CALCULATING PROBABILITY OF A RECESSION

A quick way to discern if the United States is nearing a recession is to generate an
estimate of the probability of a recession based on the Federal Reserve hypothetical
model. The formula (for those who want to set up an Excel spreadsheet) is (www.federal
reserve.gov/releases/h15/update/):
NORMSDIST(−2.17 − 0.76*(10Year − 3Month) + 0.35*FederalFundsRate)
Where:
10Year = 1-quarter Average of Daily 10-Year Constant Maturity Treasury Yields
3Month = 1-quarter Average of Daily 3-Month Constant Maturity Treasury Yields
Federal Funds Rate = 1-quarter Average of Daily Federal Funds Rates
The easiest way to do the calculations is to link to the following web site and input
the data required in the formula. You can easily get the value of the 10-year Treasury bond, the 3-month yield, and the federal funds rate at www.federalreserve.gov/releases/
h15/update/. Once you get the value of the 10-year Treasury bond and the 3-month
yield, simply input their values into the inversion calculator, available at http://political
calculations.blogspot.com/2006/04/reckoning-odds-of-recession.html.
On March 21, according to the current model, the probability of a recession due
to the relationship between the 10-year and 3-month bond yield curve was 52 percent.
Table 3.2 shows the data inputs giving this result. One month later, on April 21, the data
showed that the probability of a recession was even lower, at 45.9 percent. These probabilities
are the results of models. They are not guarantees but do give insights into what
the professional economists are thinking.
A further visualization of the relationship between a recession and the yield curve as
developed by the Federal Reserve researchers is shown in Figure 3.3. Obviously, a great deal of work is being constantly done by economists to try to pinpoint the probability of

a recession.
A S S I G N M E N T
Using the Formula in this Section, Calculate the Probability of a Recession on
a Weekly Basis
Check whether the probability is rising or falling as you are monitoring the results. At the same
time, ask yourself the question: Is the dollar getting stronger or weaker? Doing this assignment
will help you sharpen your understanding of sentiment toward the dollar and whether that
sentiment reflects economic fundamentals.


By ABE COFNAS