RM Topic

A Quantitative Analysis of the Yield Curve:
Forecasting the Length and End of a Recession
Dissertation
Submitted to Northcentral University
Graduate Faculty of the School of Business
in Partial Fulfillment of the
Requirements for the Degree of
DOCTOR OF BUSINESS ADMINISTRATION

FINANCIAL MANAGEMENT
by
VAUGHN COX
Prescott Valley, Arizona
April 2015
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Abstract
Economists, finance professionals, businesses, and governments analyze economic
activity to forecast recessions to put in place plans that will minimize the impacts of a
recession. A tool that could identify how long a recession might last could reduce the
unwanted effects of a recession. While researchers have identified that the interest rate
term spread, a component of the yield curve, can effectively predict if a recession is
probable and approximately when it might begin, it is not known whether the components
of the interest rate yield curve might also be able to predict how long a recession might
last. The purpose of this quantitative correlational study was to analyze the components
of the yield curve to determine if they could be used to forecast how long a recession
might last or when a recession might end. Data for the study was gathered for the U.S.
economy for the period from 1942 to 2012. The data set for the entire time period and for
each of the twelve recessionary periods was analyzed using the autodistributive lag and
vector autoregression models. It was found that there was a statistically significant
correlational relationship for two yield curve components, the interest rate term spread
and the three-month T-bill rate, that could be used to forecast when a recession might
end. Prior to these recessions the interest rate term spread drops rapidly and typically
turns negative. The term spread began to increase during the recession and for the twelve
recessions analyzed rose to the level of 100 basis points on average about seven months
before the end of the recession. It was also found that the three-month T-bill rate rose
significantly before the recessions, peaked, and then fell throughout the recessionary time
period. For the recessionary periods analyzed the peak in the T-bill rate occurred on
average about eleven months before the end of the recession.
Table of Contents
List of Tables ....................................................................................................................... i
List of Figures .................................................................................................................... vi
Chapter 1: Introduction ....................................................................................................... 1
Background ..................................................................................................................... 3
Statement of the Problem ................................................................................................ 7
Purpose of the Study ....................................................................................................... 8
Theoretical Framework ................................................................................................... 9
Research Questions ....................................................................................................... 14
Hypotheses .................................................................................................................... 15
Nature of the Study ....................................................................................................... 16
Significance of the Study .............................................................................................. 19
Definition of Key Terms ............................................................................................... 20
Summary ....................................................................................................................... 21
Chapter 2: Literature Review ............................................................................................ 23
Documentation .............................................................................................................. 25
A History of United States Recessions from 1945 to 2012 .......................................... 25
What Ends Recessions and What are The Long-Term Effects of Recessions? ............ 28
The Correlation of Interest Rates and Economic Growth ............................................. 33
Using Macroeconomic Variables to Forecast Economic Growth................................. 44
Using Interest Rate Data to Forecast Economic Recessions ........................................ 49
Summary ....................................................................................................................... 58
Chapter 3: Research Method ............................................................................................. 61
Research Methods and Design ...................................................................................... 61
Population ..................................................................................................................... 63
Sample........................................................................................................................... 63
Materials/Instruments ................................................................................................... 65
Operational Definition of Variables.............................................................................. 66
Data Collection, Processing, and Analysis ................................................................... 68
Assumptions.................................................................................................................. 74
Limitations .................................................................................................................... 76
Delimitations ................................................................................................................. 77
Ethical Assurances ........................................................................................................ 77
Summary ....................................................................................................................... 78
Chapter 4: Findings ........................................................................................................... 80
Results ........................................................................................................................... 83
Evaluation of Findings ................................................................................................ 162
Summary ..................................................................................................................... 165
Chapter 5: Implications, Recommendations, and Conclusions ...................................... 169
Recommendations ....................................................................................................... 189
Conclusions ................................................................................................................. 192
References ....................................................................................................................... 195
List of Tables
Table 1 A History of United States Recessions from 1945 to 2010 ................................. 27
Table 2 Descriptive Statistics for Explanatory and Dependent Variables, 284
observations ...................................................................................................................... 85
Table 3 Correlation Matrix of the Variables ................................................................... 87
Table 4 Unit Root Stationary Tests; Three-Month T-Bill, Term Spread, and GDP Growth
........................................................................................................................................... 89
Table 5 Unit Root Stationary Test, Three-Month T-Bill Rate .......................................... 89
Table 6 ADL Regression, Term Spread of Interest Rates, Individual lags, 1942-2012 ... 92
Table 7 ADL Regression, Term Spread of Interest Rates, Individual lags, 2007-09
recession ........................................................................................................................... 92
Table 8 ADL Regression, Term Spread of Interest Rates, Individual lags, 2001 recession
........................................................................................................................................... 92
recession ........................................................................................................................... 93
recession ........................................................................................................................... 93
Table 11 ADL Regression, Term Spread of Interest Rates, Individual lags, 1980
recession ........................................................................................................................... 93
recession ........................................................................................................................... 94
recession ........................................................................................................................... 94
recession ........................................................................................................................... 95
Table 15 ADL Analysis, Term Spread of Interest Rates, Individual lags, 1958 recession.
........................................................................................................................................... 95
recession ........................................................................................................................... 96
recession ........................................................................................................................... 96
recession ........................................................................................................................... 97
Table 19 ADL Analysis, Term Spread of Interest Rates, Significant lag periods for all
recessions .......................................................................................................................... 98
Table 20 ADL Regression, Term Spread of Interest Rates, Lag Combinations, 1942-2012
........................................................................................................................................... 99
recession ......................................................................................................................... 100
Table 22 ADL Regression, Term Spread of Interest Rates, Lag Combinations, 2001
recession ......................................................................................................................... 100
recession ......................................................................................................................... 100
recession ......................................................................................................................... 101
recession ......................................................................................................................... 101
recession ......................................................................................................................... 102
Table 27 ADL Regression s, Term Spread of Interest Rates, Lag Combinations, 1969-70
recession ......................................................................................................................... 102
recession ......................................................................................................................... 103
recession ......................................................................................................................... 103
recession ......................................................................................................................... 104
recession ......................................................................................................................... 104
recession ......................................................................................................................... 105
Table 33 Adjusted R2 Values for the Term Spread, ADL Analysis ................................ 106
Table 34 ADL Analysis, T-bill Rate, First Difference, individual lag periods, 1942-2012
......................................................................................................................................... 107
Table 35 ADL Analysis, T-Bill Rate, First Difference, individual lag periods, 2007-09
recession ......................................................................................................................... 107
Table 36 ADL Analysis, T-bill Rate, First Difference, individual lag periods, 2001
recession ......................................................................................................................... 108
recession ......................................................................................................................... 108
recession ......................................................................................................................... 108
Table 39 ADL Analysis, T-Bill Rate, First Difference, individual lag periods, 1980
recession ......................................................................................................................... 109
recession ......................................................................................................................... 109
recession ......................................................................................................................... 109
recession ......................................................................................................................... 110
recession ......................................................................................................................... 110
recession ......................................................................................................................... 110
recession ......................................................................................................................... 111
recession ......................................................................................................................... 111
Table 47 ADL Analysis, T-Bill Rate, First Difference, significant lag periods for all
recessions ........................................................................................................................ 112
Table 48 ADL Regression, T-bill Rate, First Difference, lag combinations, 1942-2012
......................................................................................................................................... 113
Table 49 ADL Regression,, T-bill Rate, First Difference, lag combinations, 2007-09
recession ......................................................................................................................... 114
Table 50 ADL Regression, T-bill Rate, Lag Combinations, 2001 recession ................. 114
recession ......................................................................................................................... 114
recession ......................................................................................................................... 115
Table 53 ADL Regression, T-bill Rate, First Difference, lag combinations, 1980
recession ......................................................................................................................... 115
recession ......................................................................................................................... 115
recession ......................................................................................................................... 116
recession ......................................................................................................................... 116
recession ......................................................................................................................... 116
recession ......................................................................................................................... 117
recession ......................................................................................................................... 117
Table 60 Adjusted R2 Values for the T-Bill, ADL Analysis ............................................ 118
Table 61 ADL Regression, T-bill and Term Spread Combined, full data set (1942-2012)
......................................................................................................................................... 119
Table 62 ADL Regression, T- Bill and Term Spread Combined, 2007-09 recession .... 120
Table 63 ADL Regression, T- Bill and Term Spread Combined, 2001 recession ......... 120
Table 64 ADL Regression, T- bill and Term Spread Combined, 1990-91 recession..... 121
Table 74 Adjusted R2 Values for the Combined T-Bill and Term Spread, ADL Analysis
......................................................................................................................................... 126
Table 75 VAR Analysis, GDP Growth as the Dependent Variable, full data set (19422012) ............................................................................................................................... 128
Table 76 VAR Analysis, Term Spread as the Dependent Variable, full data set (19422012) ............................................................................................................................... 129
Table 77 VAR Analysis, T-bill Rate as the Dependent Variable, full data set (1942-2012
......................................................................................................................................... 130
Table 78 Granger Causality, GDP Growth as the Dependent Variable, full data set
(1942-2012)..................................................................................................................... 131
Table 79 VAR Analysis, GDP Growth as the Dependent Variable, 2007-09 Recession.
......................................................................................................................................... 132
Table 80 VAR Analysis, Term Spread as the Dependent Variable, 2007-09 Recession 133
Table 81 VAR Analysis, T-bill Rate as the Dependent Variable, 2007-09 Recession ... 133
Table 82 Granger Causality, GDP Growth as the Dependent Variable, 2007-09
Recession......................................................................................................................... 134
Table 83 VAR Analysis, Term Spread as the Dependent Variable, 2001 Recession ..... 136
Table 84 VAR Analysis, T-bill Rate as the Dependent Variable, 2001 Recession......... 136
Table 85 Granger Causality, GDP Growth as the Dependent Variable, 2001 Recession.
......................................................................................................................................... 137
Table 86 VAR Analysis, GDP Growth as the Dependent Variable, 1990-91 Recession 138
Recession......................................................................................................................... 139
Table 91 VAR Analysis, T-Bill Rate as the Dependent Variable, 1981-82 Recession ... 140
Recession......................................................................................................................... 141
Table 93 VAR Analysis, GDP Growth as the Dependent Variable, 1980 Recession .... 142
Table 94 VAR Analysis, Term Spread as the Dependent Variable, 1980 Recession. .... 142
Table 95 VAR Analysis, T-Bill Rate as the Dependent Variable, 1980 Recession ........ 143
Table 96 Granger Causality, GDP Growth as the Dependent Variable, 1980 Recession
......................................................................................................................................... 143
Table 99 VAR Analysis, T-Bill Rate as the Dependent Variable, 1973-75 Recession ... 145
Recession......................................................................................................................... 146
Table 101 VAR Analysis, GDP Growth as the Dependent Variable, 1969-70 Recession
......................................................................................................................................... 146
Table 102 VAR Analysis, Term Spread as the Dependent Variable, 1969-70 Recession
......................................................................................................................................... 147
Table 103 VAR Analysis, T-Bill Rate as the Dependent Variable, 1969-70 Recession . 147
Recession......................................................................................................................... 148
Table 105 VAR Analysis, GDP Growth as the Dependent Variable, 1960-61 Recession
......................................................................................................................................... 149
Table 106 VAR Analysis, Term Spread as the Dependent Variable, 1960-61 Recession
......................................................................................................................................... 149
Table 107 VAR Analysis, T-Bill Rate as the Dependent Variable, 1960-61 Recession . 150
Recession......................................................................................................................... 150
Table 109 VAR Analysis, GDP Growth as the Dependent Variable, 1958 Recession .. 151
Table 110 VAR Analysis, Term Spread as the Dependent Variable, 1958 Recession ... 151
Table 111 VAR Analysis, T-Bill Rate as the Dependent Variable, 1958 Recession. ..... 152
......................................................................................................................................... 153
Table 115 VAR Analysis, T-Bill Rate as the Dependent Variable, 1953 Recession ...... 155
......................................................................................................................................... 155
......................................................................................................................................... 157
Table 122 VAR Analysis, Term Spread as the Dependent Variable, 1945 Recession. .. 158
......................................................................................................................................... 160
Table 125 Vector Autoregression, GDP Growth as the Dependent Variable, All Periods
......................................................................................................................................... 161
Table 126 Granger Causality, GDP Growth as the Dependent Variable, Summary of All
Periods............................................................................................................................. 162
Table 127 Changes in the Term Spread of Interest Rates during Recessionary Periods
......................................................................................................................................... 176
Table 128 Changes in the T-bill Rate during Recessionary Periods ............................. 183
Table 129 Recession End Lead Time, Interest Rate Term Spread and Three-Month T-Bill
Rate ................................................................................................................................. 187
List of Figures
Figure 1 ADL Analysis, Term Spread, Significant Occurrences by Lag Period............... 99
Figure 2 ADL Analysis, T-bill rate, Significant occurrences by lag period ................... 113
Figure 3 Term Spread of Interest Rates, Frequency of significant lag periods .............. 174
Figure 4 Term Spread of Interest Rates (1942-2012) ..................................................... 177
Figure 5 T-Bill Rate, Frequency of statistical significant lag period ............................. 181
Figure 6 Three-Month T-Bill Rate (1942-2012) ............................................................. 184
1
Chapter 1: Introduction
A recession is a significant decline in economic activity spread across an
economy that can last from a few months to more than a year (National Bureau of
Economic Research [NBER], 2010). When a recession occurs there is a visible effect on
economic growth as measured by gross domestic product (GDP), real income,
employment, production, and wholesale and retail sales (Hall, 2003). Recessions are most
commonly identified by changes in economic growth as measured by GDP Growth
(NBER, 2010). Since the end of World War II the United States (U.S.) experienced 12
recessions (NBER, 2011). In each case, economic growth turned negative, unemployment
levels increased, and income levels stagnated or declined (Kliessen, 2003; Labonte &
Makinen, 2002; & Zanowitz, 1996). A tool that could identify when a recession will
occur, how long it will last, and when it will end would be valuable and could reduce the
unwanted effects of a recession (Peck & Yan, 2011). In fact, governments, businesses,
families, and all sectors of the economy could use such a tool to plan for recessions and
to minimize their negative effects (Jiang, Koller, & Williams, 2009).
Researchers have studied the effectiveness of using interest rate data to forecast
GDP growth and found a strong positive correlation between the interest rate data and
GDP growth (Estrella, 2005). These results support the assertion that interest rate data
can be used to forecast changes in economic growth and recessions and that changes in
interest rate data could be used to forecast when a recession might occur (Ang, Piazzesi,
& Wei, 2006). Put simply, the term spread of interest rates (the difference between shortterm and long-term interest rates) can be used to determine the probability that a
recession might occur. In fact, Powell (2006) concluded that when short-term interest
2
rates are higher than long-term interest rates (the interest rate term spread turns negative)
there is a high probability that GDP growth will also turn negative resulting in a
recession. Estrella and Mishkin (1996) extended this research by studying these same
relationships (i.e., the relationship between the interest rate term spread and economic
growth, as measured by GDP) and concluded that the term spread of interest rates could
be used to effectively forecast when a recession would occur. They concluded that the
term spread of interest rates turned negative approximately two to six quarters before a
recession begins. This trigger, a negative interest rate term spread, has preceded and
correctly predicted every U.S. recession since World War II (Chauvet & Potter, 2005).
Researchers (e.g., Chauvet & Potter, 2005; Estrella & Mishkin, 1996; Powell,
2006) concluded that yield curve interest rate data can be used to forecast if a recession is
probable and if so, when it might occur. The need for businesses, governments,
individuals, and families to be able to know not only when a recession will begin, but
also how long it will last and when it will end has been identified as the appropriate next
step in this line of research (Barnard, 2010; Engemann & Wall, 2010; Ouyang, 2009).
This study examined whether or not interest rate data could also be used to
forecast how long a recession might last or when a recession might end. In this chapter
background information about forecasting recessions is provided; the problem and
purpose statements specific to this study are presented; and the theoretical framework for
this study is reviewed. Research questions and hypotheses, the nature and significance of
the study, and the definitions of key terms are also included in this chapter.
3
Background
When the 2007-2009 recession began in December of 2007 the unemployment
rate in the U.S. was 5.0%; approximately 7.7 million Americans were unemployed
(Bureau of Labor Statistics, 2007). By October of 2009 the unemployment had more than
doubled to 10.2% and 15.7 million Americans were without a job (Bureau of Labor
Statistics, 2009). During the recession, the production of goods and services as measured
by GDP fell from $14.4 trillion in the second quarter of 2008 to $13.9 trillion in the
second quarter of 2009 (Bureau of Economic Analysis, 2012). This decline in GDP was
approximately $530 billion, which equates to approximately $1,700 per U.S. resident
(U.S. Census Bureau, 2012). Federal tax revenue also fell during the recession. In 2009
total receipts for the Federal government were $2.1 trillion, which is $500 billion or
19.2% less than the 2007 figure of $2.6 trillion (Office of Management and Budget,
2012). These figures illustrate the significant negative economic impact that can result
from a recession.
When an economy is in recession, governments, businesses, and individuals are
all negatively affected and it is impossible to develop and sustain a successful economy
(Orlov & Roufagalas, 2008; Stevenson & Wolfers, 2008). In recessionary times,
governments experience stress as there is a decline in tax and fee revenue and an increase
in the demands for expenditures to offset the negative effects of the recession (Barnard,
2010). During recessions most businesses experience lower demand for their products
which leads to declines in revenue, reductions in hiring, layoffs, and lower profitability or
losses (Ouyang, 2009). As indicated at the outset, individuals and families are also
adversely affected by a recession. Engemann and Wall (2010) determined that
4
recessionary times result in increased unemployment, fewer work hours, and declining
wages.
When identifying recessions (i.e., when they start, how long they last, and when
they end) the most significant economic factor is the change in economic growth as
measured by GDP growth (NBER, 2010). When GDP is growing the economy is
expanding and income levels are increasing, whereas when GDP is falling there is
negative economic growth, income levels are declining and the economy is in recession
(Hall, 2003). Negative economic growth as measured by GDP growth is the most
common measure of when a recession begins and a return to positive GDP growth is the
most common measure of when a recession ends (NBER, 2011). Put simply, when GDP
growth turns negative for more than a few months it is defined as the start of a recession
and when GDP growth turns positive again it is defined as the end of the recession and
the beginning of the next growth period. The topic of this research was whether or not it
was possible to effectively forecast the beginning, length, and ending of a recession. The
key factor in answering the question is the ability to effectively forecast economic growth
as measured by GDP growth (Baran, 2011).
Previously researchers examined different variables such as inflation,
manufacturing capacity utilization, monetary policy, and interest rates to determine the
relationship between these variable and economic growth as measured by GDP growth.
For example, Estrella (2005) studied inflation rates and concluded that there was a
positive correlation between GDP growth and inflation. Moreover, Diebold, Rudebusch,
and Aruoba (2006) analyzed the utilization rates of manufacturing capacity and
determined that there was a positive correlation between utilization rates and GDP
5
growth. More recently, Lengwiler and Lenz (2010) examined the monetary policy of the
Federal Reserve Bank and concluded that there was a positive correlation between GDP
growth and monetary policy. Researchers also examined other variables including energy
consumption, the competitive environment, and government spending and identified
positive correlation between these variables and GDP growth (Apergis & Payne, 2011;
Ciarreta & Zarraga, 2010). The variable that demonstrated the highest and most
consistent positive correlation with GDP growth was the interest rate as measured by the
yield curve. Several researchers have concluded that the interest rate yield curve is
positively correlated with GDP (Ang et al., 2006; Bianchi, Mumtaz, & Surico, 2009;
Estrella, 2005; & Smith & Taylor, 2009). These researchers also concluded that when
forecasting economic growth, whether a recession will occur, and when it might begin,
the interest rate yield curve and its components are the variables that have the most
predictive value.
Hall (2003) defined the interest rate yield curve as a graph that plots the interest
rates of bonds having equal credit quality, but differing maturity dates. A normal yield
curve is upward sloping as long-term interest rates are normally higher than short-term
interest rates. Hall identified the primary variables in the yield curve as: short-term
interest rates (the rate paid on borrowings of one year or less); long-term interest rates
(the rate paid on borrowings of more than one year with ten years being the most
common rate used) and the term spread of interest rates (the difference between shortterm rates and long-term rates). Yield curve interest rate data was used by Ang et al.
(2006) to create a model to forecast GDP growth and the level of the term spread of
interest rates. They then back tested this model to successfully predict every recession
6
from 1964 to 2001. Similarly, Powell (2006) searched for an event or trigger that could
be used to forecast a recession. He examined yield curve data for the six recessions that
occurred from 1956 to 2006 and concluded that the best indicator was when the interest
rate term spread inverted (turned negative) at a level of 100 basis points or higher. In
each of the six recessions examined, the trigger was identified approximately one year
before the recession. The research described above demonstrates that a negative interest
rate term spread can be used to effectively forecast an impending recession.
Peck and Yang (2011) recognized the need for an additional tool that could
forecast recessions, not only when one might occur, but also how long it might last, and
when it might end. In light of this they studied investors who must decide the best time to
begin investing again after a recession and concluded that investors often miss out on the
benefits of an economic recovery as they are uncertain when it is best to reenter the
investment markets. A tool that could forecast recessions and how long they last, would
also be helpful to government policy makers as the tool could be used to better time the
fiscal spending and government support efforts that occur during a recession (U.S.
Government Accountability Office, 2011). Jiang et al. (2009) identified the need for
businesses to know when a recession might end. The information would be used to
manage operations during the recession and to prepare the business for the growth period
following the recession.
The variables of the yield curve are positively correlated with economic growth as
measured by GDP growth (Ciarreta & Zarraga, 2010). The inversion of the term spread
of interest rates has been shown to be an effective tool to forecast the beginning of a
recession (Powell, 2006). Whether or not these same yield curve variables could be used
7
to forecast the length of a recession or when a recession might end is unknown and
presents a meaningful gap in the empirical literature. The purpose of this research study
was to address this gap.
Statement of the Problem
Economic hardship and stress occur during a recession. In the last recession the
median family net worth in the U. S. fell from $126,400 in 2007 to $77,300 in 2010
(Federal Reserve, 2012). In the same timeframe, government revenue at the Federal level
fell over 19% (Office of Management and Budget, 2012) and business profits fell over
16% (U.S. Census Bureau, 2012). The economic hardship experienced by these sectors of
the economy was significant and currently it is impossible for any of these sectors to
accurately anticipate the course a recession will take. They each could benefit from a
forecasting tool that could identify when a recession might occur, how long it might last,
or when it might end (Peck & Yang, 2011). Thus the problem addressed in this study was
that governments, businesses, and families cannot effectively plan for a recession, make
effective decisions, and take actions to minimize the negative economic effects of a
recession because they have no way of knowing how long a recession might last or when
a recession might end (Jiang, et al., 2009). This inability to forecast the length or ending
of a recession exists, in part because of a theoretical understanding of the factors that
contribute to the length and duration of a recession is lacking (Barnard, 2010; Engemann
& Wall, 2010; Ouyang, 2009). While researchers have demonstrated that the two
variables yield curve (the term spread of interest rates and the level of short-term interest
rates) can be used to forecast GDP growth, which can then be used to forecast if a
recession is probable and approximately when a recession might begin (Moersch & Pohl,
8
2011), to date, an effective tool that can forecast how long a recession will last or when a
recession will end has not been identified.
Purpose of the Study
The purpose of this quantitative correlational study was to examine the extent to
which two variables of the yield curve can be used to forecast GDP growth, which in turn
could be used to forecast how long a recession might last or when a recession might end.
The explanatory variables in this study included the interest rate term spread and the level
of short-term interest rates. Economic growth is the most common measure used to
determine when a recession begins and when it ends (NBER, 2010) and therefore
economic growth as measured by GDP growth was used as the dependent variable. The
explanatory variables of this economic study were examined against the dependent
variable both individually and together. The analysis included the creation of a
correlation matrix with the two explanatory variables and the dependent variable, as well
as both a single and multiple regression analysis that included the two explanatory
variables and the dependent variable. Specifically, the regression method that was used
for the single regression analysis was the autoregressive distributed lag (ADL) method.
For the multiple regression analysis both the ADL method and the vector autoregression
(VAR) method were used. Archival data, published by the Federal Reserve Bank and the
Department of Commerce was be gathered for the 71-year period from 1942 to 2012. The
data included the reported figures for each of the three variables during this time period.
The data is published quarterly resulting in 284 (71 x 4) observations.
9
Theoretical Framework
Why business cycles occur, or why the market economy moves through periods
of expansion and recession is a key theoretical issue (Salerno, 2012). Several different
competing theories have been created to address what causes recessionary business
cycles and what can be done to prevent them. The theory with which this study most
closely aligns is the Austrian business cycle theory (Adrian & Hyun, 2009). Competing
theories include the Keynesian business cycle theory (Onwumere, Stewart, & Yu, 2011),
the monetary business cycle theory (Benk, Gillman & Cerge-Ei, 2005), and the real
business cycle theory (Kiyotaki, 2011). Proponents of these four theories compete with
each other in their efforts to explain the business cycles in an economy (Salerno, 2012;
White, 2008).
Interest rates and their effect on the cost and availability of capital is an important
component of these theories (Templeman, 2010). This is because interest rates are a
bellwether of economic growth, economic decline, and recessions (Bianchi et al., 2009;
Smith & Taylor, 2009). Also, interest rates have a direct impact on the health of the credit
markets, the cost of debt, and the amount of debt capital used by firms; the level of
interest rates affects the cost of debt capital and the relationship between short and longterm interest rates affect the availability of debt capital (Mossavar-Rahmani & Maleki,
2009). A description of each theory and how this study might affect that theory follows.
Austrian business cycle theory. The Austrian business cycle theory asserts that
economic expansions occur as a result of an increase in capital investment (Salerno,
2012). These expansions are sustainable if the increase in capital investment is funded by
an increase in savings, however, if the expansion is not funded by an increase in savings,
10
but is rather funded by monetary policy or an increase in debt, the expansion will not be
sustainable, and eventually, the unsustainable expansion will falter and an economic
contraction or recession will result (Adrian & Hyun, 2009). Templeton (2010) explained
the reasoning behind the Austrian business cycle theory; that the interest rates charged on
the increased debt are not at appropriate market rates, but rather are at less than market
rates, and thereby result in a misallocation of capital across the economy. As the level of
misallocation increases, the additional economic capacity becomes inefficient, earns
below market rates of return, and eventually becomes idle. The expansion then turns to
contraction until the misallocation is corrected. Efforts to support a period of economic
growth through credit expansion, lower interest rates, or increased government spending
will not correct the misallocation, rather these actions only postpone and perhaps magnify
the correction (Salerno, 2012).
This study fits well with the Austrian business cycle theory. The study examined
interest rates and the components of the yield curve to determine their ability to forecast
certain aspects of business cycles. The study identified that periods of economic
expansion have lower interest rates followed by a period of rapid increase in interest rates
prior to the start of a recession. This is followed by a period of declining interest rates
prior to the ending of the recession. These results support and strengthen the Austrian
business cycle theory. The other three theories, the Keynesian business cycle theory, the
monetary business cycle theory, and the real business cycle theory are competing
theories. The basic concepts of each of these three theories are discussed below.
Keynesian business cycle theory. The Keynesian business cycle theory offers a
competing perspective against the ideas of the Austrian business cycle theory. Keynesian
11
economists believe that during periods of expansion there is an inevitable breakdown in
the very conditions that created the economic growth, which results in market efficiencies
becoming marginalized (Ireland, 2011). These inefficiencies become manifest in
changing expectations, rising asset prices, increasing costs, shortages of resources, policy
errors, and other items that make it harder and less efficient to create and sustain
economic growth (Onwumere et al., 2011). Harvey (2011) explained that when these
breakdowns reach a sufficient level the result will be a market contraction. In effect, the
market grows, overheats, contracts, cools down, and then growth can begin again;
essentially expansions cause recessions which then cause expansions.
At first look this study appeared to fit well with the Keynesian theory. The two
explanatory variables of the study (the term spread of interest rates and the level of shortterm interest rates) could be examples of the efficiencies or inefficiencies described in the
theory (Powell, 2006). An inverted yield curve would be considered an abnormal or
inefficient factor (Harvey, 2011). Abnormally high or rising short-term interest rates are
also an anomaly that would be considered an inefficiency of the Keynesian business
cycle theory (Lengwiler & Lenz, 2010). But when compared to the Austrian theory the
Keynesian theory appears to be over broad. The Austrian theory focuses on capital
investment and the resulting interest rates while the Keynesian theory considers other
factors; any component of the economy that could contribute to changes in the business
cycle (Adrian & Hyun, 2009).
Monetary business cycle theory. The monetary business cycle theory also offers
an alternative perspective to both the Austrian business cycle theory and the Keynesian
business cycle theory. Monetary theory proponents contend that a market economy is
12
inherently stable and that if left alone, the economy will generally find a point of
equilibrium, and that business cycles of expansion and recession are caused by external
shocks that cause instability and uncertainty resulting in the economy being put out of
equilibrium (Benk et al., 2005). Furthermore, monetary theory proponents advocate that
recessions are often caused or extended by inappropriate government responses to the
economy (Posen, 2011). Proponents of this theory contend that government action should
consist of setting appropriate targets for monetary expansion and fiscal spending and then
sticking to those targets thereby allowing for the self-correcting components of the
economy to move towards equilibrium (Onwumere et al., 2011).
Governments often pursue economic policies that affect interest rates; either
trying to keep interest rates low in an effort to make debt capital easy to obtain and
affordable in an effort to stimulate economic growth or forcing interest rates higher to
prevent inflation and to keep the economy from overheating (Lengwiler & Lenz, 2010).
Monetary business cycle theorists claim that the triggers that have been identified in
forecasting recessions (the two explanatory variables to be used in this study: the term
spread of interest rates and the level of short-term interest rates) are the variables that
would be targeted and inappropriately manipulated by government policy resulting in
economic downturns (Benk et al., 2005). The difference between the monetary theory
and the Austrian theory is the monetary theory focuses on the size and growth of the
money supply while the Austrian theory focuses on interest rates and capital investment
(Adrian & Hyun, 2009).
Real business cycle theory. The real business cycle theory offers an outlook that
is different from the Austrian, Keynesian, and monetary business cycle theories. The real
13
business cycle theory is an application of the standard general equilibrium theory of
market economics and perhaps the most important component of this theory is that if an
economy is managed properly it can experience continuous economic growth and
expansion without recessions (Kiyotaki, 2011). Proponents of this theory assert that there
is an optimum allocation of resources between the different components and sectors of
the economy and that if the allocation of resources in the economy can remain in balance
or in equilibrium, economic growth will perpetuate. However, if the resource allocation
of the economy is significantly out of balance a recession will result (Ohanian, 2010).
Various events such as natural disasters, technological innovation, resource shortages,
inappropriate government intervention, demographic changes, or other similar events can
throw an economy out of balance resulting in shocks to the economy and if the shocks are
significant enough a recession will be the result (DeVroey & Pensieroso, 2006). Similar
to monetary business cycle proponents, real business cycle theorists claim that
occurrences of inverted interest rate spreads and high levels of short-term interest rates
are the result of economic mismanagement, misallocation, or inappropriate government
actions (Ohanian, 2010). The real business cycle theory is significantly different than the
Austrian theory. The real business cycle theory assumes a closely managed economy
where resources are controlled and allocated. Within the theory there can be many causes
of a recession, but all center on misallocation of resources (DeVroey & Pensieroso,
2006). The Austrian theory is different in that it focuses on capital investment and the
resulting interest rates (Adrian & Hyun, 2009).
14
Research Questions
The purpose of this study was to determine whether or not the two variables of the
yield curve can be used to forecast how long a recession will last or when a recession will
end. This was investigated by determining what relationship (if any) existed between the
two explanatory variables (the term spread of interest rates and the level of short-term
interest rates) and the dependent variable: economic growth as measured by the GDP
growth. As stated above, economic growth as measured by the GDP growth is used to
determine the beginning and ending points of a recession. Negative GDP growth is the
most common measure of when a recession begins and a return to positive GDP growth
was the most common measure of when a recession ends (NBER, 2011). Put simply,
when GDP growth turns negative for more than a few months it is defined as the start of a
recession and when GDP growth becomes positive again it is defined as the end of the
recession.
The analysis included the creation of a correlation matrix with all three variables
(the term spread of interest rates, the level of short-term interest rates, and economic
growth) and regression analysis comparing the two explanatory variables (both
individually and together) with the dependent variable. To this end, the following
research questions were developed:
Q1: To what extent, if at all, can the term spread of interest rates be used to
predict GDP growth, which can then be used to predict how long a recession will
last or when a recession will end?
15
Q2: To what extent, if at all, can the level of short-term interest rates be used to
Q3: To what extent, if at all, can the combination of the term spread of interest
rates and the level of short-term interest rates be used to predict GDP growth,
which can then be used to predict how long a recession will last or when a
recession will end?
Hypotheses
There are three hypotheses presented below. They pertain to the three research
questions previously presented.
H10: The term spread of interest rates cannot be used to statistically significantly
predict GDP growth, which can then be used to predict how long a recession
might last or when a recession might end.
H1a: The term spread of interest rates can be used to statistically significantly
H20: The level of short-term interest rates cannot be used to statistically
significantly predict GDP growth, which can then be used to predict how long a
recession might last or when a recession might end.
H2a: The level of short-term interest rates can be used to statistically significantly
16
H30: The combination of the slope of the yield curve, the term spread of interest
rates, and the level of short-term interest rates cannot be used to statistically
significantly predict GDP growth, which can then be used to predict how long a
recession might last or when a recession might end.
H3a: The combination of the term spread of interest rates and the level of shortterm interest rates can be used to statistically significantly predict GDP growth,
which can then be used to predict how long a recession might last or when a
recession might end.
Nature of the Study
The purpose of this quantitative correlational study was to examine the two
variables of the yield curve to determine their effectiveness in predicting GDP growth,
which could then be used to forecast how long a recession might last or when a recession
might end. A quantitative correlational design is used in economic studies like this when
there is only one set of data (there is no control group) and the data is statistically
analyzed to determine the relationship between the variables (Garson, 2011). In this
study, the purpose was to determine if the variables of the yield curve can be used to
predict GDP growth, which can then be used to forecast how long a recession might last
or when a recession might end. This purpose was accomplished by using regression
analysis techniques to determine the correlation and predictive relationship between each
of the two explanatory variables (short-term interest rates and the term spread of interest
rates) and the dependent variable (GDP growth). The regression analysis methodology
that was used was the autoregressive distributed lag (ADL) method when examining each
individual explanatory variable and both the ADL method and the vector autoregression
17
(VAR) method were used when examining the two explanatory variables together. As the
purpose was to determine the correlation and predictive relationship between the two
explanatory variables and the dependent variable, the best design for this study was a
quantitative correlational design (Garson, 2011).
There were three key variables in the study: two explanatory variables and one
dependent variable. The first explanatory variable was the term spread of interest rates.
The second explanatory variable was the level of short-term interest rates. The dependent
variable was economic growth as measured by the GDP growth. These variables are
macroeconomic statistics, which are compiled and published by U.S. government
agencies. The data set that was used included these variables for the U.S. economy for the
71-year period of 1942 to 2012; 1942 was selected as the beginning year as it precedes
the 1945 recession by three years. 1945 marks the end of World War II and the beginning
of the postwar economic period. Economic researchers frequently use the post 1945 time
period as the postwar economic environment is very different from the war and
depression economy that existed prior to 1945 (Dotsey, 1989; Estrella & Mishkin 1996).
The analytical procedures applied to the data included the creation of a correlation
matrix, a single regression analysis, and a multiple regression analysis. Two types of
regression analyses were performed. The first was the autoregressive distributed lag
(ADL) model and the second was vector autoregression (VAR). The ADL method was
used when performing the regression analysis for both the single and multiple
explanatory variable analysis. The VAR method was used when performing the multiple
regression analysis with two or more explanatory variables. The ADL and VAR forms of
regression were used because they allow for regression analysis with time-lagged
18
variables (Stock & Watson, 2012). A time-lagged regression analysis is important as this
study evaluated whether the value of the explanatory variables observed in the current
time period could be used to forecast the dependent variable in future time periods. The
amount of time between the current observation and the effect on the dependent variable
is the time lag. The ADL and VAR regression analysis can compare the dependent
variable with the value of the explanatory variable observed one, two, three, or more time
periods in the past. A traditional regression analysis compares the explanatory variable
and dependent variable observed during the same time period. Both of these methods
compare the relationship of the explanatory variable observed at a point of time one or
more periods before the observation of the dependent variable. The ADL and VAR
regression techniques were ideal options for this study because the results of the
regression analysis identify whether or not the explanatory variables (the term spread of
interest rates, and the level of short-term interest rates) can be used to reliably forecast the
future value of the dependent variable (GDP growth).
The creation of the correlation matrix was important as it identified which
variables, if any, had a high degree of correlation. This was necessary to determine
whether or not the VAR analysis had the potential problem of multicollinearity. Perfect
multicollinearity exists if two variables are perfectly correlated and imperfect
multicollinearity exists if two or more variables have a high degree of correlation (Stock
& Watson, 2012). If there is perfect multicollinearity the VAR regression results are not
valid. To avoid this one of the two perfectly correlated variables is dropped from the
study. Imperfect multicollinearity may exist if there is a high level of correlation between
two of the variables (Stock & Watson, 2012). If imperfect multicollinearity is suspected
19
then the VAR results are accurate in total, but the individual regression coefficients for
the variables may not be accurate. If imperfect multicollinearity is suspected then the
regression is run again dropping one or more of the variables in an effort to identify the
true effect of each variable.
Significance of the Study
This study was significant in a number of ways. First, the results of the study have
expanded the literature examining the relationship between interest rates, economic
growth and recession. Researchers have confirmed that the yield curve is helpful in
predicting whether a recession will occur and approximately when it will begin (Ang et
al., 2006; Estrella, 2005; Powell 2006). Second, this study has provided new information
that is helpful in determining whether or not the yield curve can also be used to predict
how long a recession might last or when a recession might end. Finally, the results of the
study could be used to create an effective tool for practitioners to use when predicting
how long a recession might last and when a recession might end.
The ability to forecast how long a recession might last or when a recession might
end could be used in several different economic and business applications. First, investors
could use the information to help time investment and asset allocation decisions (Peck &
Yang, 2011). Second, governments could use the information to better time government
support and fiscal spending efforts during a recession (U.S. Government Accountability
Office, 2011). Finally, businesses could use the information to manage operations during
a recession and to be better prepared for the expected growth period that would follow
the recession (Jiang, et al., 2009).
20
Definition of Key Terms
Economic growth. Economic growth is defined as an increase in the nation's
capacity to produce goods and services and is usually measured by the GDP growth
(Harvey, 2011).
Government bonds. Government bonds are long-term debt obligations of the
U.S. Treasury department. They are typically issued for maturities of 10 years or longer
(Harvey, 2011).
Gross domestic product. Gross Domestic Product is the market value of all final
goods and services produced in the U.S. over a period of time, usually one year (Harvey,
2011).
Interest rate term spreads. The interest rate term spread is defined as the
difference in the yield between a short-term debt obligation and a longer term debt
obligation of similar credit quality. This measurement can be presented in either a
percentage or basis point format (Harvey, 2011).
Long-term interest rates. A long-term interest rate is the interest rate or rate of
return paid by corporate or government borrowers who borrow money for more than one
year (Harvey, 2011).
Recession. A recession is defined as a significant decline in economic activity
spread across the economy, lasting more than a few months and visible in the effect on
GDP, real income, employment, production, and wholesale and retail sales (NBER,
2010).
21
Short-term interest rates. A short-term interest rate is the interest rate or rate of
return paid by corporate or government borrowers who borrow money for less than one
year (Harvey, 2011).
Treasury bills. A Treasury bill is a short-term debt obligation of the U.S.
Treasury department. Treasury bills are most commonly issued for 90-day (three-month)
or 180-day (six-month) maturities (Harvey, 2011).
Summary
The U.S. experienced 12 recessions between 1945 and 2012 (NBER, 2011). The
average length of these recessions was approximately 11 months with an average decline
in GDP of 3.7% (Zarnowitz, 1996; Labonte & Makinen, 2002). Based on the 2011 GDP
figure of $15.1 trillion, a 3.7% decline in GDP would result in a decline in output of
nearly $560 billion (Bureau of Economic Analysis, 2012). During the 2007-2009
recession unemployment peaked at 10.2% (NBER, 2011). Recessions hurt nearly all of
the sectors of the economy: governments face demands for increased spending while tax
revenue is declining (Barnard, 2010); individuals and families suffer from increased
unemployment, lower wages, and fewer work hours (Engemann & Wall, 2010); and
businesses experience declines in revenue and profitability (Ouyang, 2009). Given the
large impact that recessions have on the various sectors of the economy, predicting the
given course of a recession has important implications and fortunately research has
determined that certain factors can aid in the course of predicting a recession.
Interest rate information, specifically, the interest rate yield curve has been shown
to be positively correlated with GDP growth and has been used to predict and forecast
changes in economic growth and the beginning of recessions (Ang et al., 2006; Bianchi et
22
al., 2009; Estrella, 2005; & Smith & Taylor, 2009). The term spread of interest rates
typically turn negative between two and six quarters before a recession begins (Chauvet
& Potter, 2005; & Powell, 2010). This trigger, a negative interest rate term spread has
preceded every U.S. recession since World War II.
Perhaps the yield curve can also be shown to be a valuable forecasting tool in
determining how long a recession might last and when a recession might end. This was
the purpose of this study: to determine whether or not the yield curve could be used to
predict the length of a recession or when a recession might end. Such a forecasting tool
can be of value to governments, businesses, and individuals as they manage their
finances, revenue, and expenses during recessionary times.
This study used a quantitative research methodology with a correlational design.
The explanatory variables used in the analysis were two components of the yield curve:
short-term interest rates and the interest rate term spread. Economic growth, as measured
by the GDP growth, was the dependent variable. The data used in the analysis was from
the U. S. Economy for the 71-year period from 1942 to 2012. The variable data sets were
collected from macroeconomic statistics published by U. S. Government agencies.
The analysis consisted of the creation of a correlation matrix to determine the
level of correlation that exists between the variables. The analysis also included a
regression analysis where each individual explanatory variable was compared to the
dependent variable followed by a multiple regression analysis where the two explanatory
variables in combination were be compared to the dependent variable. The conclusions
from the analysis were used to create a model identifying how the explanatory variables
could be used to forecast changes in the dependent variable.
Chapter 2: Literature Review

