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A Strong Signal That Recession Is Looming

The clearest signal that the U.S. economy is likely to fall into a recession in the next year is coming from interest rates. One of the first people to establish the signaling value of interest rates was Arturo Estrella, then an economist at the Federal Reserve Bank of New York. I interviewed him recently about his life, his research and what he foresees for the economy.

Before I get to Estrella, though, here’s the chart that has a lot of economists, including him, deeply worried. It shows the path of yields this year on two Treasury securities, the three-month bill and the 10-year note. More than 90 percent of the time the yield on the shorter-term security is lower than the yield on the longer-term security. When the pattern flips, as it did this year, it’s a strong signal that a recession is nigh.

Using monthly averages for the two securities, Estrella calculates that there’s about a 95 percent chance of a recession in the coming year. (Other economists analyze different pairs of securities, such as two-year versus 10-year notes, and consequently get slightly different results.)

To see why Estrella is so certain, picture a narrow band where short- and long-term rates are roughly equal. Inside that band, it’s hard to say what will happen to the economy. But things are much clearer when there’s a noticeable gap between short- and long-term rates, in either direction.

Estrella has calculated that going back to 1968, every time the long-term rate was at least 0.07 percentage points higher than the short-term rate, the economy escaped recession. And every time the long-term rate became at least 0.07 percentage points lower than the short-term rate, the economy entered a recession within six to 17 months. The average gap so far in December is 0.81 percentage points, which is the biggest since 1981 and deep into recessionary territory.

Why would the “inversion of the yield curve,” as the flipping phenomenon is called, tell us anything about the economic outlook? It’s pretty simple, actually. The Federal Reserve has strong influence over short-term interest rates. When it raises them — usually to snuff out inflation — it makes borrowing more expensive, which often goes too far and causes a recession. At the same time, longer-term rates can decline because of expectations of lower inflation or a decline in the “real” (inflation-adjusted) rate of interest. Those expectations intensify when a recession appears likely.

A 1989 New York Fed research paper by Estrella and Gikas Hardouvelis, later published in the Journal of Finance, was the first to establish that an inversion of the yield curve predicted recessions, although some other scholars, including Campbell Harvey of Duke University’s Fuqua School of Business, had looked more generally at the yield curve’s predictive value. Frederic Mishkin, a Columbia University economist who spent time as Estrella’s boss when Mishkin was the New York Fed’s research director, told me: “Arturo was a top intellect. Boy, he really had the goods.”

Estrella has a story about how he accidentally angered E. Gerald Corrigan, who was the president of the New York Fed at the time. A Fed governor in Washington had put out a request for research on whether there was predictive power in the yield curve and Corrigan put his people to work on it, hoping to show that the answer was no. Not knowing of Corrigan’s preferences, Estrella innocently reported in a big meeting that yes, indeed, his research showed that the yield curve had predictive power. “His reaction was not something you can print in the paper,” Estrella said. “I thought I was going to get fired. A few months later, I was transferred to bank supervision.” (Albeit with a promotion.)

Estrella told me his interest in the predictive power of interest rates dates back to his childhood in San Juan, P.R., where he attended Catholic schools. “My math teacher was a nun,” he said. “She was also in charge of the music program. We hit it off very well.” He earned a bachelor’s degree in philosophy at Columbia with a special interest in Ludwig Wittgenstein, the kind of philosopher beloved by the technically minded. He followed that with master’s degrees in math at the University of Puerto Rico and the University of Michigan and a doctorate in economics at Harvard.

Estrella left the Fed in 2008 and taught at Rensselaer Polytechnic Institute in Troy, N.Y., until 2018, when he took emeritus status. I asked him what he thinks of the Fed’s aggressive rate increases. “It’s a very difficult line to draw, whether something is necessary to control inflation or not,” he said. “I don’t know if what they’re doing right now is necessary. My gut feeling is that they’re going too far.”

About three-quarters of occupations in the United States became more “age-friendly” between 1990 and 2020, but a lot of the new jobs were filled by young people, according to a working paper released on the National Bureau of Economic Research website in September. “Many of these age-friendly jobs have been taken up by females and college graduates, as the occupational characteristics preferred by older workers (e.g., flexibility, office work, less strenuous demands, etc.) also appeal to these groups,” wrote Daron Acemoglu of Massachusetts Institute of Technology, Nicolaj Sondergaard Muhlbach of Aarhus University in Denmark and Andrew J. Scott of London Business School.

“‘Innovation’ and ‘creativity’ are now tedious obligations of every middle manager and worker, having lost whatever modernist zeal they once had.”

— William Davies, “Economic Science Fictions” (2018)


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