Monetary Policy, Inflation Outlook, and Recession Probabilities

Abstract

Why does the short-term slope of the yield curve predict recessions? In this Economic Perspectives article, we explore the economic forces underlying Treasury yields’ fluctuations and highlight the roles of a tight monetary policy stance and expectations of lower inflation in predicting downturns. While the monetary policy stance is still accommodative, indicating a low recession probability, the negative inflation slope points to higher odds of a recession within a year. We find that an aggressive removal of policy accommodation increases the recession probability to 60%.

Keywords: yield-curve slope, recession forecasts, monetary policy, bond risk premia, policy path, inflation forecasts, near-term forward spread, Asset Markets and Pricing, Equities, Fixed Income Securities, Business Fluctuations, Cycles, Prices

JEL Classification: G10, G12, E32, E37, E44, E52