Fed Using Model That Failed to Predict 5 Recessions
By, DARYL MONTGOMERY
Jul 09, 2010
The Federal Reserve uses a yield curve based model to predict recessions. This model is currently predicting only a 10% chance of a double-dip. This shouldn't make investors confident though since the model failed to predict the Great Recession and four other major recessions as well.
The Federal Reserve is confident that a double-dip recession won't be taking place. One of the major forecasting tools they use to determine this is yield curve analysis. This approach has never really worked and can't possibly work in a ZIRP (zero interest rate policy) environment.
According to their yield curve model, the Fed is predicting there is only a 10% chance of a recession in the near future. Before breathing a sigh of relief, investors should ask themselves how well this model has worked in the past. Here are the relevant questions and answers:
Did the model accurately predict the 2007-09 recession, the worst since the Great Depression? Well, no it didn't.
Did the model accurately predict the 2001 recession? Err, well no it didn't do that either.
Did the model accurately predict the 1990-91 recession? Well, it missed that one as well.
Did the model predict the huge downturn in 1973-75? Well no, it failed then too.
Did the model predict the 1969-70 downturn? No, it missed that one also.
The only time the model predicted a greater than 50% chance (and it was only a little above 50%, so the prediction was basically no better than tossing a coin) of a recession was for the 1980 and the 1981-82 recessions. This had nothing to do with the double dip nature of those recessions, but was a factor of the high interest rate environment that made it possible for short-term interest rates to be higher than long-term rates. It is quite obvious that the higher interest rates are, the better this model works. The model in fact can't work at all when short-term rates are close to zero as they are now. In such circumstances, the yield curve can't invert because nominal long-term interest rates would have to be negative - an impossibility. So with our current low interest rates, the Fed model will never predict a recession.
As usual when the economy is falling apart, the Fed is making its usual positive comments of how things are really in good shape and the public should ignore all the reality-based signs of trouble. Dallas Fed President Richard Fisher was on CNBC on Wednesday and stated with confidence, "while the recovery has slowed, it is unlikely the U.S. will fall back into recession". The Fed was also very confident of avoiding the Great Recession as well and continued to say so long after the recession had begun.
Mr. Montgomery is Author of Inflation Investing – A Guide for the 2010s. He's an independent market strategist and trader along with organizer of the New York Investing meetup.
