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St. Louis Fed Analysis Shows Probability of Recession Based on Short-Term Yields |  Missouri

(The Center Square) – When interest rates on bank deposits or short-term bonds are higher than on long-term products, a recession could be imminent, according to analysis by the St. Louis Federal Reserve. .

In response to high inflation in 2022, the Federal Open Market Committee raised the federal funds rate from 0% to 0.25% to current levels of 5.25% to 5.5%. Inflation has receded from highs of around 10% last year, but the effects of rising interest rates will continue to influence the economy.

Christopher J. Neely, Vice President of the St. Louis Fed, analyzed the yields of bank deposits and bonds in the short, medium and long term. He found that short-term rates are now higher than long-term rates and have been for most of the past year.

“This is concerning because past yield curve inversions have reliably predicted recessions, that is, sustained downturns in economic activity, as defined by the National Bureau of Economic Research,” Neely wrote in a statement. blog post.

“The model, however, is not perfect; there were false positives — that is, high probabilities of a recession when no recession happened — in the late 1960s and late 1990s,” Neely wrote.

While there are multiple reasons why yields can predict a recession, there are two common theories, he writes. First, short-term interest rates rise when the Fed raises rates, making it more expensive to borrow for investment and consumption, slowing the economy. Second, low medium- and long-term interest rates point to weak investment and growth going forward.

Neely’s analysis of different expected returns and inflation rates showed how trends predated the recessions of 1975 and 1981.

“In summary, the inverted yield curve is consistent with the assertion that current monetary policy is moderately tight and that there is a relatively high probability of a recession over the next 12 months,” Neely wrote. “But no prediction is certain.”

Neely added that the models predict recession probabilities of 40%, 50% and 60%, which shows the likelihood of the economy being unaffected.

“Furthermore, it should be remembered that forecasting relationships can and do break down,” Neely wrote. “Past successes do not guarantee future results. Information from other sources can give us greater confidence in yield curve forecasts, or suggest skepticism about them.