In this study the two variables of the yield curve (the term spread of interest rates
and the level of short-term interest rates) were be analyzed to determine whether or not
these variables can be used to forecast the change in GDP growth that could be used to
mark the beginning or end of a recession. The literature that provides a foundation for
this topic and contributes to the body of knowledge in this area is reviewed and discussed
in this chapter, which is divided into five sections.
In the first section, the history of the U. S. recessions that occurred between 1945
and 2012 is reviewed in an effort to provide the reader with a perspective of the
frequency, duration, and serious effects recessions have had on the U. S. economy. The
second section examines what economic policies have been used in efforts to end
recessions and what long-term effects recessions have had on the U. S. economy. In
combination, the first and second sections review the economic problems that exist as a
result of recessions with the purpose being to illustrate the benefits that might be
achieved by being able to forecast when a recession will end or how long a recession will
last.
The third section of this chapter presents literature that examines the relationship
between interest rates and economic growth. As one of the basic premises of this study is
that there is a close relationship between interest rates and economic growth and that
interest rates can be used to forecast economic growth it is important to take a close look
at this relationship. The literature demonstrates that the availability of capital is positively
correlated with economic growth and that the level of interest rates, whether they are high
or low, has a significant effect on the availability of capital (Harvey, 2012; King &
24
Levine, 1994). The literature also shows that there is a strong positive correlation
between interest rates and economic growth (Bianchi et al., 2009: Smith & Taylor, 2009).
The fourth section presents literature from studies that investigate the question of
what variables, other than interest rates, might be used to forecast economic growth. This
is a critical section as it addresses whether or not interest rates and the yield curve
components are the best variables to be used in this study. If there are other variables that
can be used to forecast economic growth and thereby recessions, they should be seriously
considered as part of the study. The literature demonstrates that while other variables
(e.g., stock market prices, corporate profits, capacity utilization, electric consumption) are
positively correlated with economic growth (Apergis & Payne, 2011; Cornell, 2010;
Panopoulou, 2009; Wang & Wen, 2011) none of them have a correlation that is as strong
or consistent over time as interest rates (Bianchi et al., 2009).
The fifth and final section presents the literature examining the question of
whether or not interest rates can be used to forecast whether or not a recession is eminent
and if it is, when it might begin. This is perhaps, the most important assumption of this
study. The intent of the study was to take this premise (i.e., that interest rates can be used
to forecast if and when a recession might occur) and extend the analysis to determine if
interest rates can also be used to forecast the length or end of a recession. The literature
reviewed herein shows that interest rate data was successfully used to forecast each of the
12 recessions that occurred between 1945 and 2012 (Estrella, 2005; Moersch & Pohl,
2012), that the typical lead time of the forecast was two to six quarters (6 to 24 months)
(Powell, 2006), and that this relationship exists not only in the U. S. economy but also
25
internationally (Moersch & Pohl, 2012). The final section of this chapter constitutes a
summary of the chapter.
Documentation
The search for articles relevant to this study was completed using a variety of
Internet websites and source databases such as the Northcentral University (NCU) library
and Internet search engines such as Google Scholar. Within the NCU library the searches
were performed using the business source databases (EBSCOhost, Euromonitor
International, LexisNexis, ProQuest, SpringerLink, and Wiley Online Library) that were
available. Searches were conducted with a variety of relevant words or phrases such as

growth an

Searches were conducted only for
peer-reviewed articles and research studies. When a relevant article was identified the
references included within that article were reviewed in an effort to identify additional
articles. Also, if a researcher was identified that had written more than one relevant
article, a search for all of the research articles published by that researcher was
conducted.
A History of United States Recessions from 1945 to 2012
There have been 12 recessions in the U.S. since World War II (NBER, 2011).
This is an average of one recession every five years and five months. The average
recession lasted eleven months with the shortest being six months long from January to
July in 1980 (Zanowitz, 1996), and the longest being 18 months, from December of 2007
to June of 2009 (NBER, 2011). In each of these recessions there was a significant decline
in the production of goods and services as measured by GDP, a significant increase in
26
unemployment, and a significant decline in real personal income (Engemann & Wall,
2010). The average decline in GDP during the 12 recessions was 3.7%. A 3.7% decline,
when applied to the 2011 U.S. GDP figure of $15 trillion, would mean a reduction in
GDP of nearly $560 billion (Bureau of Economic Analysis, 2012). Assuming the current
population of the U.S. of approximately 315 million this figure represents more than
$1,700 per person (U.S. Census Bureau, 2012). While the average decline across U.S.
recessions was 3.7%, the range of decline was between 0.3% and 12.8%. The 2001
recession had the smallest decline, which was 0.3% (Kliesen, 2003), and the 2007
2009
recession had the largest decline, which was 12.8% (NBER, 2011).
During these 12 recessions the average peak unemployment rate was 7.6%. In
2011 there were over 154 million Americans in the workforce (Bureau of Labor
Statistics, 2011). An unemployment rate of 7.6% would mean that over 11.7 million
workers are unemployed. The highest unemployment rate experienced in these recessions
was 10.2%, which occurred in both the 1981-1982 recession and in the 2007
2009
recession (Labonte & Makinen, 2002; NBER, 2011).

