(The Center Square) – When interest rates on short-term bank deposits or bonds are higher than long-term products, a recession could be around the corner, according to an analysis by the St. Louis Federal Reserve.
In response to high inflation in 2022, the Federal Open Market Committee increased its federal funds rate from between 0% and 0.25% to the current levels of 5.25% to 5.5%. Inflation has receded from highs of approximately 10% last year, but the effects of higher interest rates will continue to influence the economy.
Christopher J. Neely, a vice president at the St. Louis Fed, analyzed the yields of short-, medium- and long-term bank deposits and bonds. He found short-term rates are now higher than long-term rates and have been for most of the last 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 blog post.
“The model is not perfect, however; there were false positives – that is, high probabilities of recession when no recession occurred – in the late 1960s and late 1990s,” Neely wrote.
While there are multiple reasons why yields can predict recession, he wrote there are two common theories. One, short-term interest rates rise when the Fed raises rates, making it more expensive to borrow for investment and consumption, therefore slowing the economy. Two, low medium- and long-term interest rates reveal low investment and growth in the future.
Neely’s analysis of differing yields and expected inflation rates showed how trends preceded recessions in 1975 and 1981.
“In summary, the inverted yield curve is consistent with the claim that currently monetary policy is moderately restrictive and that there is a relatively high probability of recession in the next 12 months,” Neely wrote. “But no forecast is certain.”
Neely added the models predict 40%, 50% and 60% probabilities of recessions, which shows a likelihood the economy won’t be adversely affected.
“In addition, one should remember that forecasting relations can and do break down,” Neely wrote. “Past success doesn’t guarantee future results. Information from other sources can give us greater confidence in, or suggest skepticism about, the yield curve forecasts.”