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January 19, 2007

The Yield Curve: Still A Wild Card

Although the incoming data related to real activity in the U.S. may not prove the case against the 2007 crash-and-burn scenario, it sure is not providing much support for it.  From housing starts, to retail sales, to industrial production, you have to actually work to generate some negative spin. One should always seek perspective, of course, and there are indeed reasons to restrain your optimism.  Listen, for example, to Dean Baker:

The consensus estimate for retail sales growth in December was 0.5 percent. Naturally, people were surprised when growth was reported at 0.9 percent, as the NYT (among others) told us. Well, they really should not have been surprised, because the November numbers were revised down by 0.4 percent, which means that the December sales level was just where the consensus estimate put it.

You might make a similar case for the industrial production index, which grew more than expected in December, but was revised down (into negative growth territory) in both November and October. And you can always blame the weather for making things look too darn good.

Nonetheless, I think a fair-minded assessment -- if I may speak fair-mindedly myself -- would be "not bad."

Then there is the yield curve where, despite some recent movement, the spread between long-term and short-term interest rates remains stubbornly south of zero.  Writing in the online version of the Cleveland Fed's Economic Trends feature, Joe Haubrich and Brent Meyer review a little history, and do a little extrapolating:

The slope of the yield curve has achieved some notoriety as a simple forecaster of economic growth. The rule of thumb is that an inverted yield curve (short rates above long rates) indicates a recession in about a year, and yield curve inversions have preceded each of the last six recessions (as defined by the NBER). Very flat yield curves preceded the previous two, and there have been two notable false positives: an inversion in late 1966 and a very flat curve in late 1998. More generally, though, a flat curve indicates weak growth, and conversely, a steep curve indicates strong growth...

While such an approach predicts when growth is above or below average, it does not do so well in predicting the actual number, especially in the case of recessions. Thus, it is sometimes preferable to focus on using the yield curve to predict a discrete event: whether or not the economy is in recession. Looking at that relationship, the expected chance of a recession in the next year is 43%.

Not everyone is convinced, of course, but right now it looks to me to be the bears' strongest suit.