The ROC is an increasing function: As we reduce the critical value, the false and true positive rates are both increasing. This curve is called the receiver operator characteristic (ROC) curve, and Figure 2 depicts two stylized versions of the ROC curve: lines A and B. We can plot the true positive rate against the false positive rate as we vary the critical value. Observations when recessions do not occur (Sample 0)Ĭonditional on the critical value, the true (false) positive rate is the share of observations in Sample 1 (Sample 0) for which the indicator variable exceeds the critical value.Observations when recessions occur (Sample 1).We obtain the two rates by splitting the sample in two: To be precise, the choice trades off the true positive rate against the false positive rate. The choice of a critical value trades off the chance of correctly (wrongly) predicting a recession when a recession does (not) happen. Once we decide the critical values for the available indicators, we also need a criterion that lets us rank their forecasting performance. Similarly, we could choose zero as a critical value for the growth rate of the CBLI. For the interest rate spreads, the standard critical value is zero: We predict a recession if the spread is negative (or in other words, if the yield curve is inverted). To gauge these indicators' accuracy, we first have to decide critical values for the indicators that would convince us that a recession is imminent. So, how accurate are these indicators? Measuring the Effectiveness of Recession Indicators But we also occasionally have negative spreads and declining CBLIs that are not followed immediately by recessions. The shaded areas represent periods that the National Bureau of Economic Research (NBER) Business Cycle Dating Committee has declared to be recessions.Ĭlearly, prior to a recession, interest rate spreads become negative, and the CBLI declines. Indicator Readings and Recessionsīelow, we plot the interest rate spreads in Figure 1a and the level and year-over-year percentage change of the CBLI for the period 1962 to 2022 in Figure 1b. The latter is reflected in the spread of 10-year over two-year Treasury rates (10Y2Y) that is often discussed in the financial press, and the former is reflected in the near-term-forward (NTF) spread recently advocated for by the 2018 paper " The Near-Term-Forward Yield Spread as a Leading Indicator: A Less Distorted Mirror" and the 2022 article " (Don't Fear) The Yield Curve, Reprise."įinally, rather than adding several other alternative series, we consider the Conference Board's index of leading indicators (CBLI) that combines information from what are considered to be the 10 best leading indicators. A long-term component that captures the spread between long-term and medium-term maturities.A medium-term component that captures the spread between medium-term and short-term maturities.One can view the spread as being composed of two components:
This spread frequently shows up as a good indicator of future recessions in studies of comprehensive sets of recession indicators.
Recession Indicatorsįor the baseline indicator, I use the spread of the 10-year Treasury bond rate over the three-month Treasury bill rate, which we'll call 10Y3M. I find that adding any one of these alternative indicators to the baseline interest rate spread does not improve forecast performance for recessions significantly. I also look at two alternative interest rate spreads over different maturities as well as a portmanteau index of leading indicators. As of now, this baseline indicator does not yet indicate an elevated risk of recession. The baseline indicator that I examine is the interest rate spread of long-term government bonds over short-term government bonds, which is commonly referred to as the yield curve. In this article, I review indicators that have proven useful in predicting recessions. While these moves are aimed at corralling inflation, there is some concern that this policy action might cause a recession.
With inflation reaching levels not seen in decades, the Federal Open Market Committee has tightened policy in response, namely by rapidly increasing the federal funds target rate and winding down the Fed's balance sheet.
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