Tim Duy: "The risk of recession has risen to levels that demand attention from the Fed"

From Tim Duy's Fed Watch, 24 March 2019:

Everyone has their pet recession indicator; many are probability models based on some combination of yield spreads and other leading indicators. Most will be raising red flags like this estimate of the probability of recession in six months based on the 10s2s and 10s3mo spreads and initial unemployment claims:

... The risk of recession has risen to levels that demand attention from the Federal Reserve. In the two cases of similar spikes in the 1990s, a recession was avoided by the rapid response of the Fed in the form of rate cuts. The times that response was lacking, a recession followed.

So now I switch from analyst to commentator: The above leads me to the conclusion that the Fed needs to get with the program and cut rates sooner than later if they want to extend this expansion.

If you're going to look at "yield spreads" as a recession indicator, you're going to have to explain why, in the 1990s, the yield curve inversions did not lead to recession. Tim Duy explains it.

I wanted to see what Duy was looking at, so I took his graph, erased the background, and used the graph as an overlay on a FRED graph of the Federal Funds rate.

The Fed Funds rate is the red line. The dates, the text, and the Y-axis values on the FRED graph are also red. The Y-axis is on the right. (I remember the days when a FRED graph had to have a left-hand scale. If you showed only one data series, you couldn't show it using a right-hand scale. Now you can. That's a handy feature.)

I matched up the two graphs using the X-axis tic marks. FRED's are faint and hard to see through the overlay, but they are there. (You can click the graph to get a better view.)

Tim Duy's graph overlaid on FRED's FEDFUNDS

I see what Duy is talking about. FedFunds (red), running low in 1993 (just above Duy's green line), then rising to the 6.0 level on the right-hand scale, then dropping just a little. And just as it stops dropping, the probability of recession (blue) falls to near zero. The "red-drop, blue-drop" pattern repeats in 1998. I see it. Alan Greenspan postponed the recession by lowering interest rates. Twice.

Looking at recession probability spiking upward at the right end of his graph, Tim Duy says

The risk of recession has risen to levels that demand attention from the Federal Reserve.

He says, and we saw, that

In the two cases of similar spikes in the 1990s, a recession was avoided by the rapid response of the Fed in the form of rate cuts.

Reinforcing that observation with symmetry and thoroughness, Duy adds

The times that response was lacking, a recession followed.

Duy makes a good case.

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