The Yield Curve And Recessions: Against U.S. - Centricism

by Philip Pilkington

One of the nicest stylized facts in applied economics is that if the Fed inverts the yield curve it will cause a recession. Inverting the yield curve basically means that the Fed hikes the short-term interest rate goes higher than the long-term interest rate. In theory this should lead to long-term lending drying up, investment falling significantly (usually in housing and inventories) and, ultimately, a recession.

The track record of this as an indicator of recessions in the US is too impressive to dismiss. Take a look at the chart below. The shaded areas are recessions. As you can see, every time the short-term interest rate (blue line) climbs about the long-term interest rate (red line) we see a recession within around 12 months or so.

yieldcurvesUS

The question, however, is whether this is universal economic constant. And when we turn to the data from other countries we quickly see that it is not.

All the data that follows if from the St. Louis Fed but I have done the graphs myself so that I could include lines indicating British and Japanese recessions.

Okay, so let’s take the UK first. This graph is pretty rough but the green lines are the starts of recessions and the thinner black lines are points when the short-term interest rate rose above the long-term interest rate without causing a recession. The short-term interest rate is the blue line and the long-term interest rate is the red line.

yieldcurvesUK

As we can see, the story here is a bit more complicated than in the US. Only three out of the five recessions were precipitated by an inverted yield curve. Meanwhile the yield curve inverted seven times without causing a recession.

This does not bode well for the notion that this correlation might be constant across time and space.

So, let’s turn to Japan. Unfortunately, the data available for Japan is only from during the so-called Lost (Two) Decade(s) and so we will be dealing with a rather unusual period. Nevertheless, it should still prove interesting.

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