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The Odds On A U.S. Recession


Economic Trends

THE ODDS ON A U.S. RECESSION

The yield curve says they're rising

With some 40% of the world economy already contracting, fears are growing that the U.S. itself will be dragged into recession. While most economists believe it can avoid this fate--particularly with the Federal Reserve's shift toward monetary ease--most also admit that the risks of recession have risen in recent months.

One way of assessing those risks is to relate them to the shape of the yield curve--the spread between interest rates on debt securities with different maturities. Among the most sensitive of leading economic indicators, the yield curve is normally upward-sloping, with short-term rates lower than long-term rates. An upwardly sloping curve points to expanding economic activity ahead.

When the curve flattens or inverts, on the other hand, it almost invariably signals a coming slowdown or contraction. As it happens, the slope of the curve has been dropping sharply over the past year and has recently been almost flat. Even after the Fed's recent quarter-point rate cut, virtually the entire spectrum of interest rates is now below the rate on overnight money set by the Fed.

In 1996, a study by economists at the Federal Reserve Bank of New York found that the yield curve was a far better predictor of coming recessions than a number of other leading economic variables, including stock prices and the index of leading indicators. Using data from 1960 to 1995, the researchers constructed an index of the probability of a recession occurring four quarters ahead, based on how much interest rates on 10-year Treasuries exceed or fall below those on 3-month Treasury bills.

Back in early August, this spread was positive by about 0.45 of a percentage point, indicating that the chance of a recession in a year's time was only 15% or so, according to the New York Fed study. But since then the spread has almost disappeared (chart), raising the risk of a recession in 1999 to 25%. (For the risk to exceed 50%, 10-year rates would have to fall below 3-month rates by 0.83 of a percentage point.)

While a 25% recession risk may appear small, it's noteworthy that the spread gave off exactly the same signal in late 1989, a year before the 1990 recession. Moreover, the researchers point out that the yield curve has been a lot less variable in the 1990s than in earlier decades, lessening the likelihood of strong recessionary signals.

Many economists see the odds of a downturn next year as even greater. Salomon Smith Barney puts the risk at 35%. James Glassman of Chase Securities Inc. places it at 50%. And Standard & Poor's DRI believes the chance of a recession occurring before the end of 2000 now stands at 50-50.

Indeed, at least one forecaster, David A. Levy of the Jerome Levy Economics Institute at Bard College, thinks the odds of a 1999 recession have risen to 75%.BY GENE KORETZReturn to top

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HOW TAX CUTS AFFECT THE RICH

They don't inspire longer hours

One of the major arguments for tax cuts and low tax rates at the high end of the income scale is that they promote behavior that improves economic efficiency and fosters growth. Specifically, the lower taxes on income are, the more likely people are to work, save, and invest. Because the earnings of highly paid people in a market system reflect high relative productivity, the payoff for society from tax cuts on high incomes, it has been claimed, should be particularly large.

At least as far as work time is concerned, however, the impact of tax cuts on high-income individuals appears exaggerated, report economists Robert A. Moffitt of Johns Hopkins University and Mark Wilhelm of Indiana University-Purdue University at Indianapolis. In a new study, they examine how the work habits of high-salaried men were affected by the 1986 tax reform act. Since the act, which created two basic rates of 15% and 28%, reduced marginal tax rates for the affluent far more than for other taxpayers (the top rate was 50% prior to its passage), one might expect to find them putting in longer hours.

Yet the study, whicH looked at some 500 affluent working men in both 1983 and 1989, found no increase at all in their work time--even though their real take-home pay rose appreciably as a result of both the tax cut and pay hikes. And the reason seems to be that many were already working their butts off.

"Such men," the authors write, "were already working such long hours (often over 3,000 per year) that there was little remaining opportunity for response to lower taxation."BY GENE KORETZReturn to top


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