The Funds Rate Gap as a Predictor of Recessions

Policymakers have become more concerned about an inverted yield curve because a faster pace of rate hikes makes an inversion more likely and because inversions precede recessions. Another recession signal is a rise in the fund’s rate above its estimated neutral. These signals will often occur together because they both reflect a tightening of monetary policy that is especially aggressive.  

Measuring the Funds Rate Gap 

We define the “funds rate gap” as the difference between the real fund’s rate and the FOMC’s estimate of r star. We assume r-star was 2½% before 2012 (when the FOMC first reported rate projections), after which we take participants’ median estimate asr-star.i 

When the Funds Rate Moves Above Its Neutral Rate, A Recession Follows 

Figure 1 shows the funds rate gap since 1961 with recessions shaded. Every time the fund’s rate has risen above the estimate of the real neutral rate, a recession has quickly followed. And, over this period, there has never been a recession when the fund’s rate did not previously move above its neutral rate.  

We project that the funds rate will move to ½ percentage point above neutral by 2020. 

The Funds Rate Gap in a Probit Model 

Table 1 shows a probit regression with the fund’s rate gap as the independent variable. The coefficient on the fund’s rate gap is positive and significant; the probability of recession increases with the fund’s rate gap. 

Figure 2 shows the probability of recession over the next four quarters based on that regression. Based on that regression, the probability of a recession over the next four quarters is only 10% today. In our forecast,  the fund’s rate gap increases and becomes positive by 2019. By 2020, the probability of a recession has increased to 20%. 

While the probability of recession over the next four quarters is estimated at only 20% in 2020, the probability of recession ahead of the two past recessions was also only about 20% to 30%.

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