The 2007 2009 recession was the most severe recession (NBER, 2011). The
GDP fell from $14.4 trillion to $13.9 trillion (Bureau of Economic Analysis, 2012). The
unemployment rate in the U.S. increased from 5.0% or 7.7 million Americans
unemployed in 2007 (Bureau of Labor Statistics, 2007) to 10.2% or 15.7 million
Americans unemployed in 2009 (Bureau of Labor Statistics, 2009). As shown in these
figures recessions inflict a significant strain on the economic production, tax revenue,
employment, and income of an economy (Orlov & Roufagalas, 2008; Stevenson &
Wolfers, 2008). Table 1 provides detailed information on each of the 12 recessions.
27
Table 1
A History of United States Recessions from 1945 to 2010
Recession
1945
Beginning
and
Ending
Dates
Feb. to
Oct.
Duration
8
months
Change
in GDP
-12.7%
Peak
Unemployment
Rates
5.2%
Comments
The primary cause was the decrease
in government spending that
occurred as the war ended and the
economy shifted from a wartime to
peacetime economy (Zarnowitz,
1996).
1949
Nov.
1948 to
Oct. 1949
11
months
-1.7%
7.9%
The recession began shortly after

President Truman's "Fair Deal"
economic reforms. It also followed a
period of monetary tightening
(Labonte
& Makinen, 2002)
1953
July 1953
to May
1954
10
months
-2.6%
6.1%
The recession followed a tightening

of monetary policy by the Federal
Reserve because of inflation fears
(Dell, 1957).
1958
Aug.
1957 to
April
1958
8
months
-3.1%
7.5%
Monetary policy was tightened

during the two years preceding the
recession
(Labonte & Makinen, 2002).
1960
61
April
1960 to
Feb. 1961
10
months
-1.6%
7.1%
Monetary policy was tightened

during 1959 and 1960 prior to the
recession
1969
70
Dec. 1969
to Nov.
1970
11
months
-0.6%
6.1%
The recession coincided with a fiscal

tightening policy of the Federal
government and monetary tightening
by the Federal Reserve (Labonte &
Makinen, 2002).
1973
75
Nov.
1973 to
March
1975
16
months
-3.2%
9.0%
This recession included both rising

unemployment and rising inflation.
During this time period, oil prices
increased by over 400% (Zarnowitz,
1996).
Jan. 1980
to July
1980
6
months
-2.2%
7.8%
This was a relatively brief and mild

recession which was followed
approximately one year later by the
deep recession of 1981-82
(Zarnowitz, 1996).
July 1981
to Nov.
1982
16
months
-2.7%
10.2%
The Iranian crisis in 1979 led to

sharp increases in oil prices and
inflation. This was followed by tight
monetary
policy in an effort to control inflation
1980
1981
82
28
Table 1
A History of United States Recessions from 1945 to 2010 (cont.)
1990
91
2001
2007
09
July 1990
to March
1991
8
months
-1.4%
7.8%
The recession followed the Iraqi

invasion of Kuwait and the resulting
oil price spike (Labonte & Makinen,
2002).
March
2001to
Nov.
2001
8
months
-0.3%
6.3%
This was a relatively short and mild

recession. The most significant
aspect of this recession was the
collapse of
the stock market dot-com bubble
(Kliesen, 2003).
Dec. 2007
to June
2009
18
months
-12.8%
10.2%
This was the worst and longest

recession since the great depression
which began in 1929. This recession
began with the collapse of the
housing bubble and the subprime
mortgage crisis. This was followed
by a collapse in the banking and
automotive industries (NBER, 2011).
What Ends Recessions and What are The Long-Term Effects of Recessions?
Researchers have conducted a number of studies that address the question of what
ends recessions (Carvalho, Eusepi, & Grisse, 2012) and what the long-term effects of
recessions might be (Ouyang, 2009). These questions are important to this study as they
identify some of the negative effects of a recession that might be prevented or minimized
with better information about when a recession might end or how long a recession might
last.
What ends recessions? A recession ends when the economy shifts from decline
or negative economic growth to expansion or positive economic growth (NBER, 2010).
This shift is typically identified by an increase in employment, an increase in income
levels, and a shift from negative to positive economic growth. Romer and Romer (1994)
explained that when an economy is in recession the government and central bank
typically enact policies intended to minimize the effects of the recession and stimulate
29
expansionary growth that will end the recession. They identified two practices that are
commonly used by government: the first is the expansion of the money supply through
monetary policy and the second is the use of fiscal policy to increase consumption by
either individuals or the government. With monetary policy the Federal Reserve Bank
increases the supply of money in the economy which is expected to lower interest rates,
make more funds available for borrowing, and increase aggregate consumption (Carvalho
et al., 2012). Carvalho et al. explained that the effect is not only to make it easier for
firms to borrow and individuals to spend, but also to stimulate the positive expectations
and optimism that are needed to turn a recession into a period of growth. This optimism
is expected to cause individuals and firms to act as if the recession is ending thereby
stimulating economic growth. Romer and Romer (1994) found that for the eight
recessions from 1945 to 1994 the Federal Reserve Bank reacted by expanding the money
supply and that, on average, the expansion of the money supply resulted in adding
approximately two percentage points to real growth in GDP. They concluded that
monetary policy was more successful than fiscal policy because it could be applied
quickly and effectively. Similarly, Emara and Hassan (2010) studied the 2007 to 2009
recession and concluded that monetary policy was an effective tool that assisted in the
recovery and shortened the length of the recession.
Fiscal policy occurs when government either increases government spending or
implements a tax cut with the intent that taxpayers will increase spending and
consumption (Romer & Romer, 1994). Romer and Romer explained that the increase in
government spending is designed to put more money into the economy with the intent of
increasing consumption which stimulates economic growth. They also described how a
30
similar effect can occur with a reduction in taxes. Lower taxes puts more money in

stimulates economic growth. To this end Romer and Romer examined the eight U. S.
recessions that occurred between 1945 and 1994 and found that fiscal policy, while
commonly applied, was only minimally effective in bringing about the end of a recession.
They concluded that the fiscal policy efforts were either too small or too late; that fiscal
policies are difficult to administer in an effective way. Similarly, Emara and Hassan
(2010) studied the 2007 to 2009 recession and concluded that the fiscal policy efforts to
end the recession were sluggish and had only limited effectiveness.
The long-term effects of a recession. There are strong differences of opinion on
what long-term effects a recession has on an economy. Some researchers believe that
recessions, while painful, are good for an economy and have no significant long-term
effects (Beaudry & Koop, 1993; Ouyang, 2009). Other researchers believe that recessions
have significant long-term negative effects on the growth and the wellbeing of an
economy (Aghion, Angelotos, Banerjee & Manova, 2010; Barlevy, 2004; Ouyang, 2009).
The traditional view is that recessions improve the economy by identifying inefficiently
used resources and inefficient companies which fail during the recession resulting in the
reallocation of their resources to more efficient applications (Ouyang, 2009). This
reallocation occurs in two ways: first, as inefficient and unprofitable companies fail, their
assets are purchased and redeployed in new applications that are more efficient and more
profitable; and second, as companies identify inefficient aspects of their own operations
they restructure to be more efficient and more profitable (Maksimovic & Phillips, 1998).
A limitation of this study is that it does not consider the effect of young efficient
31
companies that are destroyed by a recession, not because they are inefficient, but rather
because they do not have resources needed to survive the recession (Ouyang, 2009).
Beaudry and Koop (1993) agreed with the conclusion that recessions do not have
any significant long-term negative effects; that the long-term effects of recessions were
minimal due to what is called the bounce back effect. They explained that the rate of
economic growth immediately following a recession is usually significantly higher than
average economic growth rates. This short-term higher growth rate or bounce back will
typically make up for the economic growth that was lost during the recession. This
bounce back phenomenon was confirmed and supported by Kim, Morley, and Piger
(2005). They found that for U. S. recessions between 1949 and 2003 the average annual
economic growth for the first four quarters following these recessions was 6.4% and for
the second four quarters following the recession the average annual growth rate was
4.0%. This compares favorably to the long-term average economic growth rate for the
same time period of approximately 3% (Bureau of Economic Analysis, 2011).
A contrary view has been reported by other researchers who concluded that there
are serious long-term effects from recessions and that the short-term bounce back of
economic growth is not sufficient to offset the negative effects of a recession (Aghion et
al., 2010; Barlevy, 2004; Ouyang, 2009; Ramey & Ramey, 1995). These researchers
concluded that the long-term negative effect of a recession is a lower long-term growth
rate in the economy (Ramey & Ramey, 1995). The economic growth figures and
recessions from 1962 to 1985 were examined for 92 countries by Ramey and Ramey.
They concluded that the economies that have fewer and less volatile recessions have
higher long-term growth rates than those economies that have more frequent or more
32
volatile recessions. In other words, while the bounce back effect may recoup the
economic growth lost because of a recession there is another factor and that is that
frequent or volatile business cycles reduce the overall long-term economic growth rate of
an economy. Their analysis also identified a negative correlation between the volatility
or severity of business cycles and long-term economic growth. Those countries with
fewer and less severe recessions had higher long-term economic growth rates than those
countries with more frequent or more severe recessions. In a similar but more current
study, Barlevy (2004) expanded the analysis by looking at data from 1951 to 1998 and
concluded that countries with fewer recessions and lower rates of volatility in their
economic growth, experienced long-term growth rates of one third to one half percentage
points higher than countries with more volatile economic growth. While the difference of
one third or one half of a percentage point may seem small over long periods of time the
difference is very significant. For example, over a 10-year period an economy with a
2.5% annual growth rate will have 10-year total growth 28.0%, while a country with a
3.0% annual growth rate will have 10-year total growth of 34.4%. In other words an
economy with a 3.0% growth rate will have 22.8% more growth in a 10-year period that
an economy with a 2.5% growth rate.
A natural next question that arises is: why do economies with fewer and less
volatile recessions have higher long-term growth rates? The literature provides two
possible answers. The first includes what is referred to as the scarring effect of
recessions. This is the idea that recessions hinder the growth and development of
potentially superior companies by destroying them during their infancy (Ouyang 2009).
Ouyang concluded that young companies with better productivity, better ideas, and better
33
technology will not survive in a recession due to the fact that they are young, small, and
therefore have fewer resources. In other words less efficient and less productive
companies survive simply because they are more established and have more resources.
Ouyang tested this hypothesis by examining the entry, exit, and productivity of firms in
the U. S. manufacturing sector from 1993 to 1997. She concluded that the scarring effect
or loss of young companies during a recession is more significant than the cleansing
effect that occurs when inefficient firms are eliminated and their resources reallocated.
The second cause of the long-term negative effects of a recession is the fact that
frequent recessions tend to push companies into an investing time frame that matches the
recessionary cycle, resulting in funds being invested in less efficient short-term projects
rather than more efficient long-term projects (Aghion et al., 2010). Aghion et al.
identified that recessions bring about tight credit markets and that tight credit markets
bring about higher interest rates and tighter credit standards. This increases both the risk
and the cost of longer-term projects and makes it more difficult for a firm to finance and
support long-term productivity improvement investments. In an effort to avoid this higher
level of risk and higher cost, firms invest in shorter term, lower productivity investments
that roughly match the business cycle, foregoing the longer term investments that would
have a more significant impact on efficiency, productivity, and long-term economic
growth. Aghion and colleagues concluded that the tighter credit associated with
recessions leads to higher economic volatility and lower long-term growth rates.
The Correlation of Interest Rates and Economic Growth
One of the foundational premises of this study was that there is a strong positive
relationship and correlation between interest rates and economic growth (Bianchi et al.,
34
2009; Estrella, 2005; & Smith & Taylor, 2009). This premise was developed through the
linking of several theoretical and foundational economic concepts. The first is that
economic growth occurs when investment or capital is added to an economy (Smith,
2009). The second is that the majority of new money or capital that is added to an
economy comes from debt (Reuters, 2011). The third is the intuitive awareness that
interest rates affect the availability and cost of debt (Chirinko, Fazzari, & Meyer, 1999).
In other words when interest rates are low and credit markets are healthy there will be
more new capital added to an economy than when interest rates are high and credit
markets are unhealthy. In summary it can be said that interest rates affect the availability
and cost of the newly added capital that stimulates economic growth.
In this section the literature that addresses the relationship between capital
formation and economic growth is reviewed. Additionally the literature on interest rates
and monetary policy is presented. Monetary policy is the action taken by the Federal
Reserve Bank to affect the size and rate of growth of the money supply which strongly
influences the level of interest rates and the availability of capital (Lengwiler & Lenz,
2010). Finally, the research that compares and measures the historic levels of correlation
between interest rates and economic growth are reviewed.
Capital and economic growth. The economic theory of free market capitalism is
centered on the idea that economic growth is created through capital formation (Harvey,
2011). This idea is at the core of the economic theory of capitalism. Adam Smith (2009),
in his book, The Wealth of Nations, defined capital as money or financial assets that are
invested for the purpose of making more money. An increase in capital is expected to
result in an increase in output or economic growth. Smith claimed that the economic
35
application of this theory occurs when an individual, firm, or country increases the
amount of capital that is invested in an economy. If the capital is put to work in a
practical and efficient way output will increase and there will be economic growth.
Solow (1956) added to the theory of capitalism by putting forth the idea that labor

ideas, education, or other intellectual abilities could be applied (or invested) in an

economy with the intent of making more money. This human capital results in an
increase in productivity or an improvement in technology that increases output and
results in economic growth.
While this theory of capital and economic growth is over 400 years old there are

Denison (1967) studied post
World War II economic growth in eight European countries and the United States. While
he found a strong correlation between capital accumulation and economic growth, He
questioned the conclusion that it was an increase in capital that resulted in future
economic growth. Rather, Denison proposed that it was increase in economic growth
that resulted in the increase in capital. In other words, Denison asserted that an increase
in economic growth (caused by productivity or technology) resulted in capital
accumulation rather than capital accumulation causing economic growth.
Capital and interest rates. Smith (2009) defined capital as money or financial
assets. In modern American corporations, invested capital is most commonly defined as

-term debt (Harvey, 2011). Equity is the
investment made by stockholders and long-

are invested in the business on a long-term basis (Harvey, 2011). Long-term debt
36
borrowing is, in fact, the largest source of capital for U. S. businesses (Reuters, 2011).
Approximately 65% of the capitalization of the Standard & index companies
comes from debt. During the first quarter of 2011 these companies had $1.85 of debt
capital for every $1.00 of equity capital.
Interest rates affect the cost and availability of debt (Chirinko et al., 1999).
Affordable interest rates are part of a normal and growing credit market. When interest
rates are low, businesses increase the amount of debt in the company, which increases
capital, which facilitates economic growth (Romer & Romer, 1994). The opposite is also
true. When interest rates are high, debt will be more expensive and harder to obtain. Thus
businesses will borrow less and debt levels will decrease, which decreases capital, which
results in decreased or negative economic growth (Norton, 2009). Healthy debt markets
facilitate economic growth and unhealthy debt markets frustrate economic growth (Tong
& Wei, 2011).
Monetary policy and interest rates. Monetary policy is described as the actions
and policies prescribed and implemented by a central bank, such as the Federal Reserve
Bank, to influence and manage both the level of interest rates and the level of the money
supply in an economy (Lengwiler & Lenz 2010). Lengwiler and Lenz (2010) identified
three primary ways that this policy is implemented. First, by buying or selling short-term
securities; buying securities increases the money supply which typically leads to lower
interest rates and easier credit and selling securities decreases the money supply which
leads to higher interest rates and tighter credit. Second, by communicating the intended
course of policy the central bank influences expectations over the medium term; investors

37
Finally, if the Central bank has established credibility in the market, its communicated
targets will have an influence on long-term interest rates. These premises are important to
this study because, if they are true, the Central bank has significant influence over the
levels of interest rates which would affect both GDP growth and the possibility of a
recession.
Empirical tests have been performed to determine whether or not the Federal

he U.S. (Lengwiler &
Lenz, 2010; Smith & Taylor, 2009). Both Lengwiler and Lenz (2010) and Smith and
Taylor (2009) concluded that monetary policy has influenced interest rates in the U.S.
Smith and Taylor (2009) examined short and long-term interest rates for two time
periods. The first was the 20 year period from the beginning of 1960 to the end of 1979
and the second was the 23 year period from the beginning of 1984 to the end of 2006.
They created a formula and model that predicted long-term interest rates based on the
policy rules of the Federal Reserve Bank. They concluded that the monetary policy
influences that are found in short-term interest rates could be used to predict future longterm interest rates. Lengwiler and Lenz (2010) examined short, medium and long-term
interest rates for the time period from the beginning of 1990 to the end of 2007 using a
vector autoregression analysis (VAR)

