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Financial market perceptions of recession risk

  • Thomas B. King
  • Andrew T. Levin
  • Roberto Perli

Over the Great Moderation period in the United States, we find that corporate credit spreads embed crucial information about the one-year-ahead probability of recession, as evidenced by both in- and out-of-sample fit. Furthermore, the incidence of “false positive” predictions of recession is dramatically reduced by utilizing a bivariate model that includes a measure of credit spreads along with the slope of the yield curve; indeed, these bivariate models provide much better forecasting performance than any combination of univariate models. We also find that optimal (Bayesian) model combination strongly dominates simple averaging of model forecasts in predicting recessions.

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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2007-57.

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Date of creation: 2007
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Handle: RePEc:fip:fedgfe:2007-57
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  1. Arturo Estrella & Gikas A. Hardouvelis, 1989. "The term structure as a predictor of real economic activity," Research Paper 8907, Federal Reserve Bank of New York.
  2. Marcelle Chauvet & Simon Potter, 2001. "Forecasting recessions using the yield curve," Staff Reports 134, Federal Reserve Bank of New York.
  3. Mark Gertler & Cara S. Lown, 2000. "The Information in the High Yield Bond Spread for the Business Cycle: Evidence and Some Implications," NBER Working Papers 7549, National Bureau of Economic Research, Inc.
  4. Michael Dotsey, 1998. "The predictive content of the interest rate term spread for future economic growth," Economic Quarterly, Federal Reserve Bank of Richmond, issue Sum, pages 31-51.
  5. Raffaella Giacomini & Barbara Rossi, 2006. "How Stable is the Forecasting Performance of the Yield Curve for Output Growth?," Oxford Bulletin of Economics and Statistics, Department of Economics, University of Oxford, vol. 68(s1), pages 783-795, December.
  6. Jonathan H. Wright, 2006. "The yield curve and predicting recessions," Finance and Economics Discussion Series 2006-07, Board of Governors of the Federal Reserve System (U.S.).
  7. Bernanke, Ben S, 1983. "Nonmonetary Effects of the Financial Crisis in Propagation of the Great Depression," American Economic Review, American Economic Association, vol. 73(3), pages 257-76, June.
  8. Arturo Estrella & Mary R. Trubin, 2006. "The yield curve as a leading indicator: some practical issues," Current Issues in Economics and Finance, Federal Reserve Bank of New York, vol. 12(Jul).
  9. James H. Stock & Mark W. Watson, 2001. "Forecasting output and inflation: the role of asset prices," Proceedings, Federal Reserve Bank of San Francisco, issue Mar.
  10. Hamilton, James D & Kim, Dong Heon, 2002. "A Reexamination of the Predictability of Economic Activity Using the Yield Spread," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 34(2), pages 340-60, May.
  11. Friedman, Benjamin M & Kuttner, Kenneth N, 1992. "Money, Income, Prices, and Interest Rates," American Economic Review, American Economic Association, vol. 82(3), pages 472-92, June.
  12. Arturo Estrella & Anthony P. Rodrigues & Sebastian Schich, 2000. "How stable is the predictive power of the yield curve? evidence from Germany and the United States," Staff Reports 113, Federal Reserve Bank of New York.
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