Predicting recessions: financial cycle versus term spread

This paper is an extension of "The financial cycle and recession risk", BIS Quarterly Review, December 2018, by the same authors. 

Focus

Since the mid-1980s, the nature of recessions has changed from inflation-induced to financial cycle-induced recessions. Against this backdrop, this paper formally assesses the forecasting performance of financial cycles to predict recessions in a panel of countries. We compare the signalling power of financial cycle measures with that of the term spread, a widely used benchmark in the literature.

Contribution

While a large body of literature finds that financial cycles matter for the real economy, research exploring how they affect the likelihood of a future recession is scant. We fill this gap.

Moreover, to ensure generality, we evaluate the forecasting performance of financial cycle measures not only for the United States but also for a panel of advanced and emerging market economies. This is in contrast to much of the literature, which focuses solely on the United States.

Findings

We find that financial cycle measures have significant forecasting power both in and out of sample. They generally perform better than the term spread across different economies and different forecasting horizons. And these results are robust to different recession specifications.

Abstract

Financial cycles can be important drivers of real activity, but there is scant evidence about how well they signal recession risks. We run a horse race between the term spread - the most widely used indicator in the literature - and a range of financial cycle measures. Unlike most papers, ours assesses forecasting performance not just for the United States but also for a panel of advanced and emerging market economies. We find that financial cycle measures have significant forecasting power both in and out of sample, even for a three-year horizon. Moreover, they outperform the term spread in nearly all specifications. These results are robust to different recession specifications.

JEL codes: C33, E37, E44

Keywords: financial cycle, term spread, recession risk, panel probit mode