Federal Reserve Bank of Chicago

Link: https://www.chicagofed.org/publications/chicago-fed-letter/2022/469

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We simulate future realizations of the policy gap and the slope of inflation forecasts from the 2022:Q2 initial conditions through 2023:Q4 using the ABC model. We then evaluate the recession probability predicted by our preferred probit model for each of these simulated paths. Through this analysis, we show that future inflation outcomes and the odds of a recession depend critically on both the pace of removal of monetary policy accommodation and on how restrictive the monetary policy stance will become over the medium term. In particular, we highlight two scenarios: The first one, which we refer to as the “baseline case,” reflects the ABC model forecasts or, equivalently, the average of all simulated paths. The second one, which we label the “tighter-policy scenario,” is characterized by a faster removal of monetary policy accommodation; it is identified by the average of the simulated paths in which policy becomes restrictive by the end of 2022.¹¹
1. Baseline case: As of early June 2022, the ABC model predicts that nominal and real yields will rise over the next six quarters, the current policy gap will narrow and become mildly restrictive in mid-2023, while core inflation will fall and remain around one percentage point above its model-implied longer-run expectations through 2023 (figure 2, blue lines in panels A and B). The expected tightening of the policy gap and a downward-sloping expected inflation path combine to increase the one-year-ahead recession probability to about 35% by 2023 (figure 2, blue line panel C). Such a level is comparable to the one estimated ahead of the 1994 monetary policy tightening cycle that was followed by a soft-landing scenario.
2. Tighter-policy scenario: In this alternative scenario, monetary policy becomes more restrictive than in the baseline case, in that the policy gap is markedly restrictive over 2023. In this case we find that core inflation declines more rapidly than under the baseline, closing the gap with its model-implied longer-run expectations almost completely by the end of 2023. By that date, in this scenario the likelihood of a recession approaches 60%, a level that, based on our historical estimates, is generally followed by a recession in our sample (figure 2, red lines).

Author(s): Andrea Ajello , Luca Benzoni , Makena Schwinn , Yannick Timmer , Francisco Vazquez-Grande

Publication Date: August 2022

Publication Site: Federal Reserve Bank of Chicago

Link: https://www.chicagofed.org/publications/economic-perspectives/2021/1

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Excerpt:

The first observation in the United States motivating the GSG hypothesis is the protracted decline in long-term real interest rates, as shown in figure 1. This figure depicts both a Treasury Inflation-Protected Securities (TIPS) rate and an expected long-term real interest rate, computed by subtracting from the nominal yield on ten-year Treasury securities the measure of ten-year expected inflation from the Survey of Professional Forecasters (SPF).⁸ From 2003 on, the TIPS rate is for the ten-year TIPS. Before 2003, we use a 30-year TIPS rate, data for which are available starting in 1998, subtracting 40 basis points from it to reflect the average term premium observed in the years when both the ten-year and 30-year TIPS are available. At the time Bernanke first articulated the GSG hypothesis, much of the focus was on Greenspan’s conundrum—that is, the continuing drop in long-term rates in 2004–05 despite repeated hikes in short-term rates during a strong economy. However, with the benefit of hindsight, the much longer-run, apparently secular nature of the drop in long-term real interest rates is evident. Very roughly, it seems fair to say that the ten-year real interest rate in the United States declined about 150 basis points between the latter half of the 1990s (when it averaged around 3.5 percent) and the prelude to the global financial crisis (when it averaged around 2 percent), and then it fell another 200 basis points commencing with the collapse of Lehman Brothers in September 2008 and continuing to the present. While the first drop of 150 basis points is very plausibly a consequence of capital inflows, the post-crisis drop of 200 basis points is unlikely to be attributable primarily to the GSG;⁹ instead, that second drop suggests a somewhat parallel story of weak domestic investment in the United States.

Author(s): Robert Barsky , Matthew Easton

Publication Date: March 2021

Publication Site: Federal Reserve Bank of Chicago

Tag: Federal Reserve Bank of Chicago

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