Recession odds growing, Fed model shows Yield curve model shows 50% odds of slowdown By Rex Nutting, MarketWatch Last Update: 12:36 PM ET Nov 1, 2006 WASHINGTON (MarketWatch) -- The odds of a recession in the United States in the next year are now greater than 50-50, according to a simplified version of a model developed by an economist at the Federal Reserve. The model, which relates the shape of the yield curve to the Fed's interest rate target, has been extremely accurate at predicting recessions in the past. But economists who study the business cycle say the model may be delivering a misleading message today. Fed economist Jonathan Wright developed the model in a paper published earlier this year, based on research by, among others, new Fed Gov. Frederic Mishkin and New York Fed economist Arturo Estrella. Read his paper. If bond yields stay at current levels for the next three months, Wright's model would predict a recession. Current yields have been in a recession-zone for only a day so far. In Wright's model, a steep, sustained inversion of the yield curve, combined with a relatively high federal funds rate, would point to a recession. The inverted yield curve does not cause a recession; it's just a signal of a pending slowdown. "Forecasters are really bad at forecasting recessions," said Lakshman Achuthan, managing director at Economic Cycle Research Institute, which did forecast the 2001 recession, based on ECRI's own leading economic indicators. Achuthan doesn't think the yield curve is the "holy grail of economic forecasting." "The yield curve doesn't pass our test to be included in our leading indicators," he said. His firm is not forecasting a recession this year or next, but is "by no means bullish." Achuthan said recessions are hard to predict. "Recessions aren't the result of the linear addition of bad things," he said in an interview. But if all the drivers of the economy -- profits, housing, interest rates, confidence and inventories -- move down together, then you have the risk of a downturn. Wright's paper seemed to influence Fed Chairman Ben Bernanke's comment in March that the flat yield curve of the time was not predicting a recession because the federal funds rate was relatively low. Read Bernanke's remarks. Inversion has been widening But now, after three more rate hikes, the federal funds rate can no longer be considered low. The yield curve represents the yields of various Treasury securities of different maturities. Typically, short-term securities yield less than long-term securities, because investors demand extra compensation for locking up their money for a longer period. This pattern is the basis for a profitable financial industry, which makes money by borrowing short and lending long. But sometimes, the curve "inverts" and short-term securities yield more than long ones. The yield on a three-month Treasury bill was yielding 5.09% on Wednesday, while the 10-year note was yielding 4.58%. The yield curve has been inverted for several months, but the inversion widened once the Fed stopped raising the federal funds rate. The inversion is now more than 50 basis points. The Wright recession indicator moved above 50% late Tuesday for the first time in this business cycle. Following a disappointingly weak reading from the Institute for Supply Management, the bond market rallied further on Wednesday, driving long-term yields lower and sending the recession odds to 52%. Following the weak economic news Wednesday, the futures market is now predicting that the Fed will cut rates in March. Yield curve not enough The recession odds have been above 50% eight times in the past 45 years. Six times, a recession followed within a year. The only occasions the economy avoided a recession were in the mid-1960s and the mid-1980s, both periods when the federal government flooded the economy with fiscal stimulus, noted David Rosenberg, chief North American economist for Merrill Lynch. Some economists pooh-pooh the link between the shape of the yield curve and the path of the economy. They say the curve is inverted not because of perceived weakness in the U.S. economy, but because of high demand for Treasurys in a global market that's awash in liquidity looking for yield. "There are structural changes in the credit markets that weaken the signal," said Chris Varvares, chief economist for Macroeconomic Advisers, a top forecasting firm. Varvares said he believes the risk of recession over the next 12 months is "quite low." In his March speech, Bernanke said the Fed policymakers won't react solely to a signal from the yield curve. "Policymakers should monitor bond yields carefully in judging the current state of the economy--but only in tandem with the signals from other important financial variables; direct readings on spending, production, and prices; and a goodly helping of qualitative information," Bernanke said. End of Story Rex Nutting is Washington bureau chief of MarketWatch.