Fed “Workhorse” Model Says Odds Of Recession In Next Year Only 3.56%; What Are The Real Odds?

Of all the ridiculous opinions as to why the US is not about to enter a recession, the Fed’s “Workhorse” Model is at the top of the list. 

 Torsten Sløk, chief international economist at Deutsche Bank, is taking the optimistic route by drawing attention to a certain economic model that currently puts the chance of an imminent contraction in the single digits. The Federal Reserve’s so-called probit model looks at the difference between 10-year and three-month U.S. Treasury rates to gauge the probability of a U.S. recession over the next 12 months.

“The Fed has a workhorse recession model where [the] yield curve today is a predictor of future recessions, and running the Fed’s probit model with today’s values for 10-year and 3-month rates shows that there is currently a 4 percent probability of a recession over the next 12 months,” Sløk said in an e-mail.

The Model

Prepare to have your eyes gloss over because here is the model.

Highlights in yellow are mine. Note that two constants are estimated using data from January 1959 to December 2005. Not only that, the constants were fitted to match what happened. Lovely. 

Practical Considerations

Those hand-picked constants happened to work in prior recessions with varying degrees of success as noted in a New York Fed paper appropriately called The Yield Curve as a Leading Indicator: Some Practical Issues.

The report failed to mention the most practical of practical issues: It’s damn hard for the 3-month to invert with 10-year treasuries when the Fed has artificially held short-term yields closet to zero.

Of course there is a practical reason for the Fed not pointing out that practicality. The article was written in 2006 before short-term yields went to zero.

You might have thought chief international economists would have stopped to consider such practical issues, but you would be wrong.

One might also have thought such issues would have crossed the minds of the New York Fed, but please banish that thought as well. 

The New York Fed research still promotes this ridiculous model on its page The Yield Curve as a Leading Indicator.

You can download the current data to play with in Excel. You can also download the current 12-month look-ahead probability chart.