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Predicting recessions: financial cycle versus term spread

Summary:
This paper is an extension of "The financial cycle and recession risk", BIS Quarterly Review, December 2018, by the same authors.  BIS Working Papers  |  No 818  |  11 October 2019 by  Claudio Borio, Mathias Drehmann and Dora Xia PDF full text (323kb)  |  29 pages 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

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

BIS Working Papers  |  No 818  | 
11 October 2019
PDF full text
 (323kb)
 |  29 pages

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

International Settlement
The Bank for International Settlements (BIS) is an international company limited by shares owned by central banks which "fosters international monetary and financial cooperation and serves as a bank for central banks". The BIS carries out its work through subcommittees, the secretariats it hosts and through an annual general meeting of all member banks. It also provides banking services, but only to central banks and other international organizations. It is based in Basel, Switzerland, with representative offices in Hong Kong and Mexico City.

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