MICHEL MARTIN, HOST:
We'd like to talk about the economy now. With a campaign for the upcoming presidential election already underway, you can expect the state of the economy to get a lot of attention. And one of the tools economists use to predict whether a recession is coming is the yield curve, so we want to tell you what that is and why it matters.
We've called Campbell Harvey for that. He's a professor of finance at the Fuqua School of Business at Duke University, and he was the first to demonstrate that the yield curve can predict a recession. Professor Harvey also says he only considers the indicator definitive if the inverted yield curve lasts for an entire quarter. And, well, the quarter ends today, so here to give us his thoughts about what's to come is professor Campbell Harvey.
Welcome. Thank you so much for joining us.
CAMPBELL HARVEY: Great to be on the show.
MARTIN: All right. So let's get the headline, and then we'll work backwards. Are we going into a recession?
HARVEY: The yield curve has inverted for a full quarter, and that has been associated with predicting a recession for the last seven recessions. So from 1960s, this indicator has been reliable in terms of foretelling a recession. And also, importantly, it has not given any false signals yet.
MARTIN: So that would mean yes (laughter).
HARVEY: That means yes.
MARTIN: OK. So let me break down - let me ask you to break down what that means. What is the yield curve, and what does it mean when it's inverted?
HARVEY: So the yield curve represents interest rates at different maturities. So usually, it's the case that a longer-term interest rate has a higher rate than a short-term interest rate. So think of a certificate of deposit at your bank. If you lock your money up for five years, you expect to get a higher rate than, let's say, locking it up for six months.
But in certain rare situations, things get backwards, and it turns out that the long-term interest rate is lower than the short-term rate. And that's called an inverted yield curve. That's exactly the situation we've got right now. And it is a harbinger of bad news.
MARTIN: So unemployment is at a 50-year low. The GDP is growing. Does that have an effect on the yield curve?
HARVEY: So what happens to GDP in the first quarter - that is the past. Corporate earnings, whatever they are - that's the past. Unemployment is a classic lagging indicator. So yes, the economy looks good right now, but the yield curve - the beauty of the yield curve is that it's about the future. It reflects the future, and it captures the expectations of the broad market in terms of what might happen in the future.
MARTIN: So before we let you go - and I apologize if this is kind of reductionist, but this is something that journalists are always accused of all the time, so I'm going to ask. Is there any risk of this being a self-fulfilling prophecy? Is there any validity to the idea that if you, you know, believe that a recession is coming that you could actually in some way influence that it will? Is there any validity to that at all? Not that it's going to change our reporting on what - the facts. But I have to ask.
HARVEY: Sure. And it's a great question. When I originally published my research, nobody much noticed the yield curve. But then it got a considerable profile in predicting the global financial crisis. So now it's on the radar screen. My model is not a model that says the yield curve causes a recession. It is a model that says, well, there's information in the yield curve that can help you forecast a recession. But the idea of self-fulfilling prophecy essentially perhaps makes it causal - that people see this red flag. They know its reliability, and they are more cautious.
So think of a company - major expansion, need to borrow money to build a new plant. The yield curve inverts, and they say, well, let's wait. Or a consumer going on a big vacation where you know that you need to borrow on the credit card. Yield curve inverts - well, maybe we should defer that expensive vacation.
So I look at it more in terms of risk management. This is an important piece of information that helps people plan. It helps corporations plan. And if you can be prudent, you avoid the situation where, oh, you go ahead and build that plant, you borrow the money, we go into recession, and you're out of business, and people are laid off. So I believe that this indicator gives people the ability to do prudent risk management and enhances the possibility that we have a soft landing, not a hard landing like the global financial crisis.
MARTIN: That was Campbell Harvey. He is a professor of finance at the Fuqua School of Business at Duke University and a research associate of the National Bureau of Economic Research in Cambridge, Mass. You heard the man.
Professor Harvey, thank you so much for talking to us.
HARVEY: Thank you.
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