about desired interest
rates had a significant influence on short, medium and long-term interest rates. Lengwiler
and Lenz identified specific examples where changes in monetary policy were
unexpected and these changes resulted in significant interest rate shocks or volatile
adjustment in interest rates. They also identified examples where changes in monetary
38
policy were anticipated and these changes resulted in a reasonably smooth adjustment by
the market to the new targeted interest rate levels. One limitation of their study was the
relatively short time period. During the period examined there were only two recessions;
the recession of 1990-1991 and the recession of 2001.
The correlation of interest rates and economic growth. The existence of a
positive correlation between interest rates and economic growth is a foundational
assumption of this study. Several researchers have examined the historical interest rate
and economic growth data of the U. S. economy, measured their statistical correlation,
and concluded that there is a strong positive correlation between the yield curve (shortterm interest rates and the term spread of interest rates) and GDP growth (Ang et al.,
2006; Bianchi et al., 2009; Dotsey, 1998; Estrella, 2005; & Smith & Taylor, 2009).
Historically, Dotsey (1998) first compared the term spread of interest rates for U.
S. Treasuries, calculated using the three-month U.S. Treasury bill and the 10-year U.S.
Treasury bond, and GDP growth rates for the period from 1957 through 1998 using
regression analysis. Dotsey discovered that movements in the term spread of interest rates
preceded changes in real GDP growth and that these two time data series where
positively correlated. Dotsey concluded that changes in the term spread of interest rates
preceded changes in GDP growth and that the term spread could be used to forecast
whether or not future economic growth activity would be weak or strong. He concluded
that the term spread of interest rates could be used to predict GDP growth up to two years
into the future. More recently, Ang et al. (2006) conducted a follow-up study and used
vector autoregression to examine the relationship between GDP growth and both the level
of short-term interest rates and the term spread of interest rates. The research included
39
data from 1960 to 2005 and used interest rate data from U. S. Treasuries with maturities
between three months and 60 months. They found a high positive correlation between
both the short-term level of interest rates and GDP growth as well as the interest rate term
spread and GDP growth. They also determined that using an interest rate term spread
calculated with Treasury bonds with longer maturities was more effective and had a
higher predictive power than an interest rate term spread calculated using Treasury bonds
with shorter maturities. One limitation of this conclusion is that the study did not include
any U.S. Treasury securities with maturities longer than five years.
Ang et al. (2006) also concluded that level of short-term interest rates had more
predictive power than interest rate term spreads. In 2009, Mueller conducted similar
research but with corporate bond interest rates instead of U. S. Treasury bond rates.
Mueller concluded that the interest rate term spread of corporate bond interest rates
actually had a higher positive correlation and better forecasting power of GDP growth
than U. S. Treasury spreads. Similarly, Harvey (1989) concluded that short-term bond
yields explained 30% of the variation in U.S. economic growth.
If the relationship between interest rates and GDP growth exists in the U. S.
economy the question must also be asked as to whether or not a similar relationship exists
in other economies. Several researchers examined this question. Diebold, Li, and Yue,
(2008), combined data from four countries (Germany, Japan, the UK and the U.S.) into a
global model in an effort to determine whether or not the relationship could be applied
globally. They examined 20 years of economic growth and interest rate data from 1985
through 2005 and concluded that the relationship and correlation between interest rate
40
data and economic growth is applicable in the global economy as well as the U. S.
economy.
With the relationship between interest rates and economic growth identified for
the U.S. economy and the global economy the question then becomes, does this
relationship exist in other individual country economies? Several researchers have
confirmed similar relationships in many other economies including Europe (Panopoulou,
2009), Canada and Germany (Estrella, 2005), the UK (Bianchi et al., 2009), Spain
(Esteve, Navarro-Ibanez, & Prats, 2012), and Australia (Suardi, 2010).
Panopoulou (2009) confirmed that the positive correlation between interest rates
and economic growth existed in the European economy as well as the U. S. economy. He
examined the correlation for the combined European area and for the individual countries
within the European area using a regression analysis and the Granger causality test. The
data set included monthly data for the period of January 1988 to May 2005. The analysis
applied non-parametric techniques to detect whether or not there was any Granger
causality between the term spread of interest rates and economic growth. Granger
causality, indicating a positive correlation, was detected when the data for the 12 euro
area countries was combined. When the individual countries were analyzed Granger
causality was detected in five of the 12 countries including Austria, Belgium, France,
Germany, and the Netherlands. No causality was identified for the other seven euro area
countries which included Finland, Greece, Ireland, Italy, Luxemburg, Portugal, and
Spain. Panopoulou concluded that for the economy of the European area as a whole and
within each of the five countries, there is strong evidence supporting a causal relationship
between the term spread of interest rates and economic growth. It is important to note (as
41
a limitation) that while the relationship between interest rates and economic growth was
confirmed for the combined twelve European countries it could not be confirmed in
seven of the twelve countries when analyzed individually.
In a similar study, Estrella (2005) examined the Canadian and German economies
to identify if a positive correlation existed between interest rates and economic growth.
Estrella concluded that a strong positive correlation between interest rate data and
economic growth also exists in both Canada and Germany. A separate study to identify
the strength of the relationship in the UK economy was conducted by Bianchi et al.
(2009). They examined the UK treasury yields for maturities between three-months and
10-years using vector auto regression from January 1970 through March 2006. They
concluded that the term structure of interest rates and economic output were positively
correlated in the UK.
Research on Australian and Spanish economies has also been conducted. Suardi
(2010) examined Australian interest rates and economic growth using cointegration
regression analysis. Suardi concluded that changes in interest rate data coincided with the
Australian recessions of 1982-1983 and 1990-1991, and the 1993 inflation targeting
period. Suardi also concluded that a strong positive correlation existed between shortterm interest rates and economic growth. Regarding the economy of Spain, Esteve,
Navarro-Ibanez, and Prats (2012) investigated the economic data looking at interest rates
and economic output from 1974 to 2010. They examined the data using a linear
cointegrated regression model and concluded that a positive correlation similar to that
shown in other countries also exists in Spain.
42
While the positive correlation between the components of the yield curve and
GDP growth has been well established, as described above, some researchers have
concluded that the relationship may be changing over time and that the forecasting ability
of the yield curve and the term spread of interest rates has fallen over the past few
decades (Bianchi et al., 2009; Giacomini & Rossi, 2006; Schrimpf & Wang, 2010). One
idea that has been presented is that the effectiveness of the yield curve as a predictor of
economic growth is dependent upon the policies of the central bank and as central banks
have become more efficient the forecasting tool has become less effective (Bianchi et al.,
2009; Giacomini & Rossi, 2006).
For example, Giacomini and Rossi (2006) examined the data for the U.S.
economy from 1970 to 2000 and concluded that there were breakdowns in the
effectiveness of using interest rate data to forecast economic growth and that these
breakdowns coincided with different periods of leadership and different applications of
monetary policy from the Federal Reserve Bank. During the 1970 to 1987 period when
Arthur Burns, William Miller, and Paul Volker were the Chairmen of the Federal Reserve
Bank there was a breakdown or weakening in the forecasting ability of the term spread of
interest rates. However from 1987 to 2000, during the time when Alan Greenspan was the
Chairman of the Federal Reserve Bank the yield curve emerged as a more reliable tool to
predict future changes in economic growth. In a similar study Bianchi et al. (2009)
investigated the UK economy, examining data from January 1970 to March 2006 and
concluded that the effectiveness of using interest rate data as a predictor of economic
growth varied based on the economic policies of the central bank. They concluded that
from 1970 to 1992 there was a weakening and increased volatility in the effectiveness of
43
the yield curve as a predictor of economic growth, however beginning in 1992, when the
Bank of England began to target inflation rates and maintain a monetary policy designed
to keep inflation rates below a specified rate, there was greater predictability and stability
in the relationship between the term spread of interest rates and economic growth.
A second idea suggesting a weakening in the forecasting effectiveness of interest
rate data is that the increase in unanticipated economic changes and economic instability
in recent years has made the predictive power of the yield curve less effective. Schrimpf
and Wang (2010) tested this assertion. Their study used a window selection technique,
which is a predictive regression tool designed to identify structural breaks in a time series
analysis and minimize the historical bias. Schrimpf and Wang found that the yield curve
is still an effective leading indicator but it is less effective than in the past. The authors
also found that the window selection technique, while a relatively new statistical
technique, was effective at identifying structural economic breaks.
The conclusions from the research cited above can be summarized as follows:
first, there is a strong positive correlation between the term spread of interest rates and
economic growth within the U.S. economy (Ang et al., 2006; Bianchi et al., 2009;
Dotsey, 1998; Estrella, 2005; & Smith & Taylor, 2009); second, that there is a strong
positive correlation between the level of short-term interest rates and economic growth
within the U.S. economy (Ang et al, 2006); third, this relationship between interest rates
and economic growth has been identified and confirmed using both interest rates from
both U.S. Treasury bonds and interest rates from corporate bonds (Harvey, 1989;
Mueller, 2009); fourth a similar correlation between interest rates and economic growth
exists in international economies as well as in the U.S. economy (Esteve et al., 2012;
44
Estrella, 2005; Bianchi et al., 2009; Panopoulou, 2009; Suardi, 2010); and finally the
effectiveness of using yield curve interest rate data to forecast economic growth depends
on the monetary policies of the central bank and may be deteriorating over time.
Using Macroeconomic Variables to Forecast Economic Growth
Above, the correlation between interest rates and economic growth was discussed.
In this section the relationship and correlation of a number of non-interest rate
macroeconomic variables is presented and reviewed. The results of these studies are
important because they identify variables that have shown a positive correlation to GDP
growth. These are variables, in addition to interest rates, that could possibly be used to
forecast GDP growth. Researchers have examined and analyzed many macroeconomic
variables in an effort to identify those variables that are positively correlated with
economic growth and that could be used to forecast GDP growth. For example, Aylward
and Glen (2000) examined whether stock prices could be used to forecast GDP growth.
Similarly, Cornell (2010) looked at corporate profits and concluded that there was a
positive correlation between corporate profits and GDP growth. Wang and Wen (2011)
investigated the relationship between capacity utilization and economic growth. Other
researchers examined whether or not electricity consumption could be used for forecast
GDP growth (Apergis & Payne, 2011; Ciarreta & Zarraga, 2010; Ferguson, Wilkinson &
Hill, 2000) and other researchers investigated if surveying business owners could be used
identify changes in economic activity that could be used to forecast GDP growth
(Hansson, Jansson, & Lof, 2005; Siliverstovs, 2010).
An understanding and knowledge of these types of studies is a key part of the
foundational knowledge needed for this study to be successful. Any study that has been
45
completed is relevant, whether the variables are interest rate data or some other
macroeconomic variable. Each of the variables in these studies has the possibility of
potentially being able to be used to effectively forecasting GDP growth. For this reason it
is important to understand the variable, how it was identified, defined, analyzed, and
what the results of the study were. A discussion of each of these variables, the analysis
performed, along with the results and conclusions will be presented below.
Stock prices. Stock market prices are believed to be forward looking

activity, growth and earnings (Aylward & Glen, 2000). If this is the case then an
aggregate of stock market values should provide information about the expected growth
in that market. This information could be useful in forecasting economic growth.
Researchers have investigated whether or not stock prices do indeed have a positive
correlation with GDP growth and whether or not they can be used to forecast economic
growth (Aylward & Glen, 2000; Panopoulou, 2009).
Aylward and Glen (2000) examined the stock market pricing and GDP growth of
23 countries for the forty-two year period from 1951 to 1993. They concluded that a
positive correlation existed in 21 of the 23 countries examined and that the U.S. had the
strongest positive correlation with a correlation coefficient 0.64. Their results showed
that the correlation was significantly different between countries and while there was a
positive correlation this did not generally convert into being able to use stock market
information to successfully forecast economic growth. Similarly, Panopoulou (2009)
analyzed the stock prices and GDP growth for 12 European Union countries for the
period from January of 1988 through May of 2005. He concluded that the leading
46
indicator value of the stock market was only useful about 50% of the time and that the
forecasting ability of stock market prices was better when it was combined with other
leading indicators such as interest rates. The general conclusion of both Panopoulou
(2009) and Aylward and Glen (2000) was that while there is a positive correlation
between stock prices and GDP growth the relationship was not strong enough to be used
to effectively forecast GDP growth.
Corporate profits. Gross Domestic Product is defined as the economic output of
an economy, which is a result of the efforts and successes of the firms and corporations
within the economy. If this is correct then corporate profitability, the most common
measure of corporate success, could possibly be a measure of future economic growth
and success. Cornell (2010) examined corporate profitability and economic growth in an
effort to identify if there was a relationship between them that could be used to predict
levels of GDP growth. In his study U.S. data for the period of 1947 through 2008 was
analyzed. Cornell found that there was a positive correlation between the level of
corporate profits and GDP but that corporate profits were not a leading indicator of GDP
growth. Rather, he found that the ratio of corporate profits to total GDP fell within a
range of between 3% and 11% with an average of about 8%. Cornell found that when the
ratio of earnings to GDP was less than 8% future profits tended increase towards the 8%
amount and when the ratio was greater than 8% future profits tended to decrease towards
the 8% average. He concluded that this relationship could be used to estimate whether or
not stock prices were overvalued or undervalued but could not be used to effectively
predict the growth in GDP.
47
Capacity utilization. The idea of capacity utilization as a predictor of GDP
growth is based on the premise that when manufacturing businesses get busier, when the
utilization of manufacturing capacity increases, then economic growth is increasing and
when the opposite occurs, when capacity utilization declines, then economic growth will
either slow down or turn negative (Franke & Miller, 2007). Wang and Wen (2011)
confirmed this idea when they analyzed GDP growth and capacity utilization in the U.S.
for the period from 1948 to 2007. They concluded that capacity utilization is positively
correlated to the average growth rate of GDP but that capacity utilization is not a good
predictor of future economic growth. They found that the average utilization over time
correlates well with the average growth rate over time, but that short-term changes in
utilization were not good predictors of short-term changes in economic growth. Wang
and Wen also concluded that countries with low volatility in capacity utilization rates had
higher long-term GDP growth rates. This suggested that a key factor for economic
growth is stability in capacity utilization.
In a similar study, Franke and Miller (2007) compared two variables, first the
addition of new capital, and second the increase of capacity utilization to economic
growth in the same economy. They concluded that in the short-term, capacity utilization
had a much more significant impact on economic growth than capital formation did.
Frank and Miller also concluded that there is a strong positive correlation between
capacity utilization and economic growth and that this correlation is stronger than the
correlation between capital formation and economic growth.
Electricity consumption. Ferguson et al. (2000) presented the idea that energy
utilization, specifically electricity consumption, could be correlated with economic
48
growth. They contended that electricity plays a critical role in the production of goods in
an economy and that the availability of electricity has been an important part in the
technological and production advancements in developed countries. Their study
demonstrated that there was a high positive correlation between electricity usage and the
level of economic growth.
Other researchers also investigated the question of whether or not changes in
electricity consumption had a causal relationship with changes in GDP. For example,
Ciarreta and Zarraga (2010) investigated this relationship in 12 European countries for
the 17-year period from 1970 through 2007. They concluded that in the short run there
was strong causality from electricity consumption to GDP, but in the long run there was
an equilibrium relationship between GDP growth and electricity consumption. They also
identified that one issue of importance was the effect of energy prices on electricity
consumption; specifically would increases in energy prices reduce consumption and
thereby reduce GDP growth? In other words, would conservation efforts that reduce
consumption have a negative effect on GDP? Similarly, Apergis and Payne (2011)
looked at 88 countries for the 46-year time period from 1960 through 2006. They found
that the causal relationship varied based on the income level of the country. Bidirectional
causality existed for high income and upper middle income countries while unidirectional
causality from electricity consumption to economic growth existed for lower-middle and
low income countries. Both the Apergis and Payne study and the Ciarreta and Zarraga
study identified a causal relationships between electricity consumption and GDP growth
but neither study examined whether or not electricity consumption would be effective in
forecasting GDP growth.
49
Business surveys. Hansson, Jansson, and Lof (2005) asserted that businessmen
and employers were closest to the ups and downs of an economy and thereby would have
first-hand knowledge that could be used to identify economic trends. They conducted a
study to determine whether the results of surveys of businesses could be used effectively
forecast GDP. For their analysis they used the Swedish Business Tendency Survey (BTS)
which is a large survey that is taken quarterly in Sweden. The survey has been conducted
regularly since 1996 and included as many as 7,000 firms from all sectors of the
economy. Hansson et al. concluded that in the short-term (one to two quarters) the survey
respondents were better at forecasting GDP than other competing forecasting methods. A
similar study was completed by Siliverstovs (2010) using the KOF Economic Barometer
which is a leading indicator that is developed from business tendency surveys collected
by the KOF Swiss Economic Institute. Siliverstovs compared the forecast from the KOF
Economic Barometer against actual GDP data for the period from 2006 through 2010 and
concluded that forecasts made from the business surveys were more accurate than
forecasts based on a univariate autoregressive model. Both Siliverstovs (2010) and
Hansson, Jansson and Lof (2005) concluded that in the short-term, surveys completed by
businessmen and employers could be used to accurately forecast changes in GDP growth.
Using Interest Rate Data to Forecast Economic Recessions
Background. The study of the relationship between yield curve interest rate data
an

1998). Stock and Watson (1989) were instrumental in building the foundation for the
research by finding that one of the components of the yield curve, the term spread of
interest rates, was an important variable worthy of being included in the index of
50
economic indicators. Estrella and Hardouvelis (1991) expanded the knowledgebase by
carefully documenting the relationship between interest rate spreads and future economic
growth. Other researchers confirmed the relationship and defined the nature of it in
greater detail (Estrella 2005; Estrella & Mishkin 1996; Powell 2006). The essence of the
relationship between the components of the yield curve and economic growth is this: at
some point in time, prior to a period of negative economic growth (a recession), there
will be a decline in the term spread of interest rates; it will turn negative (Estrella &
Mishkin, 1996). Dotsey (1998) agreed with Estrella and Mishkin and confirmed that the
key forecasting factor was an inverted term spread. This inverted term spread observation
was confirmed by Powell (2006) when he examined the data from past recessions to
identify the level of the term spread inversion that could be used, as a signal, to forecast
an impending recession. He examined the six recessions between 1969 and 2002. The
yield curve variables that Powell used to calculate the interest rate term spread included
the three-month Treasury bill rate and the 10-year Treasury bond rate. Powell found that
for each of these six recessions the yield curve inverted significantly (by at least 100
basis points) within the two years immediately preceding each recession. Powell
concluded that an important factor to look for, when attempting to forecast recessions,
would be an interest rate term spread inversion of 100 basis points or more. Estrella
(2005)
U. S. recessions from 1950 to
2002 concluding that each of these recessions was preceded by a sharp drop in the
interest rate term spread. Like Powell, Estrella used the difference between the threemonth Treasury bill rate and the 10-year Treasury bond rate as his measure. Estrella also
concluded that it was the level of interest rate term spread and not the level of change in
51
nominal interest rates that is important. It did not matter if the interest rate yield spread
changed by 100 or 200 or 300 basis points. Rather, what was significant was the level of
short-term rates compared to the level of long-term rates. Estrella identified that it was
the time period when short-term rates are equal to or higher than long-term rates that was
important. This was when the interest term spread turned negative and this was the factor
that preceded an economic downturn.
Several researchers (e.g. Estrella, 2005; Estrella & Mishkin, 1996; Dotsey, 1998)
concluded that the yield curve has been an effective forecaster of recessions. This leads to
the question of whether or not the yield curve could be used to forecast the level of
economic growth during non-recessionary times. Chauvet and Potter (2005) conducted a
study to examine and compare four different recession forecasting models in an effort to
determine if they could predict changes in economic growth in addition to recessions.
The first model was a time invariant conditionally independent model; the second was a
time varying conditionally independent model that considered multiple breakpoints
across a business cycle; the third model had constant parameters with an autocorrelated
latent variable; and the fourth model had time varying parameters with an autocorrelated
latent variable. All four forecasting models used yield curve data from January 1954 to
March 2001. The study identified that some of the models successfully predicted
slowdowns in economic growth that did not result in a recessions. However, Chauvet and
Potter concluded that while the yield curve is a statistically significant predictor of future
economic activity it is not stable enough to be used effectively to forecast ongoing
changes in economic growth.
52
The probability of a recession. If a negative interest rate term spread is an
accurate forecaster of a recession a relevant question is can a probability be assigned to
the yield curve data to identify the likelihood that a recession will occur? Ang et al.
(2006) examined this question by looking at all the recessions from 1964 to 2006. They
looked at not only the term spread but also the level of interest rates and they also
calculated the term spread using a variety of different bond maturities to identify which
maturity had the best results. This data was analyzed using ordinary least squares (OLS)
regression analysis and vector autoregression (VAR) analysis. Ang et al. concluded that
the higher the interest rate spread the lower the probability of a recession and the lower
the spread the higher the probability of a recession. They also concluded that the term
spread calculated with the longest maturities had the best predictive power. For example,
it would be expected that an interest rate term spread calculated from a three-month
Treasury bill rate and a 10-year Treasury bond rate would result in more accurate
projections than one calculated from a three-month Treasury bill rate and a five-year
Treasury bond rate. Powell (2006) examined the recessions between 1970 and 2005 and
created a model that assigned a probability of recession to different levels of the term
spread. Ang et al. (2006) concluded that if the term spread was a positive 121 points or
higher the probability of a recession was less than 5% but if it was a negative 240 basis
points or lower the probability of a recession was greater than 90%. The point at which
the probability of a recession exceeded 50% was an interest rate term spread of a negative
82 basis points or lower. It was based on this research that Powell concluded that the best
single level or trigger that could be used to predict a recession was a term spread of a
negative 100 basis points.
53
Short-term interest rates and forecasting recessions. Ang et al. (2006)
discovered that in addition to their conclusions regarding the term spread of interest rates,
that nominal short-term interest rates contain more information about GDP growth than
the term spread of interest rates. They found that high short-term interest rates preceded
periods of negative economic growth. Moersch and Pohl (2011) also found evidence of
short-term interest rate predictive power. They examined recessions in seven countries
between 1970 and 2008. The data analyzed included short-term interest rates (threemonth) and the term spread between long-term (10-year) and short-term interest rates.
They concluded that for four of those countries, Canada, the U.S., Germany, and the UK
the term spread of interest rates was the more powerful predictor but for the other three
countries, Australia, France, and Japan the level of short-term interest rates was the better
predictor. Moersch and Pohl presented the idea that in these countries the monetary
policy of the central bank and the resulting levels of interest rates were more significant.
What is the forecasting lead time? Another important question when
considering the components of the yield curve as predictors of a recession was what is the
lead time; how long before a recession can the signal be identified? Estrella and Mishkin
(1996) examined this question for the recessions from 1970 to 1996 and Moersch and
Pohl (2011) examined the question for the recessions from 1970 through 2008. Both
studies had similar results and conclusions. Estrella and Mishkin constructed a model
based on their analysis of the five recessions and calculated the probability of a recession
one quarter, two quarters, four quarters and six quarters in advance of each of the
recessions. The results supported their conclusion that the signal is strongest two to four
quarters prior to a recession. Moersch and Pohl examined six U.S. recessions and
54
concluded that the term spread was best used to forecast recessions three to four quarters
in advance of the recession.
Have there been yield curve failures? If the yield curve can be used to forecast
recessions an important question to ask is whether or not the yield curve has failed in its
predictive power. In other words, have there been recessions that were not predicted by
the interest rate data of the yield curve or have there been false positive forecasts where
the yield curve forecast recessions that did not occur? Dotsey (1998) examined these
concerns and identified two incidences of false or inaccurate predictions: one where the
yield curve did not accurately predict a recession; and one where a predicted recession
did not occur. Dotsey first identified that in 1966 the interest rate term spread turned
negative by approximately 50 basis points but no recession followed. The second failure
identified by Dotsey was the failure of the yield curve to forecast the 1990-1991
recession. Approximately one year before the recession the term spread dropped from
about 250 basis points to about zero but the term spread did not turn negative as it had
prior to other recessions. Dotsey concluded by stating that while the term spread contains
valuable information about future economic growth it is not as precise as practitioners
would like it to be.
Does the yield curve work in international markets? If the yield curve has
been successful in forecasting recessions in the U.S. economy could it also be effective in
forecasting recessions in the economies of other countries? A number of researchers
addressed this question and concluded that the answer is yes (Estrella, 2005; Chauvet &
Potter, 2005, Moersch & Pohl, 2011). For example, Moersch and Pohl (2011) examined
the recessions from 1970 through 2008 and found that the yield curve could be used to
55
effectively forecast recessions in Canada, Germany, and the UK as well as the U.S.
Estrella (2005) concluded that the term spread of interest rates could be used to
effectively forecast recessions in Germany and Canada.
The yield curve versus the forecasting professionals. If the yield curve is an
effective tool to forecast recessions an appropriate question is how does the historic
performance of the yield curve compare to other methods of forecasting? This question
was investigated by Rudebusch and Williams (2009) who compared the published
historic forecasts of economic professionals provided by the Survey of Professional
Forecasters (SPF) with forecasts made using the yield curve. The SPF is a quarterly
forecast that has been published since 1968. The Federal Reserve Bank of Philadelphia
surveys economists and forecasters, compiles the information, and publishes it as the
SPF. Rudebusch and Williams compared the forecast of the SPF to forecasts based on the
yield curve for the 1968 to 2007 time period. During this time period there were six
recessions. They found that the yield curve forecasts were more consistent and reliable
than the professional forecasts. In their research they analyzed forecasts one quarter, two
quarters and four quarters before each recession. They found that one quarter before a
recession the SPF forecasts were more accurate than the forecasts made using the yield
curve, however, at both the two quarter and four quarter time frames the yield curve
forecasts performed much better than the forecasts of the professional economists and
forecasters. In all fairness Rudebusch and Williams point out that the primary purpose of
SPF is not to forecast recessions, but rather to forecast economic growth rates.
The yield curve and the stock market. If the yield curve is a successful tool
that can be used to forecast recessions then an appropriate question is how can a
56
practitioner use this tool in the real economy? Resnick and Shoesmith (2002) tested the
application of the yield curve in the stock market. In their study they compared the results
of two investment portfolios. The first portfolio used a traditional buy and hold strategy
buying and holding the S&P 500 equity index. The second portfolio was a market timed
portfolio that bought the S&P 500 equity index during periods of growth, but during
periods of recession they sold the S&P 500 equity index and bought 30 day Treasury
bills. The trigger for selling the S&P equity index and buying the Treasury bills was the
point when the yield curve predicted a recession and the trigger for selling the Treasurybills and buying the S&P 500 was when economic growth turned positive. The
researchers assumed the portfolio was held for the 29-year period from the beginning of
1971 through the end of 1999. Resnick and Shoesmith found that an investor in the
market timed portfolio, that based their investment decisions on the yield curve and
economic growth, earned a rate of return of 4.8 percentage points higher than an investor
using the buy and hold strategy. With the buy and hold strategy, one dollar invested in
January 1971 would have been worth $46.71 in December 1999. With the market timing
strategy one dollar invested in January 1971 would have been worth $74.93 in December
1999. For the 28 year holding period of this test, the market timing strategy produced a
return $28.22 or 60.55% higher than the buy and hold strategy.
Is the yield curve still effective today? As described above the forecasting

