The Yield Curve vs. Unemployment Rate in Predicting Recessions

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Economists look at several indicators when gauging whether the economy is heading toward a recession. A recent Economic Synopses essay examined the predictive power of two of the most commonly used indicators: the yield curve and the unemployment rate.

Business Economist and Research Officer Kevin Kliesen explained how these two indicators are used in evaluating the likelihood of a recession:

• The yield curve inverts, meaning that interest rates on short-term Treasuries become higher than longer-term Treasuries.
• The unemployment rate declines to a trough, and then begins to climb back up.

Kliesen noted that both scenarios regularly occur prior to a recession. (Graphs depicting these trends are available in his essay, “Recession Signals: The Yield Curve vs. Unemployment Rate Troughs.”)

Kliesen then examined whether unemployment rate troughs are better indicators of recessions than yield curve inversions. The tables below review the past seven recessions, noting how long before the recession took hold that the unemployment rate hit a trough and the yield curve inverted.

Kliesen noted that, on average, unemployment rate troughs occurred about nine months before a recession hit, while yield curve inversions happened about 10 months before. “The table also indicates that, on average, the unemployment rate increases by 0.4 percentage points over the eight-month period between the trough and the NBER-defined peak,” he wrote.

“Overall, both indicators tend to be reliable signals of a coming recession,” Kliesen concluded. “But as with all recession signals, the wise economic analysts should examine many indicators rather than betting the farm on one or two.”

He pointed out that the unemployment rate can move up and down during an expansion, so knowing that the rate has hit a trough may not be possible. “For example, from October 1962 to February 1963, the unemployment rate rose from 5.36 percent to 5.95 percent, only to resume falling afterward,” Kliesen noted.

Also, while yield curve inversions are clear when they happen, “false positives have also occurred with the yield curve, such as the one that occurred in 1966.”

• Economic Synopses: Recession Signals: The Yield Curve vs. Unemployment Rate Troughs
• On the Economy: Why Were Young Families Hit So Hard by the Recession?
• Dialogue with the Fed: Staying Ahead of the Yield Curve