Perfect Recession Predictors

Abstract

Define a perfect recession predictor as one that correctly predicts every recession and does not falsely signal a recession when one does not occur. The benchmark spreads (10-year minus 2-year and 10-year minus 3-month term spreads, and the nearterm forward spread) are far from perfect, and generate up to 59 mispredictions from 1962 to now. Using a supercomputer to search over 645 million series of forward and term spreads that are averaged over different horizons, we discover 83 perfect spreads. In contrast to the benchmark spreads, the perfects tend to be forward spreads starting 4 years out with a moving average of about a year. We use a New Keynesian model to rationalize these features of the perfects and highlight the underlying economic mechanisms. Finally, we expand on the concept of perfect spreads to construct recession-predicting indices and show their superior statistical performances compared to the benchmarks.