Can Interest Rates Predict Business Cycles?

By Silk, Leonard | THE JOURNAL RECORD, September 7, 1991 | Go to article overview

Can Interest Rates Predict Business Cycles?


Silk, Leonard, THE JOURNAL RECORD


Changes in the spread between short-term and long-term interest rates may be the best means of forecasting business-cycle turning points.

When short rates are lower than long _ as they are now _ the economy tends to grow. But when long rates drop below short, recession looms.

Over the last 25 years, movements in the "term structure" of interest rates, or yield curve, have correctly predicted all the major peaks and troughs in the U.S. business cycle, according to Prof. Campbell R. Harvey of Duke University's Fuqua School of Business.

Unlike other indicators, the yield curve has put out no false signals.

In the third quarter of 1968, the curve began an inversion, changing its slope from positive to negative, and correctly signaled the recession of 1969-70, which started five months after long rates dropped below short rates.

The yield curve inverted two months before the 1973-75 recession began. In the fourth quarter of 1978 and in the fourth quarter of 1980, the yield curve inverted, recovered and inverted again, correctly predicting the double-dip recessions of 1980 and 1981-82, which some economists see as one recession.

How about the latest recession, which may or may not be over?

The administration attributed the onset of the recession to the outbreak of the Persian Gulf crisis in August 1990. But the inversion of the yield curve in the second quarter of 1989 had predicted the downturn that began five months later _ the average lag between inversions and recessions.

But so slight was the inversion in the last three quarters of 1989 that it was unclear whether the economy was facing recession or just a spell of sluggish growth. The inversion in the third quarter of 1989 was only 30 basis points (with long-term rates just 0.3 percent below short-term rates). By comparison, the inversion in the fourth quarter of 1980 was 340 basis points (3.4 percent), correctly predicting the deep recession of 1981-82.

In July 1990, with the yield curve positive again, Harvey correctly predicted that the economy would begin its recovery about the middle of 1991. That forecast now appears to be on target. The index of leading indicators posted a sharp increase of 1.2 percent in July.

But the downward revision by the Commerce Department of the preliminary estimate of the growth of gross national product, corrected for inflation, in the second quarter to minus 0.3 percent from positive 0.4 percent has made some economists dubious about the end of the recession.

For his part, Harvey holds that the present upward sloping yield curve signals a robust recovery, not a weak or moderate one, as most economists are forecasting. …

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