Foolproof Recession Indicators

Economist Paul Kasriel at the Northern Trust has come up with a recession indicator that has called six consecutive recessions with no misses and no false positives dating back to 1962. It does, however, have a single miss in 1960. The condition is an inverted yield curve as measured by the 10-year Treasury yield minus the fed funds rate, in conjunction with an annual rate of change falling below zero on the CPI-adjusted monetary base.

With a small tweak in methodology as described below, we can pick up that isolated miss in 1960.

Paul discussed his idea with me in an “Interview With Paul Kasriel,” and I mentioned it in January in “Leading Economic Indicators.”

Comments From Paul Kasriel:

“The ‘real’ unadjusted monetary base (bank reserves plus currency) seems to provide fewer false recession signals than does real M2 growth. That does not necessarily mean that the real base does a better overall job of forecasting real GDP, just that it does a better job of forecasting official recessions.”

Mish Note: “Real” in this case means inflation adjusted via the PCE price deflator, and “unadjusted monetary base” means a nonseasonally adjusted monetary base.

“I have used the PCE price deflator to get ‘real,’ rather than the CPI for purely arbitrary reasons here, not theoretical — I don’t have time to explain now, but it is not a big issue.”

Mish Note: There is a potentially confusing mix of terminology here, but none of the charts in this post were seasonally adjusted (except perhaps for consumer sentiment, and on that I am unsure). Our inflation adjustments used the CPI, and any references to “real” in what I wrote (as opposed to what Kasriel wrote) mean CPI adjusted. As Kasriel suggests, there is little difference between the two. We tried both and settled on using the CPI because that is what Frank Shostak did as explained in “Money Supply and Recessions.”

“Starting with the recession of 1970, a negative spread on the 10-year Treasury minus the fed funds rate in conjunction with a contracting year-over-year change in monetary base/CPI has predicted recessions with no false signals. In Q3 and Q4 of 2005, the real monetary base contracted, but the interest rate spread still was positive. Now, the interest rate spread has turned negative, but the real monetary base is no longer contracting — just barely.”

Kasriel fully explains his theory in the March 22 article, “Recession Imminent? Both the LEI and the KRWI Are Flashing Warning”:

“I have found that every recession starting with the 1970 recession has been immediately preceded by the following combination — a negative spread between the yield on the Treasury 10-year security and the federal funds rate (hereafter referred to as ‘the spread’) on a four-quarter moving average basis and a year-over-year contraction in the quarterly average of the CPI-adjusted monetary base. The monetary base is the sum of bank reserves and coin/currency, both of which have been created out of thin air, as it were, by the Fed.

“[The following chart] shows the historical behavior of the ‘Kasriel Recession-Warning Indicator’ (KRWI)…


“The KRWI has given no false signals in that when it has warned of a recession, there has been one. Unlike the LEI, which signaled a recession for 1967, the KRWI did not. However, the 1960 recession was not signaled by the KRWI, because the spread remained positive, although it did narrow. As of the fourth quarter of last year, the spread moved into negative territory, but the year-over-year change in the real monetary base remained positive. So like the LEI, as of the fourth quarter of last year, the KRWI had not signaled that a recession was imminent…

“Barring upward revisions in the LEI and KRWI and sharp increases in the immediate months ahead, both of these indicators will be sending a signal that a recession is on the horizon. Perhaps this will be the first time in over 45 years that the KRWI will emit a false signal and only the second time that the LEI emits a false signal. Perhaps.”

10-Year Treasury Minus 3-Month Treasury

For comparison purposes, I asked Bart at to put together a chart showing the 10-year Treasury yield minus the three-month Treasury yield (as opposed to the FF rate), just to see what we could find:


Bingo! A perfect seven of seven with no misses and no false positives. The two blue-gray ovals are conditions where only one of two conditions were met.

Note: The above chart was formulated by subtracting $IRX (the three-month Treasury discount) from $TNX (the 10-year Treasury yield). The former is a discount, not a yield, so the chart is slightly off the stated intent, but it is extremely close. I had Bart look at the actual data, and the numbers did go negative intramonth, even if it does not show it on the chart. Using a true yield, instead of a discount, would make the spread more negative, so the signal was definitely given (even if ever so slightly).

Interestingly enough, the 10-year minus the three-month spread by itself has no misses since 1960 (seven for seven), but it did have a single false positive in 1967. The CPI-adjusted monetary base was also seven for seven, but with a false positive in 2005. False positives in isolation are shown in blue-gray ovals. Together, they are perfect.

Thus, by using Kasriel’s idea of a paired set of indicators, but substituting the three-month yield for the fed funds rate, we achieve a perfect seven of seven dating back to 1960, picking up the single miss of Kasriel’s KRWI in 1960.

M Prime Update

M’ is an Austrian money supply indicator that I have been following for some time and started charting (with help from Bart) back in January. See “Money Supply and Recessions” for the theoretical justification of M’.

M Prime and Recessions


An annual rate of change in M’ dipping below the 0% line is a pretty rare event, but does not necessarily lead to a recession. On the other hand, in each of the last six recessions, M’ did have a significant dip (though not as severe as the one we see now).


  • The sweeps data is notoriously late. I am not sure why. The latest data we have are for January. We extrapolated that data forward for two months. That is the best we can come up with at this time
  • The biggest difference between M’ and M1 is in sweeps data. M’ properly picks up sweeps data, while M1 has been distorted since 1995 by the lack of them
  • Kasriel mentioned to me in the interview that he felt the Fed includes sweeps data in its M1 analysis. We get the data from an obscure Fed publication that is not updated very frequently. Why aren’t sweeps data part of the mainstream data and more up to date?
  • We took this series back as far as we could find data. Unfortunately, that is no further than 1968.

Real M Prime (CPI Adjusted) and Recessions


As far as predicting recessions goes, the above chart is clearly an improvement over M’ straight up. The CPI-adjusted M’ gives off very strong but not perfect recession warning on a cross of the 0% line on an annual rate of change basis. In conjunction with an inverted yield curve, M’ is a perfect six of six with no false positives.

Unless it’s different this time, another recession is headed our way. Depending on whether one uses M’ or the monetary base as a starting point (either will do in conjunction with the 10-year-minus-three-month-Treasury spread), we are headed for a perfect seven of seven or eight of eight in recession predictive ability (with the difference being how far back the data series goes). Both sets have no misses and no false positives. None of this even takes into consideration the mess in housing, which is a pretty good leading indicator in and of itself.

Those looking at M2 or M3 alone as proof of economic expansion or as some sort of inflation picture are missing the big picture. The economy is slowing far faster than most think by the three best leading indicators one can find (the yield curve, rates of change in M’ or monetary base, and housing). Financial speculation as evidenced by growth in M3 and the final buildout of retail stores already under construction are all that is keeping the good ship Credit Bubble afloat.

Mike Shedlock ~ “Mish”

March 30, 2007