The Role of Financial and Macroeoconomic Conditions in Forecasting Recession

Abstract

The question of what is the economic environment that is most likely to anticipate a recession is still open, as the literature has emphasized either the importance of deteriorating financial conditions and that of worsening macroeconomic indicators. Using a probit forecasting model, we show that measures of market stress and the inflation-unemployment situation have concurred to predict recessions in the United States and the United Kingdom at least since late 1990s, improving standard specifications based on the yield curve slope alone. The predictive power of financial and macro factors has changed over time: weakening financial conditions were central in forecasting recessions in the early 2000s, while both factors have been equally important before the Great Recession. Following the post-Covid recovery, the strongest signals have come from record high inflation and tight labor markets, leaving central banks between a rock and a hard place: either tighten, increasing recession risks, or accept high inflation to avoid a hard landing.

Keywords: recession, yield curve slope, financial conditions, monetary policy tightening, inflation, probit

JEL Classification: D81, E31, E32, E37, E44