Wednesday, 02 May 2018 13:00

So, are we headed for a recession? Here’s what the Fed looks for

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How to know if there’s a recession monster lurking — there’s no single indicator, alas.

It’s the topic gripping markets as the U.S. economy approaches the longest expansion on record: When will the U.S. fall into recession, and how will we know?

The bad news is, there’s no single variable that can tell you a recession is about to come. But it turns out that a few, in combination, give you a pretty good idea. According to the St. Louis Fed[1], this is what usually happens before a recession:

• Oil prices have shot up ahead of nearly every post-war recession; asset bubbles swelled before the two most recent recessions; and the yield curve has inverted before all recessions since 1960.

So with that in mind, MarketWatch has distilled those into four charts — on oil, the yield curve, and simple valuation methods for the stock market and housing.

The yield curve, here, is just the yield on the 10-year TMUBMUSD10Y, +0.38%[2]  minus the 2-year TMUBMUSD02Y, +0.49%[3]  . For the stock market, so-called Tobin’s Q was used, which is the value of stocks divided by the book value. For housing, prices were compared to rent.

Looking at the data above, a few things stand out. For one, oil prices CLM8, +0.13%[4]     are on the upswing, as OPEC has acted to limit supply.

The stock market DJIA, -0.27%[5]   doesn’t appear to be as overvalued as the dot-com boom, and the housing market doesn’t appear to be as overvalued as it was during the subprime boom. Interestingly, what’s different from the run-up to the last two recessions is that both markets appear to be overvalued at the same time.

One piece of good news, is that yield curve hasn’t inverted, though it has flattened out considerably.

The question of precisely why an inverted yield curve is a good predictor of a recession is still a matter of debate.

A March paper from the San Francisco Fed [6]offered this explanation: “Long-term rates reflect expectations of future economic conditions and, while they move up with short-term rates during the early part of an expansion, they tend to stop doing so once investors’...

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