30 years to learn about and adapt to this information (Schrimpf & Wang, 2010). The
natural question is does the yield curve still work as an accurate tool to forecast
recessions and is it still as effective as it was in the beginning? Several researchers have
57
examined this question and some have determined that the yield curve has lost some of
its luster and power (Chauvet & Potter, 2005; Dotsey, 1998; Schrimpf & Wang, 2010).
Others concluded that the yield curve is still effective and continues to be a valuable
forecasting tool (Emara & Hassan, 2010; Moersch & Pohl, 2011).
As early as 1998, Dotsey concluded that the accuracy of GDP growth forecasts
prepared using the yield curve were less precise than during earlier periods. He could not
conclude whether the less precise forecasts were the result of a permanent or temporary
change in the structure of the economy. In 2005, Chauvet and Potter concluded that the
signals from the yield curve used to predict recessions are far from precise and that they
had deteriorated over time. They posited that the predictive power likely depends on how
the economy responds to the monetary policy of the central bank. In 2010, Schrimpf and
Wang examined the period of 1967 to 1997. They used a relatively new statistical
regression method called the window selection method. It allows the researcher to pin
down the exact dates of significant structural breaks in the economy of the country.
Schrimpf and Wang concluded that there was significant instability in the relationship
between the term spread and economic growth. Their results strongly suggest that the
yield curve is losing its edge as a predictor of economic growth and recessions.
While the researchers mentioned above concluded that the predictive value of the
yield curve has diminished, other researchers

power is as strong as ever and that yield curve signal predicting the 2007-2009 recession
was as strong as the signals for previous recessions (Moersch & Pohl, 2011). Emara and
Hassan (2010) examined the 2007-2009 recession and concluded that the yield curve
signal was strong. They found that what was surprising was that most economists and
58
forecasters were taken by surprise by the recession. This raises the question of whether or
not forecasters and economists are using this tool as they forecast economic growth.
Moersch and Pohl analyzed the six recessions between 1970 and 2008, including the start
of the most recent 2007-2009 recession, and concluded that the interest rate term spread
remains useful for forecasting recessions in a number of countries. While some
researchers are concluding that the yield curve is becoming less powerful as a forecasting
tool it was successful in forecasting the most recent 2007-2009 recession.
Summary
The purpose of this study was to analyze the two variables of the yield curve (the
term spread of interest rates and the level of short-term interest rates) to determine
whether or not these variables could be used to forecast the changes in GDP growth that
are used to mark the beginning or end of a recession. In this chapter the literature that
provides a foundation for this area of study and contributes to the body of knowledge in
this area was presented and reviewed.
In the first section, the history of the U. S. recessions that occurred between 1945
and 2012 was reviewed. During this time period there were a total of 12 recessions or on
average, one every 65 months. On average each recession lasted 11 months (NBER,
2011) and resulted in a 3.7% decline in the production of goods and services (Bureau of
Economic Analysis, 2012). This history was provided in an effort to provide the reader
with a perspective of the frequency, duration, and serious effects recessions have on the
U. S. economy.
In the second section of the chapter the economic policies that have been used in
the efforts to end recessions was discussed. The two most common economic policies
59
applied by the Federal government were monetary policy and fiscal policy (Romer &
Romer, 1994). Of the two methods monetary policy was found to be the most effective at
stimulating the economic growth that is needed to end a recession (Emara & Hassan,
2010). The second section also presented the research that has investigated the long-term
effects of recessions. In this area there are two conflicting areas of thought. The first is
that recessions are, in effect, a cleansing of the economy and the economic growth that is
lost during the recession is made up after the recession (Ouyang, 2009). The second area
of thought is that economies that have more severe or volatile recessions have lower
long-term growth rates than economies with fewer and less volatile recessions (Barlevy,
2004). In combination, the first and second sections of the chapter review the economic
problems that exist as a result of recessions. The purpose being to illustrate the benefits
that might be achieved by forecasting when a recession will end or how long a recession
will last.
In the third section of this chapter the literature that examines the relationship
between interest rates and economic growth was presented and discussed. The research
showed that the availability of capital was positively correlated with economic growth
and that the level of interest rates, whether they are high or low, has a significant effect
on the availability of capital (Harvey, 2012). The literature also showed that there was a
strong positive correlation between interest rates and economic growth (Bianchi et al.,
2009: Smith & Taylor, 2009).
The fourth section of the chapter presented the literature from studies that
investigated the question of what variables might be used to forecast economic growth.
This critical section addressed the question of whether or not interest rates are the best
60
variables to be used in this study. The conclusions from the literature were that while
other variables such as stock market prices, corporate profits, capacity utilization, and
electric consumption are positively correlated with economic growth (Apergis & Payne,
2011; Cornell, 2010; Panopoulou, 2009; Wang & Wen, 2011) none of them have a
correlation that is as strong or consistent over time as interest rates (Bianchi et al., 2009).
In the final section, the question of whether interest rates can be used to forecast
whether or not a recession is eminent was examined. This is the most critical assumption
of this study. The literature did show that the yield curve interest rate data was
successfully used to forecast each of the 12 recessions that occurred during the study
period of 1945 to 2012 (Estrella, 2005; Moersch & Pohl, 2012). The literature also
showed that the yield curve interest rate forecast had a typical lead time of between two
and six quarters (6 to 18 months) (Powell, 2006). Moersch and Pohl (2011) concluded
that the relationship exists not only in the U. S. economy but also internationally.
61
Chapter 3: Research Method
Governments, businesses, and families experience economic hardship and stress
during a recession (Jiang et al., 2009). In the last recession (2007-2009) the median
family net worth in the U. S. fell from $126,400 in 2007 to $77,300 in 2010; a decline of
nearly 39% (Federal Reserve, 2012). In the same timeframe government revenue at the
Federal level fell over 19% (Office of Management and Budget, 2012). Business profits
also fell over 16% (U.S. Census Bureau, 2012). The economic hardship experienced by
these sectors of the economy during a recession is significant. All sectors could benefit
from a tool that could assist in identifying when a recession might occur, how long it
might last, or when it might end (Peck and Yang, 2011). The current study represented a
first step in identifying and researching such a tool. While the yield curve had been
shown to be an effective tool to forecast whether or not a recession is probable and
approximately when a recession might begin (Ang et al., 2006; Moersch & Pohl, 2011;
Powell, 2006; & Rudebusch & Williams, 2009), it was not known whether or not the
components of the yield curve could be used to predict how long a recession might last or
when a recession might end. The purpose of this quantitative correlational study was to
examine two variables of the yield curve (the term spread of interest rates and the level of
short-term interest rates) to determine whether or not they are effective in forecasting
economic growth which can then be used to effectively forecast how long a recession
might last, and when it might end.
Research Methods and Design
For this study, a quantitative research methodology with a correlational design
was employed. With quantitative methodology, mathematical or statistical methods are
used to measure the relationship between two or more variables or to measure the before
62
and after effect of a treatment on a variable (Vogt, 2007). Qualitative research methods
use non-quantitative data (information that is non-numeric and unstructured) to
understand behavior and to identify themes and insights into the research topic (Black,
1999). Mixed methods research combines both methods with the central premise being
that combining quantitative and qualitative approaches can provide a better understanding
of the research problem than either approach alone (Creswell & Plano-Clark, 2007). The
quantitative research method was selected as this study was an economic analysis
intended to identify and define the relationship between the two explanatory variables
from the yield curve (the term spread of interest rates and the level of short-term interest
rates) and the dependent variable, which was economic growth as measured by GDP
growth.
Within the quantitative research method umbrella there are three primary research
designs: causal-comparative, correlational, and experimental (Vogt, 2007). The
correlational design is used when there is: only one set of data; when the data is nonrandom; when there is no control group; and when the data will be statistically analyzed
to determine the relationship between the different variables of the data set (Garson,
2011). This study fit well within the parameters of the quantitative study with a
correlational design. The measurements of variables that were used in the study are
historical economic statistics that are non-random. There was no control group and no
treatment group. There was only one set of data, which consisted of historical interest rate
and economic growth data. The data of the study was statistically analyzed to determine
the relationship between each explanatory variable (short-term interest rates and the term
spread of interest rates) and the dependent variable, which was GDP growth. It was
63
appropriate to use the correlational design in a retrospective economic analysis study like
this study (Vogt, 2007).
The purpose of the study was to determine the relationship between the two
explanatory variables, individually and in combination, with GDP growth. This research
design aligned with the goals of the study. The research methodology met the purpose of
the study because the results of the statistical analysis provided the answers to the
research questions. The analysis provided the information needed to answer the questions
about the correlation, relationship, and forecasting effectiveness of the yield curve
interest rate variables in determining how long a recession might last or when a recession
might end.
Population
There were no human participants in this study. The population data set available
for use in this study consisted of a time series of macroeconomic variables of the yield
curve which included the interest rate term spread, the level of short-term interest rates,
and economic growth as measured by GDP growth. The potential population included
data from the 1800s to the present time. The interest rate data, both short-term and longterm, that were used, came from historic interest rate data published by the Federal
Reserve Bank. The GDP data that was used came from historic GDP figures published by
the U.S. Department of Commerce. The term spread of interest rates were calculated
from the Federal Reserve Bank interest rate data.
Sample
The sample data sets that were used in the analysis included the two explanatory
variables (the interest rate term spread and the level of short-term interest rates) and the
64
one dependent variable (GDP growth). The data set included these variables for the U.S.
economy for the 71-year period of 1942 to 2012; 1942 was selected as the beginning year
as it was three years prior to the 1945 recession. The 1945 recession was the first
recession after World War II. Economic researchers frequently use the postwar time
period in economic studies as the postwar economic environment is very different from
the war and depression economy that existed before the war (Dotsey, 1989; Estrella &
Mishkin, 1996). Within this time period (71 years) there was 284 data points for each
variable. Gross Domestic Product figures are published quarterly so 71 years times four
quarters per year equal 284 data points. All available data points for the time period were
used in the analysis. The interest rate data, both short-term and long-term, that was used,
came from historic interest rate data published by the Federal Reserve Bank. The GDP
data that was used came from historic GDP figures published by the U.S. Department of
Commerce. There were no human participants or surveys in this study.
A power analysis has been completed to assure that the sample size was large
enough to detect a relationship, should one exist. The power analysis was completed
using the software program StatCalc3 (Soper, 2012) for the analyses that were run in this
study (i.e., correlation and regression). The power analysis was completed twice, first
assuming one explanatory variable and second, assuming two explanatory variables. This
double analysis was necessary as the study first examined the relationship of each
individual explanatory variable with the dependent variable and then examined the
relationship of the two explanatory variables in combination with the dependent variable.
The additional assumptions of the power analysis were an effect size (f2) of 0.15 and an
alpha or confidence interval of 0.05. An effect size of 0.15 was appropriate as the intent
65
was to identify the relationship of the predictive and dependent variables even if the
effect of the relationship was small (Durlak, 2009)
When the power analysis was completed assuming one explanatory variable, a
sample size of 54 resulted in a power level of 0.8 and a sample size of 71 results in a
power level of 0.9. When the power analysis was completed assuming two explanatory
variables, a sample size of 76 resulted in a power level of 0.8 and a sample size of 98
resulted in a power level of 0.9. The sample size of 284 that was used in the analysis was
much greater than the numbers suggested by the power analysis. Accordingly, it is
believed that the sample size was more than sufficient.
Materials/Instruments
No instruments or materials were used in this study. The data used in the study
was historical economic data that is available from the Department of Commerce and the
Federal Reserve Bank. The interest rated data used, both the three-month Treasury bill
rate and the 10-year Treasury bond rate, are compiled by the Federal Reserve Bank and
published daily. The Federal Reserve Bank publishes this data on its website at
http://www.federalreserve.gov/econresdata/statisticsdata.htm. The GDP figures are
compiled by the Bureau of Economic Analysis (BEA) of the Department of Commerce
and published on a quarterly basis. The Department of Commerce publishes this data
quarterly by news release. Copies of these news releases as well as historic data can be
found on the BEA website at www.bea.gov. While no formal instruments or materials
were used, the data was entered into a database for the statistical analysis.
66
Operational Definition of Variables
There are three variables that were used in this study: two explanatory variables
and one dependent variable. They include: economic growth as measured by the GDP
growth (the dependent variable) and the interest rate term spread and the level of shortterm interest rates (the latter two of which were the explanatory variables).
Gross Domestic Product growth. Economic growth is defined as an increase or

