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Introduction
An inverted yield curve—defined as an episode in which long-maturity Treasury yields fall below their short-maturity counterparts—is a powerful near-term predictor of recessions. While most previous studies focus on the predictive power of the spread between long- and short-maturity Treasury yields, Engstrom and Sharpe (2019) have recently shown that a measure of the nominal near-term forward spread (NTFS), given by the difference between the six-quarter-ahead forward Treasury yield and the current three-month Treasury bill rate, dominates long-term spreads as a leading indicator of economic activity.

Why does the NTFS predict recessions?
In this note we explore the economic forces that shape the NTFS dynamics and identify channels through which the NTFS forecasts recessions. In particular, we highlight the roles of the current stance of monetary policy and short-term inflation expectations in predicting downturns. Moreover, we examine the tradeoff between the Federal Reserve's ability to reduce inflation by increasing the federal funds rate and the effect of such intervention on the estimated likelihood of an upcoming recession.

The NTFS is an informative gauge of market-participants' expectations about future near-term monetary policy actions, such as the raising and lowering of the federal funds rate by the Federal Reserve. Thus, it carries information about current and near-term real interest rates, future expected inflation, and the interest rate forward risk premium (or term premium), which in turn are linked to expectations of future business cycle outcomes.

Building on these insights, we decompose the NTFS into four terms: the current and expected stance of monetary policy, measured as the policy gap between current or expected short-term real rates and their longer-run equilibrium level (r∗); the slope of inflation forecasts; and the term premium on the short-maturity forward yield. We explore the effect of these channels on the estimated probability of a recession and find that the power of the NTFS mostly lies in the information contained in the current real rate gap and the slope of short-run inflation expectations. In contrast, the near-term expected policy gap and the near-term premium contain little information that predicts downturns.

We perform the NTFS decomposition with the dynamic term structure model of Ajello, Benzoni, and Chyruk (2020, ABC), estimated on quarterly Treasury yields and inflation data from 1962Q2 to 2022Q2. The ABC model provides a good fit of the yield curve as well as core and headline inflation, both in and out of sample—an important requirement to decompose the sources of information contained in the NTFS that we exploit in this study.4 We focus on a long sample period that starts in the early 1960s to inform the analysis with data from the inflationary episodes from the 1960s through the early 1980s, as well as data from later years during which inflation realizations and expectations declined.

Using the variables from the NTFS decomposition, we estimate a probit model that predicts the probability of a recession in the U.S. economy over the next twelve months. We find that tighter current monetary policy relative to a neutral stance, i.e., a narrower current policy gap, and a downward near-term slope of the expected inflation path are significant predictors of recessions. In contrast, the near-term expected policy gap and the near-term premium contain little information that predicts downturns. Moreover, we show that the quality of fit and the predictive ability of our model is at par with other probit specifications that only include nominal yield spreads data.

https://www.federalreserve.gov/econres/notes/feds-notes/monetary-policy-inflation-outlook-and-recession-probabilities-20220712.htm

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