all three scenarios.
“LEI forecast trends indicate that the macroeconomic outlook is likely to deteriorate progressively starting sometime next summer, even if the data suggest that a renewed recession is unlikely over the next several months,” they write.
