ST. LOUIS — A recent survey of research by the St. Louis Fed shows that the term spread, which is the difference between the yields on long-term and short-term Treasury securities, remains a useful indicator for predicting economic activity, particularly in forecasting recessions and output growth up to one year in advance.
"Can the Term Spread Predict Output Growth and Recessions? A Survey of the Literature" appears in the September/October edition of the Review, the St. Louis Fed's bi-monthly journal of economic and business issues. The article was written by David Wheelock, St. Louis Fed vice president and economist, and Mark Wohar, University of Nebraska at Omaha economics professor.
"Does the yield spread forecast output growth? Does it forecast recessions? The answer to both questions is a qualified yes," Wheelock and Wohar said.
"In general, studies show that the term spread is a more reliable predictor of recessions than of output growth and that the spread provides good recession forecasts, especially for up to one year ahead."
Nonetheless, Wheelock and Wohar found that most empirical research to date finds the spread remains useful for forecasting output growth, especially at horizons of six to 12 months. It also remains useful even if other variables, including measures of monetary policy, are added to the forecasting model. However, several recent studies have also found that the spread's ability to predict growth varies across countries and has diminished since the mid 1980s.
"For example, the term spread is likely to forecast output growth better when the monetary authority is more responsive to output than inflation, and when inflation is relatively persistent," they said.
To chart the term spread, see the St. Louis Fed’s free FRED® (Federal Reserve Economic Data) charts.
Simply add in the FRED® series code for the three-month Treasury security, DGS3MO, in the "Add Series" box on the top of the chart, and click on "Edit Graph."
With branches in Little Rock, Louisville and Memphis, the Federal Reserve Bank of St. Louis serves the Eighth Federal Reserve District, which includes all of Arkansas, eastern Missouri, southern Indiana, southern Illinois, western Kentucky, western Tennessee and northern Mississippi. The St. Louis Fed is one of 12 regional Reserve banks that, along with the Board of Governors in Washington, D.C., comprise the Federal Reserve System. As the nation's central bank, the Federal Reserve System formulates U.S. monetary policy, regulates state-chartered member banks and bank holding companies, provides payment services to financial institutions and the U.S. government, and promotes community development and financial education.