Predicting Real Growth Using the Yield Curve

The yield curve, which plots the yield of Treasury bonds against their maturity, is one of the most closely watched financial indicators.1 Many market observers carefully track the yield curve’s shape, which is typically upward sloping and somewhat convex. At times, however, it becomes flat or slopes downward (“inverts,” in Wall Street parlance), configurations that many business economists, financial analysts, and other practitioners regard as harbingers of recession (see figure 1). A recent article in Fortune labeled the yield curve “a near-perfect tool for economic forecasting” (see Clark [1996]). In fact, forecasting with the yield curve does have a number of advantages. Financial market participants truly value accurate forecasts, since they can mean the difference between a large profit and a large loss. Financial data are also available more frequently than other statistics (on a minute-to-minute basis if one has a computer terminal), and such a simple test as an inversion does not require a sophisticated analysis. In this Review, we examine the yield curve’s ability to predict recessions and, more generally, future economic activity. After comparing the curve’s forecasts with the historical record, we judge its accuracy against other predictions, including naive forecasts, traditional leading indicators, and sophisticated professional projections. This article builds on a wide range of previous research, but, taking an eclectic approach, differs from the earlier work in a variety of ways. These differences show up mainly in the way we judge forecast performance. Like the important early work of Harvey (1989, 1991, 1993) and Hu (1993), we use outof-sample forecasts and compare yield curve forecasts with other predictions (including professional forecasts), but we extend our data set to the mid-1990s. In addition, we consider how adding the yield curve improves (or reduces) the accuracy of other forecasts. In this, we follow Estrella and Hardouvelis (1991), who do not, however, use out-of-sample forecasts. Finally, building on the recent work of Estrella and Mishkin (1995, 1996), we consider how well the yield curve predicts the severity of recessions, not just their probability, and compare the forecasts with a wider range of alternatives.