GDP
growth (Harvey, 2011). Gross Domestic Product growth is stated as a percentage and is a
ratio variable. The economic growth variable that was used in this study was calculated
from the U.S. GDP figures published by the U.S. Department of Commerce, Bureau of
Economic Analysis for the time period from 1942 to 2012. The GDP growth during this
time period has typically been in the range of 2% to 4 % and has varied from a low of
10.4% (the second quarter of 1956) to a high of 17.2% (the second quarter of 1950)
(Bureau of Economic Analysis, 2013). GDP growth was used to determine the beginning
and ending points of a recession. Negative GDP growth is the most common measure of
when a recession begins and a return to positive GDP growth is the most common
measure of when a recession ends (NBER, 2011). Put simply, when GDP growth turns
negative it is defined as the beginning of a recession and when GDP growth becomes
positive again it is defined as the end of the recession and the beginning of a period of
growth. Gross Domestic Product growth, the measure of economic growth, was the
dependent variable in the study.
Interest rate term spreads. The interest rate term spread is an interval variable
that identifies the difference in the interest rate yield between a short-term bond
67
obligation and a long-term bond obligation that has the same or similar credit quality.
This interest rate term spread is typically presented in either a percentage or basis point
format (Harvey, 2011). The interest rate term spread figures used in this analysis were
calculated by taking the yield of the 10-year U.S. government Treasury bond as of a
specific date and subtracting the yield of the 90-day U.S government Treasury bill of that
same date. This difference was stated in a basis point format and was an interval variable.
The 10-year U.S. government Treasury bond yields and the 90-day Treasury bill yields
were taken from historic data published by the Federal Reserve Bank. The time range
was from the beginning of 1942 to the end of 2012. The interest rate term spread was one
of the explanatory variables of the study. The historic range of the term spread of interest
rates has varied from a low of approximately -250 basis points to a high of approximately
500 basis points. The interest rate term spread was one of the explanatory variable of the
study.
Short-term interest rates. Short-term interest rates are the interest rates or rates
of return paid by borrowers who borrow money for one year or less (Harvey, 2011). The
measurement of this variable used in this study was the rate published by the Federal
Reserve Bank for 90-day (three month) Treasury bills. The rates are published in a
percentage rate format and are ratio variables. The rates for the time period of 1942 to
2012 were used. The range of short-term interest rates during this time period varied from
a low of 0.0% to a high of 5.19% (U.S. Dept. of Treasury, 2013). Short-term interest rates
was one of the explanatory variables of the study.
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Data Collection, Processing, and Analysis
In this section the means by which data was collected, processed, and analyzed is
described.
Data collection. Data for this study was collected from a number of publicly
available sources. Economic growth and GDP data came from information published by
the Department of Commerce, Bureau of Economic Analysis. The 90-day Treasury bill
rates and the 10-year Treasury bond rates used in the study came from information
published by the Federal Reserve Bank. The term spread of interest rates was calculated
by subtracting the short-term rate as of a specific date from the long-term rate for the
same date. The data for each variable was collected for the 71 year time period from
January of 1942 through December of 2012. Gross Domestic Product data is published
quarterly resulting in 284 data points for the dependent variable. The data for the
explanatory variables is published daily; however, the analysis will only use the average
quarterly figures that coincide with the GDP data, resulting in 284 data points for each
variable.
Data analysis. An overview of the data analyses is provided below. Two types of
regression analysis were used in the study. The primary analyses used to address the three
research questions were the autoregressive distributed lag (ADL) and vector
autoregression (VAR) models. These analyses were used to determine whether or not the
explanatory variables (the term spread of interest rates and the level of short-term interest
rates) could be used to forecast economic growth, which could then be used to forecast
the beginning, length, and end of a recession. An additional analysis was performed to
address the potential problem of multicollinearity that sometimes occurs in vector
69
autoregression analysis. Multicollinearity occurs when there is a high correlation between
two or more variables in the multi regression analysis (Stock & Watson, 2012). A
correlation matrix was prepared before the regression analysis was completed to identify
the level of correlation between the variables and if a high level of correlation was
identified follow on statistical analyses would be performed to identify and minimize the
effect of multicollinearity.
Analyses. The three research questions asked whether an explanatory variable(s)
could be used to forecast the future value of the dependent variable, which could then be
used to predict how long a recession might last or when a recession might end. The three
research questions were:
recession will end?
The difference between the three questions was the explanatory variable or group
of explanatory variables that was compared to the dependent variable. To answer these
research questions two regression analyses were performed. The autoregressive
70
distributed lag (ADL) model was used in both the single variable and multivariate
regression analysis. The vector autoregression (VAR) model was used in a multivariate
analysis. These ADL and VAR forms of linear regression were used because they allow
for regression analysis with time-lagged variables (Stock & Watson, 2012). In other
words, a regression analysis is performed comparing the explanatory variable from a
previous time period with the dependent variable of the current or relevant time period.
This makes ADL the preferred regression tool when a researcher is analyzing a time
series data set in an effort to identify whether or not one variable can be used to
effectively predict or forecast another variable (Stock & Watson, 2012).
In this study the regression analysis was used to determine the relationship
between the dependent variable (GDP Growth) at a specific point in time (for example
the fourth quarter of the year) with the explanatory variables (the term spread of interest
rates and the level of short-term interest rates) from earlier time periods (for example the
third quarter of the year). The ADL and VAR analysis, use a time lag, to compare the
fourth quarter dependent variable to the third quarter explanatory variable. These
methods provide the researcher with a tool that can assess whether the third quarter
explanatory variable can be used to predict the fourth quarter dependent variable (Koop,
2009). The analysis identifies the relationship of the dependent variable, at a point in
time, with the explanatory variables at an earlier point in time; the difference in time
being the time lag. This type of analysis is ideal for the research questions in this study
because the results of the regression analysis identify whether or not the explanatory
variables (the term spread of interest rates and the level of short-term interest rates) can
be used to reliably predict, in advance, the dependent variable, GDP growth. For
71
example, if the economy is in a period of recession and the explanatory variables can be
used to forecast a change from negative to positive GDP growth then this information
could be used to forecast when the recession might end.
All of the assumptions of regression analysis apply to both ADL and VAR
methods. The most basic assumption is that the relationship between the explanatory
variable and the dependent variable is linear or approximately linear (Gujarati, 2003). An
additional assumption is that the there is no unidentified factor or variable that is
correlated to both the dependent variable and the explanatory variable. If there is such a
variable there is a possibility that the measured relationship is due to this unidentified
factor and not the result of a relationship between the dependent and explanatory
variables (Keller, 2012). Another assumption is that the differences between the
dependent variable and the explanatory variables vary normally across the measured
population (Levine & Stephan, 2010). The statistical analyses that were performed
(correlation analysis, regression analysis, and unit root tests) were used to confirm that
these assumptions are met.
An assumption specific to both ADL and VAR is that the data sets being used are
stationary, which means that the probability distribution of the data set does not change
over time (Stock & Watson, 2012). Each of the four data sets were tested to determine
whether or not they are stationary. The appropriate test for stationarity is the unit root
test. The most commonly used and accepted tests include augmented Dickey-Fuller,
Peron, and Zivot Andrews tests. These tests were used in this analysis. The first variable
is economic growth as measured by the GDP Growth. While it is known that the GDP
data series by itself is not stationary (Aslanidis & Fountas, 2013), it is expected that the
72
data set of GDP growth will be stationary. It is also expected that the data set of the term
spread of interest rates will be stationary. The stationarity of the data set made up of the
level of short-term interest rates was the most unknown. Some researchers have found
that interest rates are stationary (Cerrato, Kim, & MacDonald, 2010; Wu & Chen, 2001)
and others have found that interest rates are not stationary (Newbold, Leybourne, Sollis
&Wohar, 2001).
While it is believed that the variables used in the analysis would be stationary this
could not be determined with certainty until after the data sets were collected and the unit
root tests performed. If it were found that all of the data sets were stationary then the
ADL and VAR regression methods described above would be used. If it were found that
any of the data sets are not stationary then an appropriate form of regression, such as
cointegration regression will be used instead (Davidson, Hendry, Srba, & Yeo, 1978).
A potential problem of this multiple regression analysis was the possibility of
multicollinearity. Perfect multicollinearity exists when two or more explanatory
variables are identical and imperfect multicolinearity occurs when two or more
explanatory variables are highly correlated (Stock & Watson, 2012). Since the two
explanatory variables of the study are components of the yield curve and they are all a
measure of interest rate data there is a reasonable possibility of multicollinearity. When
perfect multicollinearity exists the results of the analysis are not valid and one of the
variables must be removed from the analysis and the analysis redone. When imperfect
multicolinearity exists, the overall results of the multiple regression analysis will be
accurate but there will be a problem with the regression coefficients on one or more of
the variables (Stock & Watson, 2012). The coefficients of at least one of the variables
73
will be imprecisely stated. In other words, if imperfect multicollinearity exists, the results
of the total regression will be accurate but the breakdown of the effect of each individual
variable will not be accurate. If it is believed that multicolinearity exists it is possible to
repeat the analysis dropping one or more of the explanatory variables (Keller, 2012). The
weakness of dropping an explanatory variable is that some important information about
the relationship may be included in the explanatory variable that is dropped (Gujarati,
2003).
To address the issue of multicollinearity a correlation matrix was prepared to
identify the level of correlation between the variables (Levine & Stephan, 2010). The
correlation matrix identified which variables, if any, have a high degree of correlation
that could potentially result in multicollinearity. If a perfect correlation between two
variables were found then there is perfect multicollinearity and one of the two variables
would be removed from the study. If imperfect multicollinearity were found, additional
multiple regression analyses would be performed in an effort to minimize the effect of the
multicollinearity. This correlation matrix analysis was completed prior to the regression
analysis.
Analysis Assessment. The results from the ADL and VAR regression analyses
were used to determine the relationships between GDP growth (the dependent variable)
and the term spread of interest rates and the level of short-term interest rates (the
explanatory variables). The analysis results identified whether or not there was a
statistically significant relationship between the explanatory variables and the dependent
variable. If there was a statistically significant relationship the analysis also identified the
timing of that relationship. For example, if there was a statistically significant
74
relationship between GDP growth, at a specific point in time, and one of the explanatory
variables from an earlier time period (say two, or three, or four quarters earlier) then it
would be possible that the explanatory variable could be used to forecast GDP growth
and the forecasted GDP growth could be used to forecast the beginning, ending, and
length of a recession. If a statistically significant relationship could be identified between
GDP growth and one or more of the explanatory variables then the data from each of the
twelve recessions included in the 1942 to 2012 time period would be examined to
determine whether or not the relationship(s) could possibly have been used to
successfully forecast the beginning, end, and length of each recession.
Assumptions
This study was based on several assumptions. The first assumption was that the
quantitative research method with a correlational design is the appropriate design for this
economic analysis study. The application of an inappropriate design could lead to
incorrect results and conclusions (Vogt, 2007). As discussed in the research methods and
design section of this chapter it is believed that the correlational design was the best
design for this study.
The second assumption was that the data used in the study was correct; that the
interest rate data published by the Federal Reserve Bank and the economic growth data
published by the Department of Commerce was complete and accurate. The selection of
the appropriate variables and correct measurement of those variables was critical to the
success of the study (Vogt, 2007). A review of the extant literature identified the Federal
Reserve Bank and the Department of Commerce as the ubiquitous source of data for both
75
historic interest rates and historic GDP data. These government agencies have been
compiling and publishing the data for over 100 years (Department of Commerce, 2012).
The third assumption was that the use of economic growth, as measured by GDP
growth, will be an appropriate operational variable for identifying the beginning and
ending of historic recessions. The Business Cycle Dating Committee of the National
Bureau of Economic Research considers several economic indicators when identifying
the beginning and ending of a recession, but the most commonly identified and prominent
variable is GDP growth (NBER, 2010).
The fourth assumption was that, when it comes to economic growth and
recessions, the future will look like the past; that the relationship between interest rates,
economic growth, and recessions that has been observed in the past will continue into the
future. Historical validity is always a key concern when studying time series data
(Trochim & Donnelly, 2008). There was no way to eliminate this potential problem, but
to minimize this threat this study analyzes twelve recessions over a 71 year period. It was
hoped that by analyzing this extended time period the effect of sporadic or one time
historic anomalies would be eliminated or minimized.
There are also assumptions specific to the statistical analyses that were used in the
analysis. When performing time series regression there is an assumption that the data
used is drawn from a stationary distribution, which means that the statistical distribution
of the data today is the same as the statistical distribution of the data of the past (Stock &
Watson, 2012). To address this assumption, a unit root test was performed on the
variables in the data set to determine whether or not the data sets were stationary. For any
variables that were found to be not stationary either the data sets were adjusted or an
76
alternative method of regression, that is appropriate for non-stationary data sets, was
selected and used.
An additional assumption was that the variables would be independently
distributed when they are separated by long periods of time (Stock & Watson, 2012).
This means that an observation of a variable is independent of an observation of the
variable a long time ago in the past or a long time into the future. Additional assumptions
of the regression analysis were that large outliers in the data set are unlikely and that none
of the variables are perfectly multicollinear (Stock & Watson, 2012).
Limitations
Historical bias was the most significant limitation that pertained to this study, just
as it is to any study that uses historical or retrospective data. Historical bias is the
possibility that the future may be very different from the past (Trochim & Donnelly,
2008). Relevant to this study, changes in government policy, economic activity, or the
fundamental components of the economy could change the economic landscape so that
the effect of interest rate activity that influenced past economic growth and past
recessions no longer applies to future economic situations. One potential example of this
is in the area of monetary policy. The Federal Reserve Bank sets and implements policies
that influence the level of interest rates, the size of the money supply, and availability of
credit (Lengwiler & Lenz, 2010). Significant changes in these policies have the potential
of changing the relationships between the variables that will be examined in this study.
The size and effect of the relationship in the future may be different than the size and
effect of the relationship in the past.
77
A second limitation was that even if the regression analysis shows a strong
relationship between the explanatory variable(s) and the dependent variable there is no
proof of causality (Trochim & Donnelly, 2008). If it is shown that a relationship exists
between an explanatory variable and dependent variable, it is not necessarily true that
changes in the explanatory variable caused the changes in the dependent variable. There
could be other factors affecting the variables.
Delimitations
There are also two delimitations that influenced this study. The first was the time
period of the data that was used in the study. The defined time series will include the
variables for the U.S. economy for the 71-year period of 1942 to 2012; 1942 was selected
as the beginning year as it is three years before the 1945 recession which was the first
recession of the postwar economic period. Data before or after this time period was not
considered in the study. The second delimitation was that the study considered and
analyzed only interest rate yield curve data. The study did not consider other variables
that might have influenced economic growth or recessions. There are other variables that
have shown a positive correlation with economic growth that could have been used.
These include items such as capacity utilization, stock and bond market activity, or
inflation.
Ethical Assurances
Before any data was collected for this study, approval was obtained from the
Institutional Review Board of Northcentral University. In performing the study the researcher
complied with all federal standards and professional requirements for ethical research. In this
research study there was no direct contact with or participation by human subjects. There
were no questionnaires, surveys, or interviews. Rather, the data that was used consisted
78
of macroeconomic variables that were collected, compiled, and published by a variety of
U.S. government agencies.
In the completion of this study, every effort was made to ensure that no part of the
findings were misleading to other researchers or professionals. Any research information
from other sources used in this study was properly cited and well documented. The analysis
performed in this study was completed in an honest manner with detailed descriptions of the
procedures and processes and without any fabrication of data or results.
Summary
The problem that this study addressed was that recessions inflict severe economic
distress on an economy and that there was no effective tool that could be used to forecast
how long a recession might last or when a recession might end (Jiang, Koller, and
Williams, 2009). The purpose of this study was to examine the two primary variables of
the yield curve to determine whether or not they could be effective in forecasting how
long a recession might last or when a recession might end.
The research design that was used in this study was a quantitative research
method with a correlational design (Garson, 2011). The quantitative research method was
used for this economic analysis to statistically analyze the relationships between the
explanatory variables and the dependent variable. A correlational design was used
because the purpose of the study was to analyze the historic economic data to determine
the relationship and correlation between the variables.
The population data set used in the analysis was a time series of macroeconomic
variables. Two components of the yield curve, short-term interest rates and the interest
rate term spread were analyzed as the explanatory variables. Economic growth, as
measured by GDP growth, was the dependent variable. The data used in the analysis was
79
for the U. S. Economy for the 71-year period from 1942 to 2012. The variable data sets
were collected from macroeconomic statistics published by U. S. Government agencies.
The analysis consisted of a number of steps. First, a correlation matrix with all
four variables was created to determine if there was a likelihood that multicollinearity
exists among the variables. Second, a regression analysis using the autoregressive
distributed lag (ADL) model was performed comparing each of the two explanatory
variables and the combination of both variables with the dependent variable. This was
followed by a multiple regression analysis using vector autoregression (VAR)
methodology, which compared both explanatory variables in combination with the
dependent variable. A detailed description of the analyses performed and the results of
these analyses is included in Chapter 4.
Chapter 4: Findings
Recessions are economically destructive events that negatively affect businesses,
governments, and families (Peck & Yang, 2011). Recessions are identified and defined
by economic growth, which is measured with the statistic of GDP growth. When GDP
growth turns negative it is typically identified as the beginning of a recession and when
GDP growth again turns positive it is typically identified as the end of the recession
(National Bureau of Economic Research, 2010). If there was an effective way to forecast
how long a recession might last (in other words, when GDP growth turns positive) then
governments, businesses, and families could take actions to minimize the negative
economic effects of a recession (Jiang, et al., 2009).
The purpose of this study was to determine to what extent, if any, the three
variables of the yield curve can forecast GDP growth which could then be used to
forecast the length of a recession. The explanatory variables in this study included: the
interest rate term spread; the level of short-term interest rates; and the combination of the
two. The dependent variable was economic growth as measured by GDP growth. The
explanatory variables were examined against the dependent variable both individually
and together.
The methodology and analysis of the data was organized in the same way as the
presentation of the research questions. The three research questions asked whether the
explanatory variable(s) could be used to forecast the future value of GDP growth, which
could then be used to predict how long a recession might last or when a recession might
end. The three research questions are restated here as follows:
81
recession will end?
To answer these questions two types of regression analysis were used. The first
was the autodistributive regression (ADL) analysis method. This method was used as the
assumption of this study was that a lagged value of the explanatory variable could be
used to predict the current or future value of the dependent variable (Stock & Watson,
2012). In other words, that the value of the explanatory variable from a period of time in
the past (one, two, three, four or more quarters ago) could be used to predict or forecast
the value of the dependent value today. The ADL analysis was performed as a single
regression analysis with each explanatory variable and as a multiple regression analysis
with the combination of both explanatory variables.
The second type of regression analysis used was the vector autoregressive (VAR)
analysis method. The VAR method is a multiple regression method that is used when
there is close relationship between the variables (both the explanatory and dependent) and
there is the possibility of a bidirectional correlation (Koop, 2009). For example, this study
82
asked whether or not term spread of interest rate values influenced or caused the GDP
growth values. The question could also be asked of whether or not GDP growth values
influenced or caused the term spread values. In other words does the explanatory variable
influence the dependent variable or does the dependent variable influence the explanatory
variable? The VAR analysis is used to identify whether or not bidirectional correlation
exists. The VAR analysis looks at all of the variables and runs a separate regression
analysis with each variable taking its turn as the dependent variable (Stock & Watson,
2012). By this process VAR analysis identifies the relationship between the variables in
both directions. If it was identified that the dependent variable also influenced the
explanatory variables then the Granger Causality test would be the appropriate test to use.
The Granger Causality test identifies whether or not there is a Granger caused
relationship between the explanatory variable(s) and the dependent variable (Granger,
1969).
The time series data was analyzed under two different time frame assumptions.
The first analysis included the entire set of quarterly data from 1942 to 2012. This
analysis was performed for the purpose of identifying long-term relationships between
the variables. The second analysis focused on each of the twelve recessionary periods that
occurred from 1942 to 2012. An analysis was completed for each recessionary period
using data from three years prior to the beginning of the recession to three years after the
end of the recession. The purpose of the second analysis was to identify and examine the
relationships between the variables that were manifest during the recessionary periods.
83
Results
The primary statistical analysis included the two types of regression analysis
indicated above, the ADL regression method and the VAR regression method. The ADL
method was used to address all of the research questions; whether the explanatory
variables (individually or combined) could be used to forecast GDP growth which could
then be used to forecast when a recession might end. The VAR method was used to help
answer the third research question of whether a combination of the explanatory variables
could be used to forecast GDP growth, which could then be used to forecast the length or
ending of a recession.
Both the ADL and VAR methods were used to identify the relationship between
the explanatory variables with the dependent variable. The ADL method was used
because the regression was done with lagged variables. The VAR analysis method was
used because of the possibility of bi-directional correlation or a bi-directional relationship
between the dependent and explanatory variables.
When using a time-series data set, as in this analysis, two statistical tests must be
completed before the ADL or the VAR regression models can be used. The two tests are
performed to identify the possibility of multicollinearity and nonstationarity.
Mulitcollinearity exists if there is a high level of correlation between any of the
explanatory variables (Sock & Watson, 2012). If this occurs then the individual variable
coefficients in a multiple regression analysis will not be accurate. To test for
multicollinearity a correlation matrix of all the variables was created to identify whether
or not any of the explanatory variables had a high level of correlation.
84
Nonstationarity occurs in a time-series if the mean or variance of the time series
changes over time; the statistical characteristics of the data set must be consistent over the
entire time-series (Koop, 2009). If the data set is not consistent it is said to be
nonstationary and if a regression analysis is performed then there is a risk that the results
will be spurious; there may appear to be a significant relationship when in fact the
relationship is not significant at all, but spurious. To test for nonstationarity a unit-root
test is used (Dickey & Fuller, 1979). If either multicollinearity or nonstationarity is
found then adjustments or additional tests are needed before the ADL and VAR analysis
can be completed. The statistical analyses presented in this chapter were completed using
two different statistical software programs. The first software package was the
Regression Analysis of Time Series Econometrics Software (RATS) and the second
statistical software package was EViews.
Data. The data used in the study included quarterly data from 1942 to 2012 for
each of the three variables: GDP growth, short-term interest rates, and the term spread of
interest rates. The data was collected from a variety of sources including the Board of
Governors of the Federal Reserve System, the U. S. Department of Commerce: Bureau of
Economic Analysis, and a Yale University economic database.
GDP growth . The GDP data was obtained from the Department of Commerce:
Bureau of Economic Affairs. The GDP figures used were presented in real dollars on a
seasonally adjusted annual basis. The GDP data was provided as annual data from 1942
to 1946 and quarterly from 1947 to 2012. The data from 1942 to 1946 was interpolated to
quarterly data so that the analysis could be completed using quarterly figures for the
entire time frame. GDP growth figures were calculated from the GDP numbers.
85
Short-term interest rates. The three-month U. S. Treasury Bill (T-bill) rate was
used for the short-term interest rate. The quarterly average T-bill rate was obtained from
the Board of Governors of the Federal Reserve System for the entire time period from
1942 to 2012. The T-bill rate obtained from the Federal Reserve database was not
seasonally adjusted so it was converted to a seasonally adjusted rate using the RATS
statistical software.
The term spread of interest rates. This variable was calculated from the T-bill
rate and the 10-year Treasury bond rate. The method used was to subtract the T-bill rate
from the 10-year Treasury bond rate. The term spread of interest rates was stated using
the basis point format. The 10-year Treasury bond rate was obtained from the Board of
Governors of the Federal Reserve System for the entire time period from 1942 to 2012.
The 10-year Treasury bond rate database was not seasonally adjusted so it was converted
to a seasonally adjusted rate using the RATS statistical software.
Descriptive Statistics. Descriptive statistics were calculated for the three
variables in the study; the two explanatory variables; the three-month T-bill rate, and the
term spread of interest rates, and the one dependent variable, GDP growth.
Table 2
Descriptive Statistics for Explanatory and Dependent Variables, 284 observations
Series
Mean
Three-Month T-Bill Rate
4.1034
3.1125
-0.3069
15.576
Term Spread of Interest Rates 147.32
119.65
-314.34
493.04
GDP Growth
0.0207
-0.0307
0.1926
0.0095
Standard Error Minimum Maximum
86
Table 2 presents the descriptive statistics for the variables. It is interesting to note
that all three of the minimum measurement of the variables occurred either just prior to or
during a recession. The minimum T-bill rate was -0.31%. This occurred in the fourth
quarter of 2008 during the 2007 to 2009 recession. The minimum term spread of interest
rates was -314, which occurred in the fourth quarter of 1980, about two quarters before
the beginning of the 1981 to 1982 recession. The maximum term spread of 493 occurred
in the third quarter of 1982, shortly before the end of the1981 to 1982 recession. The
lowest GDP growth rate of -3.07% occurred in the fourth quarter of 1945 during the 1945
recession.
Pre-regression Analysis. When performing a time-series regression there a
number of assumptions that are part of the statistical analysis. For single regression they
are that the time-series data set is stationary and homoskedastic, and for multiple
regression, that multicollinearity does not exist. A time series data set is said to be
stationary if the mean and variance of the data set are consistent over time. If the mean
and variance are not consistent then the data set is said to be nonstationary (Stock &
Watson, 2012). A time-series data set is homoskedastic if the variance of the dependent
variable is the same for all of the data (Koop, 2009). If the variance of the dependent
variable is not constant for all of the data then the time-series data set is said to be
heteroskedastic. Multicollinearity exists if there is a high level of correlation between any
of the explanatory variables (Sock & Watson, 2012). To assure that this analysis is
consistent with the assumptions of regression analysis three tests were performed. This
included a test to measure multicollinearity, nonstationarity, and heteroskedasticity. Each
of these tests is discussed below.
87
Multicollinearity. There are two forms of multicollinearity; perfect
multicollinearity and imperfect multicollinearity (Koop, 2009). Perfect multicollinearity

occurs when two or more of the variables are perfectly correlated and have a correlation
coefficient of one (Stock & Watson, 2012). If this is found then one of the variables must
to be removed from the analysis. Imperfect multicollinearity may occur when there is a
high level of correlation between two of the variables (Stock & Watson, 2012). If
imperfect multicollinearity is suspected then the regression analysis results are accurate
in total, but the individual regression coefficients for the variables may not be accurate. If
imperfect multicollinearity is suspected then the regression is run again dropping one or
more of the variables in an effort to identify the true effect of each variable (Stock &
Watson, 2012). The test for both types of multicollinearity is a correlation analysis
(Koop, 2009). Table 3 presents a correlation matrix for all three variables: The GDP
growth rate, the three-month T-bill rate, and the term spread of interest rates.
Table 3
Correlation Matrix of the Variables
Three-Month T-bill
Rate
Term Spread of
Interest Rates
GDP Growth
1.000
-0.3884
-0.0987
Term Spread of
Interest Rates
-0.3884
1.000
0.0315
GDP Growth
-0.0987
0.0315
1.000
Series
Three-Month T-bill
Rate
88
None of the variables, the term spread of interest rates, the three-month T-Bill
rate, or the GDP growth rate had high enough levels of correlation to cause a concern for
either perfect or imperfect multicollinearity.
Nonstationarity. One of the assumptions of both the ADL and VAR regression
analysis is that the data sets are stationary. This means that the joint probability
distribution of the data set does not change over time; it has a constant mean, a constant
variance, and a constant autocorrelation structure (Stock & Watson, 2012). If the
distribution of the data set does change over time then the relationships that exist between
the variables today may be different than the relationship that existed in the past. In
statistical terms if variables are nonstationary, then the conventional hypothesis tests,
confidence intervals, and forecasts can be unreliable. The statistical test used to identify
nonstationarity is the unit-root test (Davidson & MacKinnon, 1993). The most common
unit root tests include the augmented Dickey-Fuller test, the Phillips-Perron nonparametric test, and the Zivot Andrews Test. These were the unit root-tests used to test
the data sets of the three variables in this analysis (Dickey & Fuller, 1979; Perron, 1989;
Zivot & Andrews, 1992). The results of these tests are presented in Table 4. The test
results presented in Table 4 identify that the three-month T-bill rate is not stationary and
the term spread of interest rated and the GDP growth are stationary. As the T-bill rate is
not stationary it cannot be used in either the ADL or VAR analysis. The first difference
of the T-Bill rate was calculated and the unit root tests applied to this new variable to
determine whether or not it is stationary. The results are presented in Table 5.
89
Table 4
Unit Root Stationary Tests; Three-Month T-Bill, Term Spread, and GDP Growth
Augmented
Dickey Fuller Test
(t statistic)
-1.9424
Phillip Peron Test

(t statistic)
-2.3863
Zivot Andrews
Test
( t statistic)
-3.2592
Term Spread of
Interest Rates
-6.0490*
-5.9709*
-5.8610*
GDP Growth
-6.8156*
6.5650*
-11.7054*
Three-Month T-bill
Rate
* Statistically significant at 0.01 level.

Table 5
Unit Root Stationary Test, Three-Month T-Bill Rate
Three-Month T-Bill
Rate
Three-Month T-Bill
Rate: First Difference
Augmented Dickey
Fuller Test
(t statistic)
-1.9424
-7.5175*
Phillip Peron Test Zivot Andrews

Test
(t statistic)
(t statistic)
-2.3863
-3.2592
-19.6992*
-7.5431*
* Statistically significant at 0.01 level.

As can be seen in Table 5, the first difference of the three-month T-Bill rate is
stationary. Accordingly the first difference of the three-month T-Bill rate will be used in
the analysis instead of the three-month T-bill rate.
Heteroskedasticity. Heteroskedasticity exists in a regression analysis when the
variance of the dependent variable in a time series is not consistent and changes over
time. When this occurs there could be errors in the test statistics calculated during the
regression analysis (Stock & Watson, 2012). Two of the most common tests were used to
90
test for heteroskedasticity, the ARCH test and the White test (Engle, 1982; White, 1980).
The way these tests are performed is that the regression analysis is performed and then
the ARCH test and the White test are used to measure the variance to determine whether
or not the variance is consistent across the time series (Engle, 1982; White, 1980). If the
regression model is found to be heteroskedastic then the Robust Errors Estimation
Technique can be applied to the analysis to correct for the heteroskedasticity (Stock &
Watson, 2012). When the ARCH and White tests were performed on the regression
analysis of the full data set and the twelve recessionary periods, the results identified that
the data sets were heteroskedastic. To correct this, the ADL regression analyses were
redone using the Robust Errors Estimation technique. The ADL regression analysis
results presented below have been corrected for heteroskedasticity.
Autoregressive Distributed Lag (ADL) Analysis. An ADL regression analysis
was performed using GDP growth as the dependent variable and three different
explanatory variable combinations. The first ADL analysis used the term spread of
interest rates as the explanatory variable. The second ADL analysis used the T-bill rate
(the first difference of the three-month T-bill rate) as the explanatory variable. The third
ADL analysis included the two individual explanatory variables in combination; the Tbill rate and the term spread of interest rates.
The three ADL analyses were designed to provide the information necessary to
answer the three research questions of this study. The ADL analysis using the term
spread of interest rates addresses research question number one, which asks whether or
not the term spread of interest rates could be used to predict GDP growth which could
then be used to forecast how long a recession might last or when a recession might end.
91
The ADL analysis using the three-month T-bill rate addresses research question number
two, which asks whether or not the three-month T-bill rate could be used to predict GDP
growth which could then be used to forecast how long a recession might last or when a
recession might end. The third ADL analysis with both the T-bill rate and the term spread
of interest rates as explanatory variables addresses research question number three, which
asks whether or not the combination of short-term interest rates and the term spread of
interest rates could be used to predict GDP growth which could then be used to forecast
how long a recession might last or when a recession might end.
Each of these three ADL analyses was performed thirteen times: once with the
complete data set (1942-2012) and then again for each of the twelve recessionary periods
that occurred between 1942 and 2012. The data sets for the twelve recessionary periods
included the data for the period from three years before the beginning of the recession to
three years after the recession ended. The results of the three ADL analyses are presented
in the sections that follow.
ADL Analysis, the term spread of interest rates. This analysis is used to obtain
the information to answer research question number one. The ADL analysis examined the
relationship between GDP growth, as the dependent variable, and the term spread of
interest rates as the explanatory variable. The time lags of between zero and twelve
quarters (zero to three years) were examined. Table 6 presents the results for the full data
set of 1942 to 2012. Tables 7 through 18 present the results for the twelve recessionary
periods.
92
Table 6
ADL Regression, Term Spread of Interest Rates, Individual lags, 1942-2012
Variable
1. Term Spread {2 lags}
Coefficient
T-Stat
Significance
Adjusted R2
0.00001
2.61438
0.00894 *
0.6353
* Statistically significant at the 0.05 level

Table 7
ADL Regression, Term Spread of Interest Rates, Individual lags, 2007-09 recession
Variable
Coefficient
T-Stat Significance Adjusted R2
0.00003
2.63516
0.00841 *
0.2042
0.00003
2.71272
0.00667 *
0.2819
0.00004
3.63379
0.00028 *
0.3808
0.00003
2.40412
0.01321 *
0.2218
0.00003
2.90074
0.00372 *
0.2732
* Statistically significant at the 0.05 level.

