Fed Study Claims These 5 Indicators Predict Recessions

hen it comes to forecasting the economy, there are so many indicators we can look at. The list seems endless, whether that’s unemployment, exchange rates or even yield curves.

However, a recent study by Michael Kiley, an economist at the Federal Reserve, looked at the relationship between indicators and business cycles to see which ones were better across different time horizons. He came up with a list of five indicators that could be used to forecast recessions. 

The Three Categories of Indicators

The study shows that indicators can be split into three broad categories:

Financial Indicators

The first category is financial indicators. This category would include the yield curve, equity prices, exchange rates, etc. Since these are based on the markets, they are forward-looking and set expectations about the future of economic activity. 

An example given in the study says that central bank policymakers “adjust short-term interest rates with fluctuations in economic activity, and hence long-term bond yields—which embed expectations for short-term interest rates—incorporate information on future economic activity”

The two indicators the study picked are the slope of the yield curve (the difference between the 10-yr Treasury and the Fed Funds Rate), and the Baa corporate bond spread (the difference in yields between the Baa bonds and government bonds), both of which are said to be strong recession indicators. 

In this case, they found that financial indicators are best used for predicting recessions in the short-term, so less than a year.

Leading Indicators

The second category is leading Indicators, designed to show how much momentum there is in the economy.

These indicators include consumer and business confidence, housing starts, and durable goods orders. These are useful because if there’s a change in momentum in the economy, such as it begins to slow, that can relate to a change in unemployment. 

The study only picked one indicator from this category: the OECDs Composite Leading Indicator for the US, also known as the CLI. It may seem odd to pick one indicator, but this is an aggregate of many other indicators. 

As with the previous two indicators, the CLI has also proven to be a strong indicator of a recession in the short term.

Although the CLI also includes some economic activity measures, it’s not highly correlated with other measures that track the business cycle. So, that brings us to the last category. 

State of Business Cycle

The third category is the state of the business cycle, which shows where the economy is within that cycle by pointing towards whether or not economic activity is consistent with stable inflation. 

The two key indicators from this category are known: unemployment (of the civilian noninstitutional population over age 16) and inflation (measured as the YoY change in the price index for PCE). These also align well with the Fed’s stable prices and full employment mandate.

Unlike the previous two categories, which focus on the short-term, these indicators are better at predicting a recession over the medium term, which the study defined as 8 quarters or within the second year.

The Five Indicators

Now we have five indicators that could be used to predict if a recession is likely in the short to medium term. We have three short-term indicators: the yield curve, corporate bond spreads, and the OECD’s CLI. And we have two medium-term indicators: unemployment and inflation. 

Two key takeaways from the study were that term spreads (the difference between long and short yields) and the CLI were strong recession indicators in the short term. In contrast, unemployment and inflation were strong recession indicators in the medium term.

How do these indicators translate into predicting the risk of a recession? Well, a lower probability of recession is linked with the following:

• An increase in the term spread creates a steeper yield curve for government bonds. That means there’s a bigger gap between short and long-term yields. 
• A decrease in the corporate bond spread creates a narrower gap between corporate and government bonds. 
• An increase in the OECD’s CLI as an increase in momentum is expected to be associated with less risk.
• A decrease in inflation lowers the risk the central bank will need to raise rates restricting economic growth. 
• An increase in the unemployment rate again lowers the risk of inflation and increases the likelihood of stimulative policy.

The opposite case would, therefore, increase the probability of a recession.

Here’s a quote from the study, “As indicated by the red circles, the period one year before a recession quarter tends to see the following developments: the term spread is low (flat yield curve), the leading indicator is falling, inflation is high, and/or the unemployment rate is low. These patterns are discernably different than those seen outside the period one-year before a recession (the blue circles).”

However, the study also showed some key patterns to be aware of. For example, yield curves were better at predicting recessions in the short-term when the CLI and unemployment were ignored, but approaches using yield curves often overstate the recession signal without considering other factors. 

Additionally, strong momentum (CLI) could point to a recession in the medium-term. Therefore, it's important to consider all the indicators when predicting the risk of a recession as only using a subset could be misleading. 

Overall, we now have some indicators we can use, and the time horizons they are most suitable for. If you want to delve further into the topic, we’ve included a link to the study below. We’ll also be covering each of the indicators covered in more detail separately.