Table 8
ADL Regression, Term Spread of Interest Rates, Individual lags, 2001 recession
Variable
Coefficient
T-Stat Significance
Adjusted R2
0.00002
2.94953
0.00318 *
0.1187
0.00001
2.03981
0.04137 *
0.0229
0.00001
2.26416
0.02356 *
0.0579
93
Table 9
Coefficient
T-Stat
Significance
Adjusted R2
0.00002
2.24116
0.02502 *
0.1972
0.00002
2.16783
0.03017 *
0.2155
0.00002
2.40123
0.01634 *
0.2100
0.00002
2.57280
0.01009 *
0.2005
0.00002
2.17644
0.02952 *
0.1528
Variable

Table 10
Variable
Coefficient
T-Stat Significance
Adjusted R2
0.00003
4.44293
0.00015 *
0.4097
0.00002
2.95033
0.00680 *
0.2286
0.00003
2.90755
0.00793 *
0.2370

Table 11
Coefficient
T-Stat
Significance
Adjusted R2
0.00004
4.2251
0.00002*
0.2997
0.00003
2.1725
0.02985*
0.1498
Variable
94
Table 12
Coefficient
T-Stat
Significance
Adjusted R2
1. Term Spread {1 lag}
0.00004
3.06838
0.00215 *
0.2751
0.00005
5.57047
0.00000 *
0.3849
0.00004
3.30646
0.00095 *
0.2282
0.00004
3.37418
0.00074 *
0.2503
-0.00004 -3.29481
0.00099 *
0.2705
-0.00004 -2.87513
0.00404 *
0.2372
-0.00004 -2.37489
0.01755 *
0.1912
Variable
Table 13
Coefficient
0.00004
T-Stat
2.67100
Significance
0.00756*
Adjusted R2
0.1613
0.00004
2.55555
0.01060*
0.1148
0.00004
2.33479
0.01955*
0.1509
0.00005
2.88171
0.00396*
0.1856
0.00006
2.90127
0.00372*
0.2233
0.00006
2.96052
0.00307*
0.1775
2.45370
0.01414*
0.1249
Variable

0.00005
95
Table 14
Variable
Significance Adjusted R2
Coefficient
T-Stat
0.00010
2.13289
0.03293 *
0.1195
0.00012
2.47733
0.01324 *
0.2161
-0.00006
-2.29764
0.02158 *
0.0699
0.00009
2.59700
0.00940 *
0.3200
Table 15
ADL Analysis, Term Spread of Interest Rates, Individual lags, 1958 recession.
Coefficient
T-Stat
Significance
Adjusted R2
0.00010
2.66180
0.00777 *
0.1366
0.00010
2.90764
0.00364 *
0.1735
0.00010
2.49039
0.01276 *
0.1521
-0.00010
-2.64434
0.00819 *
0.1246
Variable
96
Table 16
Coefficient
T-Stat
Significance
Adjusted R2
0.00011
2.35420
0.01856 *
0.0696
0.00012
2.52206
0.01167 *
0.1138
0.00018
3.20014
0.00137 *
0.2166
0.00014
2.24698
0.02464 *
0.1286
Variable
Table 17
Variable
Coefficient
T-Stat
-0.00023
-3.04925
0.00229 *
0.1823
-0.00016
-2.13204
0.03300 *
0.0762
-0.00017
-2.10210
0.03555 *
0.0834
-0.00017
-2.12186
0.03385 *
0.0831
-0.00014
-2.00397
0.04507 *
0.0326
-0.00002
-2.25568
0.02409 *
0.1150
97
Table 18
Coefficient
T-Stat
Significance
Adjusted R2
0.00078
1.99093
0.04649 *
0.0795
-0.00070
-2.09948
0.03577 *
0.2208
-0.00087
-3.41513
0.00064 *
0.3808
-0.00087
-3.14359
0.00167 *
0.3302
-0.00084
-2.61229
0.00899 *
0.2386
-0.00097
-3.12428
0.00178 *
0.2313
Variable
1 Term Spread {1 lag}
In all thirteen periods the term spread of interest rates was identified as a
statistically significant explanatory variable of GDP growth for at least one lag period.
The full data set had one statistically significant lag period. All of the twelve recessionary
periods had two or more significant lag periods: The 1980 recession had two; the 2001
and the 1981-82 recessions had three; the 1960-61, 1958, and 1953 recession had four;
the 2007-09, 1990-91, and the 1949 recessions had five; and the 1973-75 and the 1969-70
recessions had six significant lag periods. Table 19, below, identifies the statistically
significant lag periods for the full data set and the twelve recessionary periods.
98
Table 19
ADL Analysis, Term Spread of Interest Rates, Significant lag periods for all recessions
Data Period or Recession

1. 1942-2012 data set
2. 2007-2009 recession
3. 2001 recession
Significant Lag Periods

Lag period 2
Lag periods 6, 7, 8, 9, and 10
Lag periods 8, 9, and 10
Lag periods 2, 3, and 5
6. 1980 recession
Lag periods 2 and 5
Lag periods 1, 2, 3, 4, 10, 11, and 12
Lag periods 1, 2, 3, 4, 5, 7 and 8
Lag periods 2, 3, 6 and 12
10. 1958 recession
Lag periods 2, 3, 4, and 10
11. 1953 recession
Lag periods 1, 2, 3, and 4
12. 1949 recession
Lag periods 1, 6, 7, 8, 9, and 10
13. 1945 recession
The total time period had one statistically significant lag period. The twelve
recessionary periods each had two or more statistically significant lag periods with the
median number being five. Figure 1, below identifies those lag periods that have the most
statistically significant occurrences.
100
Table 21
ADL Regression, Term Spread of Interest Rates, Lag Combinations, 2007-09 recession
Variables
1. Term Spread {5 & 8 lags}
F-Stat
9.2812
Significance
0.001294*
Adj. R2
0.4186
2. Term Spread {5, 7, & 8 lags}
6.5034
0.003001*
0.4179
3. Term Spread {5, 6, 7, & 8 lags}
4.8192
0.007456*
0.3991
7.8125
0.003110*
0.3826

*Statistically significant at the 0.05 level.
5.2449
0.008318*
0.3666
Table 22
ADL Regression, Term Spread of Interest Rates, Lag Combinations, 2001 recession
Variables
1. Term Spread {1, 2, 4, 10, 11 lags}
F-Stat
3.6055
Significance
0.03556*
Adj. R2
0.4488
2. Term Spread {1, 4, 10, 11 lags}
3.5728
0.03853*
0.3914
3. Term Spread {4, 10, 11 lags}

4.1242
0.02931*
0.3694
Table 23
Variables
F-Stat
2.1108
Significance
0.14771*
Adj. R2
0.2285
2. Term Spread {6 lags} and GDP Growth {1 lag}
3.1297
0.07525*
0.2102

2.5480
0.11384*
0.1621
101
Table 24
Variables
F-Stat
8.1137
Significance
0.00047*
Adj. R2
0.6187
2. Term Spread {1, 2, 3, 5, & 8 lags}
5.7739
0.00312*
0.5320
3. Term Spread {1, 2, 3, 5, 7, & 8 lags}
4.8625
0.00602*
0.5246
9.6489
0.00033*
0.5195
12.4977
0.00017*
0.4600

Table 25
Variables
F-Stat
5.4736
Significance
0.00749*
Adj. R2
0.3899
2. Term Spread {2, & 5 lags}
7.1600
0.00481*
0.3697
3.9029
0.01996*
0.3561
4.1235
0.02070*
0.2987

5.0987
0.01688*
0.2808
102
Table 26
Variables
F-Stat
9.9982
Significance
0.001347*
Adj. R2
0.4864
6.3722
0.004779*
0.4589
3. Term Spread {2, & 5 lags}
4.8346
0.010481*
0.4467
4. Term Spread {1, 2, 4, 5, & 10 lags}
3.6755
0.024717*
0.4132

9.5316
0.000966*
0.4057
Table 27
ADL Regression s, Term Spread of Interest Rates, Lag Combinations, 1969-70 recession
Variables
F-Stat
4.4784
Significance
0.01541*
Adj. R2
0.4360
2. Term Spread {1, 2, 4, 5, & 7 lags}
3.4262
0.03409*
0.4026
5.5793
0.01451*
0.3372
3.6653
0.03668*
0.3076

4.4111
0.02761*
0.2544
103
Table 28
F-Stat
10.9516
Significance
0.00163*
Adj. R2
0.5702
7.1311
0.00525*
0.5508
3. Term Spread {2, 3, 6 & 12 lags}
3.8806
0.03334*
0.4344
4.4336
0.02569*
0.4071

5.9344
0.01475*
0.3968
Variables
Table 29
Variables
F-Stat Significance Adjusted R2

4.7362
0.01589*
0.4830
4.2461
0.02491*
0.3642
4.2935
0.03355*
0.2793
3.3140
0.04355*
0.2484
3.6920
0.04968*
0.2405

104
Table 30
Variables
1. Term Spread {2, 3, 6, 10, & 11 lags}

10.2934
0.00051*
0.7321
15.6399
0.00010*
0.7209
3. Term Spread {3, 6, 10 & 11 lags}
11.6405
0.00031*
0.7146
12.3686
0.00067*
0.5722
3.9187
0.03434*
0.1893

Table 31
Variables
1. Term Spread {3, 4, 6, 10, & 12 lags}

8.4991
0.00227*
0.7143
2. Term Spread {3, 4, 10, & 12 lags}
6.0376
0.00802*
0.5733
3. Term Spread {3, 10 & 12 lags}
5.1880
0.01579*
0.4558
7.1976
0.00787*
0.4525
4.8656
0.01935*
0.4360

105
Table 32
Variables

29.9359
0.00000*
0.8853
39.2379
0.00000*
0.8844
33.0744
0.00000*
0.8651
22.7796
0.00003*
0.8532

39.3042
0.00000*
0.8363
The full data set and all twelve recession periods had multiple combinations of lag
periods where there was a statistically significant relationship between the term spread
lag periods and GDP growth. The adjusted R2 values for the combinations of lag periods
were much higher than for the individual lag periods. Table 33 below, identifies the
highest adjusted R2 figures for the single and combined term spread rate analyses.
106
Table 33
Adjusted R2 Values for the Term Spread, ADL Analysis
Recession
Lag Period
Adjusted R2
Lag Combination
1 , 2, &
GDP Growth 1
Adjusted R2
Full Data Set
0.6365
0.6364
2007-2009
0.3808
5&8
0.4186
2001
0.1187
1, 2, 4, 10, & 11
0.4488
1990-1991
0.2155
4, 5, 6, & 7
0.2285
1981-1982
0.4097
1, 2, 3, & 5
0.6187
1980
0.2997
2, 3, & 5
0.3899
1973-1975
0.3849
2 & 10
0.4864
1969-1970
0.2233
1, 2, 5, & 7
0.4360
1960-1961
12
0.3200
4 & 12
0.5702
1958
0.1735
2, 4, 6, & 11
0.4830
1953
0.2166
2, 3, 6, 10, & 11
0.7321
1949
0.1823
3, 4, 6, 10, & 12
0.7143
1945
0.3808
3, 7, 8, & 12
0.8853
ADL Analysis, The three-month T-bill rate, first difference This ADL analysis
examined the relationship between GDP growth, as the dependent variable, and the threemonth T-bill, first difference as the explanatory variable. This analysis provided
information relating to research question two which asks whether or not the three-month
T-bill rate (short-term interest rates) could be used to predict GDP growth rates, which
could then be used to forecast how long a recession might last or when a recession might
end. The time lags of between zero and twelve quarters (zero to three years) were
107
examined. Table 34 presents the results of the analysis for the full data set of 1942 to
2012. Tables 34 through 46 present the results for the twelve recessionary periods. While
twelve lag periods were analyzed for each period, only those periods that were
statistically significant are included in the tables.
Table 34
ADL Analysis, T-bill Rate, First Difference, individual lag periods, 1942-2012
Coefficient
T-Stat
Significance
Adjusted R2
1. T-bill {2 lags}
-0.00212
-3.70494
0.00021 *
0.5267
2. T-bill {5 lags}
-0.00138
-2.55253
0.01069 *
0.2591
Variable
Table 35
ADL Analysis, T-Bill Rate, First Difference, individual lag periods, 2007-09 recession
Coefficient
T-Stat
Significance
Adjusted R2
1. T-Bill {1 lag}
0.00552
2.34110
0.01923 *
0.1538
2. T-Bill {3 lags}
0.00634
2.09805
0.03590 *
0.2169
3. T-Bill {5 lags}
0.00536
2.24677
0.02465 *
0.1530
4.T-Bill {8 lags}
-0.00313
-2.40714
0.01608 *
0.2058
5. T-Bill {10lags}
-0.00442
-3.13145
0.00174 *
0.0870
Variable
108
Table 36
ADL Analysis, T-bill Rate, First Difference, individual lag periods, 2001 recession
Variable
1. T-Bill {10 lags}
Coefficient
T-Stat
Significance
Adjusted R2
-0.00309
-2.00816
0.04463 *
0.1717
Table 37
Coefficient
T-Stat
Significance
Adjusted R2
1. T-Bill {8 lags}
-0.00612
-2.05851
0.03954 *
0.2810
2. T-Bill {11 lags}
-0.00346
-3.92691
0.00009 *
0.2388
Variable
Table 38
Coefficient
T-Stat
Significance
Adjusted R2
1. T-Bill {1 lag}
0.00192
3.12088
0.00180 *
0.1469
2. T-Bill {2 lags}
-0.00155
-2.28651
0.02222 *
0.0810
Variable
109
Table 39
ADL Analysis, T-Bill Rate, First Difference, individual lag periods, 1980 recession
Coefficient
T-Stat
Significance
Adjusted R2
1. T-Bill {1 lag}
0.00218
3.6078
0.00031 *
0.1222
2. T-Bill {2 lags}
-0.00166
-2.4831
0.01302 *
0.1736
Variable
Table 40
Variable
1. T-Bill {12 lags}
Coefficient
T-Stat
Significance
Adjusted R2
0.00267
2.04436
0.04092 *
0.0569
Table 41
Coefficient
T-Stat
Significance
Adjusted R2
1. T-Bill {5 lags}
-0.00593
-3.34011
0.00084 *
0.2842
2. T-Bill {8 lags}
-0.00625
-3.00209
0.00268 *
0.2262
Variable
110
Table 42
Coefficient
T-Stat
Significance
Adjusted R2
1. T-Bill {4 lags}
-0.00640
-2.41068
0.01592 *
0.1765
2. T-Bill {5 lags}
-0.00540
-2.82516
0.00473 *
0.1190
3. T-Bill {8 lags}
-0.00443
-2.04790
0.04057 *
0.0824
4. T-Bill {10 lags}
0.00358
2.93145
0.00337 *
0.0370
5. T-Bill {11 lags}
0.00657
3.67525
0.00024 *
0.3144
Variable
Table 43
Variable
1. T-Bill {4 lags}
Coefficient
T-Stat
Significance
-0.00681
-3.23690
0.00121 *
Adjusted R2
0.1207
Table 44
Coefficient
T-Stat
Significance
Adjusted R2
1. T-Bill {4 lags}
-0.01871
-3.15942
0.00158 *
0.1722
2. T-Bill {6 lags}
-0.01487
-2.18772
0.02869 *
0.0677
Variable
111
Table 45
Coefficient
T-Stat
Significance
Adjusted R2
1. T-Bill {1 lag}
0.03377
2.10655
0.03516 *
0.0783
2. T-Bill {7 lags}
-0.02293
-1.96410
0.04952 *
0.0092
3. T-Bill {10 lags}
0.04398
3.16814
0.00153 *
0.1665
4. T-Bill {11 lags}
0.03068
2.97870
0.00289 *
0.0424
5. T-Bill {12 lags}
0.04010
4.05693
0.00005 *
0.1127
Variable

Table 46
Variable
1. T-Bill {7 lags}
Coefficient
T-Stat
Significance
Adjusted R2
0.14722
4.31589
0.00002 *
0.0400
In all thirteen analyses the T-bill rate was identified as a statistically significant
explanatory variable for at least one lag period. The full data set had two significant lag
periods; four recessions, 2001, 1973-75, 1958, and 1945 had one significant lag period;
six recessions, 1990-91, 1981-82, 1980, 1969-70, and 1953 had two significant lag
periods; and three recessions, 2007-09, 1960-61, and 1949 had five significant lag
periods. Table 47, below, identifies the statistically significant lag periods for each of the
thirteen analyses.
112
Table 47
ADL Analysis, T-Bill Rate, First Difference, significant lag periods for all recessions
Data Period or Recession
Lag Periods
1. 1942-2012 data set
Lag periods 2 and 5
3. 2001 recession
Lag period 10
Lag periods 8 and 11
Lag periods 1 and 2
6. 1980 recession
Lag periods 1 and 2
Lag period 12
Lag periods 5 and 8
10. 1958 recession
Lag period 4
11. 1953 recession
Lag periods 4 and 6
12. 1949 recession
Lag periods 1, 7, 10, 11 and 12
13. 1945 recession
Lag period 7
The total time period (1942
2012) had two statistically significant lag periods.
All twelve recessionary periods had one or more statistically significant lag periods with
the median number being two. Figure 2, below identifies those lag periods that have the
most statistically significant occurrences.
114
Table 49
ADL Regression,, T-bill Rate, First Difference, lag combinations, 2007-09 recession
Adjusted R2
0.4041
Variables
1. T-bill {1, 3, 5, and 8 lags}
F-Stat
4.7291
Significance
0.008741*
2. T-bill {3, 5, and 8 lags}
5.6461
0.006117*
0.3878
3. T-bill {5 & 8 lags}
5.2184
0.015087*
0.2768
5.2989
0.012803*
0.2559

4.3147
0.027681*
0.2316
Table 50
ADL Regression, T-bill Rate, Lag Combinations, 2001 recession
Adjusted R2
0.7840
Variables
1. T-bill {1, 2, 3, 4, 6, 7, 9, 10, 11, 12 lags}
F-Stat
6.0812
Significance
0.04837*
2. T-bill {1, 2, 4, 6, 7, 9, 10, 11, 12 lags}
5.2592
0.041121*
0.7325
3. T-bill {1, 2, 4, 6, 7, 9, 10, 12 lags}

4.3432
0.045094*
0.6564
Table 51
ADL Regression, T-bill Rate, First Difference, lag combinations, 1990-91 recession
Variables
1. T-bill {1, 3, & 11 lags} and
GDP Growth {1 lag}
F-Stat
5.2222
0.037001*
0.6281
2. T-bill {1, & 11 lags} and

GDP Growth {1 lag}
6.3221
0.021045*
0.6149
5.0569
0.038047*
0.4479
3. T-bill {1 & 11 lags}

115
Table 52
0.00450*
0.5450
Variables
1. T-bill {1, 3, 4, 5, 6, & 7 lags}
F-Stat
5.1923
2. T-bill {1, 3, 5, 6, & 7 lags}
4.9022
0.00655*
3. T-bill {1, 5, 6, & 7 lags}
5.3950
0.00543*
4. T-bill {1, 5, & 7 lags}
5.0894
0.01002*
0.3688

3.8844
0.03670*
0.2005
0.4816
0.4557
Table 53
ADL Regression, T-bill Rate, First Difference, lag combinations, 1980 recession
0.02815*
0.3805
Variables
1. T-bill {1, 2, 3, 4, & 5 lags}
F-Stat
3.4570
2. T-bill {2, 3, 4, & 5 lags}
3.4150
0.03359*
3. T-bill {1, 2, 3, & 5 lags}
3.3124
0.03707*
4. T-bill {2, 3, & 5 lags}

3.6933
0.03257*
0.3257
0.3162
0.2877
Table 54
0.019137*
0.3956
Variables
1. T-bill {2, 3, 4, & 9 lags}
F-Stat
4.1095
2. T-bill {2, 4, 9, & 12 lags}
3.3067
0.048031*
0.3658
3. T-bill {4 & 12 lags}
5.3630
0.018656*
0.3529
4. T-bill {2, 4, & 12 lags}

3.4152
0.049818*
0.3117
116
Table 55
0.03179*
0.4705
Variables
1. T-bill {1, 5, 9, & 10 lags}
F-Stat
4.1104
5.9225
0.01369*
0.3809
3. T-bill {1, 5, & 10 lags}
3.5994
0.04958*
0.3577
4. T-bill {4, 5, & 8 lags}
3.8418
0.03603*
0.3476
5. T-bill {3, 5, & 8 lags}

3.7087
0.39799*
0.3368
Table 56
0.03056*
0.4443
Variables
1. T-bill {1, 4, 8, & 11 lags}
F-Stat
3.9978
2. T-bill {1, 8, & 11 lags}
4.8884
0.01907*
0.4427
3. T-bill {1 & 11 lags}

6.9570
0.00883*
0.4375
Table 57
Variables
1. T-Bill Rate {2, 4, 5, 7, 8, & 9 lags}
F-Stat
Significance
3.340
0.03994*
Adjusted R2
0.4523
117
Table 58
Adjusted R2
Variables
F-Stat
Significance
1. T-bill Rate {4, 6, & 12 lags}
5.1410
0.01626*
0.5624
2. T-bill Rate {3, 4, 6, 11, & 12 lags}
4.5234
0.02044*
0.5401
3. T-bill Rate {3, 4, 6, & 12 lags}
4.7695
0.01775*
0.5013
4.2723
0.03749*
0.3038
4. T-bill Rate {6 & 12 lags}

Table 59
Variables
1. T-bill Rate {2, 4, 5, 7, & 11 lags}

7.9185
0.00297*
0.6975
2. T-bill Rate {1, 10, 11, & 12 lags}
5.6942
0.01182*
0.5729
3. T-bill Rate {10, 11, & 12 lags}
6.9959
0.00670*
0.5623
4. T-bill Rate {1, 7, 10, 11, & 12 lags}
4.5580
0.02385*
0.5596
5. T-bill Rate {2, 4, 5, & 11 lags}

5.3219
0.01239
0.5354
For the full data set and for eleven of the twelve recession periods there were
multiple combinations of different lag periods where there was a statistically significant
relationship between the T-bill lag periods and GDP growth. The 1945 recession was the
only period analyzed where there was no identified combinations of the T-bill lags that
were statistically significant. The adjusted R2 values for the combinations of lag periods
were much higher than the adjusted R2 for the individual lag periods. Table 60 below,
118
identifies the highest adjusted R2 figures for the single and combined T-bill rate analyses
for the full data set and the twelve recession periods.
Table 60
Adjusted R2 Values for the T-Bill, ADL Analysis
Recession
Lag Period
Adjusted R2
Adjusted R2
Full Data Set
0.5267
Lag Combination
1, 2, 4, 5, 9, & GDP
Growth 1
2007-2009
0.2169
1, 3, 5, & 8
0.4041
10
0.1717
1, 2, 3, 4, 6, 7, 9, 10,
11, & 12
0.7840
1990-1991
0.2810
1, 3, 11, &
GDP Growth 1
0.6281
1981-1982
0.1469
1, 3, 4, 5, 6, & 7
0.5450
1980
0.1736
1, 2, 3, 4, & 5
0.3805
1973-1975
12
0.0569
2, 3, 4, & 9
0.3956
1969-1970
0.2842
1, 5, 9, & 10
0.4705
1960-1961
11
0.3144
1, 4, 8, & 11
0.4443
1958
0.1207
2, 4, 5, 7, 8, & 9
0.4523
1953
0.1722
4, 6, & 12
0.5624
1949
10
0.1665
2, 4, 5, 7, & 11
0.6975
1945
0.0400
NA
NA
2001
0.2818
ADL Analysis, the term structure of interest rates and the three-month T-bill
rate combined. This ADL analysis examined the relationship between GDP growth, as
the dependent variable and both the term spread of interest rates and the three-month Tbill rate as the explanatory variables. This analysis provides information relating to
119
research question three, which asks whether or not the combination of short-term interest
rates and the term spread of interest rates could be used to forecast how long a recession
might last or when a recession might end. The time lags of between zero and twelve
quarters (zero to three years) were examined. Lag periods that were not statistically
significant were eliminated. This analysis was performed for all thirteen data sets; the full
data set of 1942 to 2012 and each of the twelve recession periods during that time period.
The results are presented in Tables 61 through 73 below.
Table 61
ADL Regression, T-bill and Term Spread Combined, full data set (1942-2012)
Variables
1. Term Spread {1 lag} T-bill {2 lags}
GDP Growth {1 lag}
F-Stat
Significance
Adj. R2
104.309
0.000000*
0.5254
2. Term Spread {1, 3 lags} T-bill {2, 5 lags}

GDP Growth {1 lag}
22.959
0.000000*
0.2839
3. Term Spread {1, 3 lags} T-bill {2, 5, 9 lags}

GDP Growth {1 lag}
19.831
0.000000*
0.2816
4. Term Spread {1, 3, 9 lags} T-bill {2, 5, 9 lags}

GDP Growth {1 lag}
16.261
0.000000*
0.2813
5. Term Spread {1, 3, 9, 12 lags} T-bill {2, 4, 5, 9 lags}

GDP Growth {1 lag}
12.605
0.000000*
0.2782
120
Table 62
ADL Regression, T- Bill and Term Spread Combined, 2007-09 recession
Variables
1. Term Spread {5 & 7 lags} and
T-bill {3, 5, & 8 lags}
F-Stat
6.0612
0.00213*
0.5350

T-bill {1, 3, 5, & 8 lags}
5.1720
0.00394*
0.5322

T-bill {8 lags}
7.1502
0.00125*
0.5279

T-bill {8 lags}
8.6226
0.00081*
0.5097
5.1929
0.01526*
0.3418
5. Term Spread {7 lags} and

T-Bill {8 lags}
Table 63
ADL Regression, T- Bill and Term Spread Combined, 2001 recession
Variables
1. Term Spread {9 lags} T-Bill {8 & 10 lags}
F-Stat Significance
3.3835
0.05106*
2. Term Spread {4 & 9 lags} T-Bill {8 & 10 lags}

2.6985
0.08178*
Adj. R2
0.3089
0.2981
121
Table 64
ADL Regression, T- bill and Term Spread Combined, 1990-91 recession
Adj. R2
Variables
1. Term Spread {2, 5, & 6 lags} and
T-bill {1, 2, 3, 4, & 5 lags}
F-Stat
Significance
15.4955
0.00041*
0.8788

T-bill {1, 2, 3, 4, & 5 lags}
16.9418
0.00016*
0.8746

T-bill {1, 2, 3, & 4 lags}
12.6174
0.00023*
0.8039

T-bill {1, 3, & 11 lags}
5.2378
0.04661*
0.6794
4.9440
0.01092*
0.5370

T-bill {1, 2, & 3 lags}
Table 65
5.3554
0.00334*
0.5430

T-Bill {5 & 6 lags}
6.0492
0.00216*
0.5344

T-Bill {5 lags}
7.2137
0.00104*
0.5194

T-Bill {5 lags}
7.7819
0.00123*
0.4694
9.4059
0.00121*
0.4223

T-bill {5 lags}
F-Stat
Significance
Adj. R2
Variables
1. Term Spread {1, 2, 3, & 7 lags} and
T-Bill {5 & 6 lags}
122
Table 66
Significance
Adj. R2
4.3677
0.01067*
0.4450

T-Bill {1, 2, & 4 lags}
3.5191
0.02238*
0.4185

T-Bill {1 & 2 lags}
4.5649
0.01013*
0.3933

T-Bill {1 & 2 lags}
4.7352
0.01181*
0.3276
5.8886
0.00933*
0.2983
Variables
T-Bill {1, 2, & 4 lags}

T-Bill {2 lags}
F-Stat
Table 67
Variables
T-Bill {9 lags}
T-Bill {4 & 9 lags}
T-Bill {9 lags}
T-Bill {9 lags}
T-Bill {9 lags}
Significance
Adj. R2
8.9002
0.00069*
0.6245
6.0848
0.00320*
0.6162
11.0109
0.00036*
0.6125
6.7798
0.00208*
0.6033
12.9247
0.00039*
0.5566
F-Stat
123
Table 68
Significance
Adj. R2
5.6772
0.01228*
0.6255

T-Bill {4 & 9 lags}
6.5975
0.00335*
0.5543

T-Bill {5 lags}
5.0436
0.00868*
0.5290

T-Bill {5 lags}
7.9684
0.00207*
0.5373
8.3328
0.00331*
0.4490
Variables
T-Bill {5 & 10 lags}

T-Bill {5 lags}
F-Stat
Table 69
18.4605
0.000923*
0.8534

T-Bill {4 & 8 lags}
15.3227
0.000180*
0.7925
16.6367
0.000142*
0.7577

T-Bill {4 lags}
F-Stat
Significance
Adj. R2
Variables
T-Bill {4 & 8 lags}
124
Table 70
Variables
T-Bill {2 & 7 lags}
T-Bill {2, 7, & 8 lags}
Adjusted R2
F-Stat
Significance
3.8790
0.02847*
0.4736
3.3188
0.04583*
0.4651
Table 71
Variables
T-Bill {3, 6, & 12 lags}
Adjusted R2
F-Stat
Significance
9.6265
0.00172*
0.7753

T-Bill {3, 6, & 12 lags}
10.2968
0.00107*
0.7560

12.3617
0.00047*
0.7518

T-Bill {12 lags}
12.2084
0.00104*
0.5991
8.3832
0.00283*
0.5962

T-Bill {3 & 12 lags
125
Table 72
Adjusted R2
Variables
T-Bill {4, 5, 10, & 11 lags}
F-Stat
Significance
8.9193
0.00189*
0.7253

T-Bill {4, 10, & 11 lags}
7.1310
0.00437*
0.6714

T-Bill {4, 10, & 11 lags}
7.8721
0.00300*
0.6470

T-Bill {10 &11 lags}
5.8978
0.01032*
0.4948
4.1690
0.02698*
0.4580

Table 73
Adjusted R2
Variables
T-Bill {4 lags}
F-Stat
Significance
26.9780
0.0000*
0.8739

T-Bill {4 lags}
21.7716
0.0000*
0.8738
24.2005
0.0000*
0.8227
3. Term Spread {8 &12 lags} and

T-Bill {4 lags}
In all thirteen analyses, the full data set and the twelve recessions, there were
statistically significant combinations of the explanatory variables. Table 74 below
presents those combinations which had the highest adjusted R2 value.
126
Table 74
Adjusted R2 Values for the Combined T-Bill and Term Spread, ADL Analysis
Full Data Set
T-bill and Term Spread

Lag Combination
Term Spread {1 lag} T-bill
{2 lags} GDP Growth {1 lag}
2007-2009
Term Spread {5 & 7 lags} and

T-bill {3, 5, & 8 lags}
0.5350
Term Spread {9 lags}

0.3089
1990-1991
Term Spread {2, 5, & 6 lags} and

T-bill {1, 2, 3, 4, & 5 lags}
0.8788
1981-1982
Term Spread {1, 2, 3, & 7 lags}

and T-Bill {5 & 6 lags}
0.5430
Term Spread {3 & 4 lags} and

T-Bill {1, 2, & 4 lags}
0.4450
1973-1975

T-Bill {9 lags}
0.6245
1969-1970

0.6255
1960-1961
Term Spread {4, 9, & 12 lags}

0.8534
1958

0.4736
1953

and T-Bill {3, 6, & 12 lags}
0.7753
1949
Term Spread {12 lags} and

T-Bill {4, 5, 10, & 11 lags}
0.7253
1945

and T-Bill {4 lags}
0.8739
Recession Period
2001
1980
Adjusted R2
0.5254
127
Vector Autoregression (VAR) Analysis. With an economic time series analysis

it is sometimes difficult to determine the cause and effect between variables (Stock &
Watson, 2012). For example, in this analysis the hypothesis was that historic interest rate
data (the level of short-term rates and the interest rate term spread) can be used to predict
the current or future growth in GDP. It may also be appropriate to ask the question, can
historic GDP growth figures be used to predict the level of short-term interest rates or the
interest rate term spread? In other words in which direction is there correlation or
causality or is there causality in both directions? Vector autoregression analysis addresses
this question. Vector autoregression is an extension of the ADL model that is used when
there is the possibility of bi-directional correlation (Koop, 2009). With VAR, a regression
equation is created to analyze each variable as a dependent variable. In this analysis there
are three variables so three VAR equations would be used (Lutkepohl, 2007). The first
would analyze GDP growth as the dependent variable with the interest rate term spread
and three-month T-Bill rate as the explanatory variables, the second equation would
include the interest rate term spread as the dependent variable with the other two as the
explanatory variables, and the third would include the three-month T-bill rate as the
dependent variable. For each equation the appropriate statistics are calculated to
determine the statistical significance of the relationship (Lutkepohl, 2007). The VAR
analysis was performed with all three variables. Accordingly this analysis relates to the
third research question which asks whether or not the combination of short-term interest
rates and the term spread of interest rates could be used to forecast how long a recession
might last or when a recession might end. The VAR analysis was performed for all
128
thirteen data sets; the full data set (1942
2012) and all twelve recessions during that
time period. The results of these thirteen analyses are presented below.
Vector Autoregression Analysis, Full data set (1942 2012). The results of the
VAR analysis of the full data set (1942-2012) are presented in Tables 75, 76, and 77
below. In Table 75 the results show that the VAR analysis with the GDP growth rate as
the dependent variable and the interest rate term spread and the three-month T-bill rate as
explanatory variables was statistically significant for all periods from one to twelve lags.
This indicates that there was a statistically significant predictive relationship between the
combination of the term spread of interest rates and the T-bill rate as the explanatory
variables and GDP growth as the dependent variable.
Table 75
VAR Analysis, GDP Growth as the Dependent Variable, full data set (1942-2012)
Lag Period
F Statistic
Critical Value (5%)
1
105.300
1.26
1&2
85.184
1.26
1 to 3
38.919
1.26
1 to 4
17.722
1.26
1 to 5
6.827
1.26
1 to 6
7.007
1.26
1 to 7
5.926
1.26
1 to 8
5.339
1.26
1 to 9
4.719
1.26
1 to 10
4.423
1.26
1 to 11
4.506
1.26
1 to 12
4.468
1.26
* Statistically significant at the 0.05 level
Adjusted R2
0.5260 *
0.6425 *
0.5493 *
0.4183 *
0.2392 *
0.2808 *
0.2726 *
0.2747 *
0.2682 *
0.2734 *
0.2984 *
0.3154 *
In Table 76 the results show that the VAR analysis with the interest rate term
spread as the dependent variable and the GDP growth rate and the three-month T-Bill rate
as explanatory variables was statistically significant for all periods from one to twelve
lags. This indicates that there was a statistically significant predictive relationship
129
between the combination of the T-bill rate and GDP growth as the explanatory variables
and the term spread of interest rates as the dependent variable.
Table 76
VAR Analysis, Term Spread as the Dependent Variable, full data set (1942-2012)
Lag Period
F Statistic
Critical Value (5%)
1
144.452
1.26
1&2
74.745
1.26
1 to 3
53.001
1.26
1 to 4
40.441
1.26
1 to 5
34.789
1.26
1 to 6
30.899
1.26
1 to 7
28.839
1.26
1 to 8
26.745
1.26
1 to 9
23.983
1.26
1 to 10
22.899
1.26
1 to 11
21.562
1.26
1 to 12
19.939
1.26
Adjusted R2
0.6041 *
0.6116 *
0.6257 *
0.6291 *
0.6458 *
0.6602 *
0.6793 *
0.6898 *
0.6937 *
0.7064 *
0.7138 *
0.7156 *
In Table 77 below the results show that the VAR analysis with the three-month TBill rate as the dependent variable and the interest rate term spread and the GDP growth
rate as explanatory variables was statistically significant for all periods from one to
twelve lags. This indicates that there was a statistically significant predictive relationship
between the combination of the term spread of interest rates and GDP growth as the
explanatory variables and the T-bill rate as the dependent variable.
130
Table 77
VAR Analysis, T-bill Rate as the Dependent Variable, full data set (1942-2012
Lag Period
F Statistic
Critical Value (5%)
1
3.910
1.26
1&2
3.638
1.26
1 to 3
3.779
1.26
1 to 4
3.361
1.26
1 to 5
3.211
1.26
1 to 6
3.820
1.26
1 to 7
4.390
1.26
1 to 8
4.186
1.26
1 to 9
3.997
1.26
1 to 10
4.047
1.26
1 to 11
3.959
1.26
1 to 12
3.368
1.26
Adjusted R2
0.0300 *
0.0533 *
0.0820 *
0.0922 *
0.1066 *
0.1549 *
0.2050 *
0.2176 *
0.2280 *
0.2508 *
0.2641 *
0.2624 *
The results presented in Table 75, Table 76, and Table 77 identified that there was
a bidirectional correlation between the three variables. In other words each variable could
be used, in a statistically significant way, to explain the other variables. When this
bidirectional correlation exists between variables the Granger Causality test can be used
to identify whether or not the explanatory variables important to this study, the T-bill rate
and the term spread of interest rates, could be useful, in a statistically significant way, in
forecasting GDP growth, the dependent variable (Granger 1969).
Granger causality test
full data set (1942-2012). The Granger causality test is a
statistical hypothesis test for determining whether one time series is useful in forecasting
another time series (Granger, 1969). It measures the historic ability of one variable to
predict another. Typically regression analysis measures correlation, however Granger
developed a test that measures predictive ability. If the Granger causality test shows that
the explanatory variables were found to contain information that was helpful in predicting
the dependent variable then it is said that the explanatory variable Granger causes (or
131
predicts) the dependent variable (Granger 1969). As the VAR analysis presented above
shows that there was bidirectional correlation between the three variables, the Granger
causality test was performed to identify whether or not the two explanatory variables, the
term spread of interest rates and the three-month T-Bill rate, Granger caused GDP
growth. The results of this analysis are presented in Table 78. Only those lag periods
with a statistically significant relationship are included in the table.
Table 78
Granger Causality, GDP Growth as the Dependent Variable, full data set (1942-2012)
Lag Period
Two
Term Spread
T-Bill
Combined
Chi Squared Value
Significance
1.208
1.624
13.869
0.5465
0.0328 *
0.0077 *
Three
Term Spread
T-Bill
Combined
2.355
5.666
16.829
0.5020
0.1290
0.0099 *
Four
Term Spread
T-Bill
Combined
2.252
6.089
16.607
0.6895
0.1926
0.0345 *
Five
Term Spread
T-Bill
Combined
2.121
7.988
19.237
0.8322
0.1569
0.0374 *
Six
Term Spread
1.785
T-Bill
7.957
Combined
23.107
* Significant at the 0.05 level.
0.9384
0.2413
0.0268 *
Based on the results as presented in Table 78 it can be said that the three-month
T-bill rate Granger caused GDP growth at a lead time of two lags. It can also be said that
132
the three-month T-bill rate combined with the interest rate term spread Granger caused
GDP growth at the lead times of two, three, four, five, and six lags. It cannot be said that
the interest rate term spread Granger caused GDP growth.
Vector Autoregression Analysis
2007-09 Recession. A VAR analysis was
completed for the data set from the 2007 2009 recession. The results are presented in
Tables 79, 80, and 81. Table 79 includes the results from the equation with GDP growth
as the dependent variable and the interest rate term spread and three-month T-bill rate as
the explanatory variables. Only seven lag periods were considered. The size of the data
set did not allow the analysis with more than seven lags. Three of the seven lag periods
were statistically significant. This indicates that there was a statistically significant
predictive relationship between the combination of the term spread of interest rates and
the T-bill rate as the explanatory variables and GDP growth as the dependent variable for
these lag periods.
Table 79
VAR Analysis, GDP Growth as the Dependent Variable, 2007-09 Recession.
Lag Period
F Statistic
Critical Value (5%)
1
3.88
1.87
1 to 5
2.74
2.59
1 to 6
2.79
2.41
Adjusted R2
0.2237 *
0.5010 *
0.5631 *
Table 80 includes the results from the equation with the term spread of interest
rates as the dependent variable and the three-month T-Bill rate and GDP growth as the
explanatory variables. Only seven lag periods were considered as the size of the data set
did not allow the analysis with more than seven lags. All seven lag periods analyzed
showed statistically significant results. This indicates that there was a statistically
133
significant predictive relationship between the combination of the GDP Growth rate and
the T-bill rate as the explanatory variables and the term spread of interest rates as the
dependent variable for these lag periods.
Table 80
VAR Analysis, Term Spread as the Dependent Variable, 2007-09 Recession
Lag Period
F Statistic
Critical Value (5%)
1
41.87
1.87
1&2
26.51
1.94
1 to 3
23.60
2.08
1 to 4
16.10
2.26
1 to 5
9.22
2.59
1 to 6
7.82
2.41
1 to 7
15.36
8.64
Adjusted R2
0.8034 *
0.8407 *
0.8790 *
0.8703 *
0.8259 *
0.8307 *
0.9263 *
Table 81 presents the results from the equation with the three-month T-Bill rate as
the dependent variable and the interest rate term spread and GDP growth as the
explanatory variables. Only seven lag periods were considered as the size of the data set
did not allow the analysis with more than seven lags. Only one of the seven lag periods
analyzed showed statistically significant results. This indicates that there was a
statistically significant predictive relationship between the combination of the GDP
Growth rate and the term spread of interest rates as the explanatory variables and the Tbill rate as the dependent variable for these lag periods.
Table 81
VAR Analysis, T-bill Rate as the Dependent Variable, 2007-09 Recession
Lag Period
F Statistic
Critical Value (5%)
1 to 3
3.11
2.08
Adjusted R2
0.4039 *
134
The results presented in Table 79, Table 80, and Table 81 identified that there was
a bidirectional correlation between the three variables. In other words each variable could
be used in a statistically significant way to explain the other variables. Because of this
bidirectional correlation between the variables the Granger Causality test was used to
identify if the explanatory variables, the T-bill rate and the term spread of interest rates,
could be useful, in a statistically significant way, in forecasting GDP growth the
dependent variable (Granger 1969).
2007
2009 Recession. As the VAR analysis presented
above shows that there was bidirectional correlation between the variables, the Granger
term spread of interest rates and the three-month T-Bill rate Granger caused GDP growth.
The results of this analysis are presented in Table 82 below:
Table 82
Granger Causality, GDP Growth as the Dependent Variable, 2007-09 Recession
Lag Period
Five
Term Spread
T-Bill
Combined
Chi Squared Value
Significance
9.028
17.585
28.510
0.8322
0.0035 *
0.0015 *
14.426
15.920
36.15
0.0252 *
0.0142 *
0.0003 *
Seven
Term Spread
19.051
T-Bill
18.284
Combined
52.523
0.0080 *
0.0108 *
0.0000 *
Six
Term Spread
T-Bill
Combined
135
T-bill Granger caused GDP growth at lags of five, six, and seven periods. It can also be
said that the interest rate term spread Granger caused GDP growth at a lag of six and
seven periods. The three-month T-Bill rate and the interest rate term spread combined,
Granger caused GDP growth at a lag period of five, six, and seven lags.
2001 Recession. A VAR analysis was
completed for the data set from the 2001 recession. The first VAR analysis was the
equation with GDP growth as the dependent variable and the interest rate term spread and
three-month T-Bill rate as the explanatory variables. Only six lag periods were
considered. The size of the data set did not allow the analysis with more lags. None of
the lag periods are statistically significant. This indicates that for this data set there was
no statistically significant predictive relationship between the combination of the term
spread of interest rates and the T-bill rate as the explanatory variables and GDP growth as
the dependent variable.
explanatory variables. All six lag periods showed statistically significant results. This
indicates that there was a statistically significant predictive relationship between the
combination of the GDP Growth rate and the T-bill rate as the explanatory variables and
the term spread of interest rates as the dependent variable for these lag periods.
136
Table 83
VAR Analysis, Term Spread as the Dependent Variable, 2001 Recession
Lag Period
F Statistic
1
36.45
1&2
18.99
1 to 3
10.46
1 to 4
5.80
1 to 5
5.41
1 to 6
7.71
Critical Value (5%)

1.95
2.07
2.22
2.51
3.12
5.79
Adjusted R2
0.8036 *
0.8119 *
0.7801 *
0.7148 *
0.7503 *
0.8518 *
explanatory variables. Only six lag periods were considered as the size of the data set
does not allow the analysis with more lags. Only two of the six lag periods analyzed
showed statistically significant results. This indicates that there was a statistically
significant predictive relationship between the combination of the GDP Growth rate and
the term spread of interest rates as the explanatory variables and the T-bill rate as the
dependent variable for these lag periods.
Table 84
VAR Analysis, T-bill Rate as the Dependent Variable, 2001 Recession
Lag Period
F Statistic
1
4.33
1&2
2.96
Critical Value (5%)

1.95
2.07
Adjusted R2
0.2773 *
0.3195 *
2001 recession. As the VAR analysis presented above
shows that there was bidirectional correlation between the variables the Granger causality
test was performed to identify whether or not the two explanatory variables, the term
spread of interest rates and the three-month T-Bill rate Granger cause GDP growth. The
137
only statistically significant results are in the six lag period analysis where it can be said
that the first difference of the three-month T-Bill rate Granger caused GDP growth. The
results are presented in Table 85 below:
Table 85
Granger Causality, GDP Growth as the Dependent Variable, 2001 Recession.
Lag Period
Chi Squared Value
Six
Term Spread
12.5420
T-Bill
13.2359
Combined
18.8286
Significance
0.0509
0.0394 *
0.0938
T-bill Granger caused GDP growth at a lag of six periods. The term spread did not
Granger cause GDP growth in any period. The combination of the two variables did not
Granger cause GDP growth in any period.
completed for the data set from the 1990-1991 recession. The results are presented in
as the dependent variable and the interest rate term spread and three-month T-Bill rate as
the explanatory variables. Only five lag periods were considered. The size of the data set
did not allow the analysis with more lags. Three of the five lag periods are statistically
significant.
138
Table 86
VAR Analysis, GDP Growth as the Dependent Variable, 1990-91 Recession
Lag Period
F Statistic
1
2.27
1 to 3
5.73
1 to 4
3.38
Critical Value (5%)

2.09
2.08
3.15
Adjusted R2
0.1472 *
0.6802 *
0.6002 *
explanatory variables. Only five lag periods were considered as the size of the data set
did not allow the analysis with more lags. Four of the five lag periods analyzed resulted
in statistically significant results.
Table 87
Lag Period
F Statistic
1
65.86
1&2
60.94
1 to 3
31.11
1 to 4
22.41
Critical Value (5%)

2.09
2.25
2.53
3.15
Adjusted R2
0.8984 *
0.9448 *
0.9313 *
0.9311 *
The third VAR equation for the 1990-91 recession included the three-month Tbill rate as the dependent variable and the interest rate term spread and GDP growth as
the explanatory variables. Only five lag periods were considered as the size of the data set
did not allow the analysis with more than five lags. None of the five lag periods analyzed
showed statistically significant results.
1990-1991 recession. As the VAR analysis presented
139
term spread of interest rates and the three-month T-Bill rate Granger caused GDP growth.
Table 88
Lag Period
Three
Term Spread
T-Bill
Combined
Chi Squared Value
Significance
27.645
15.779
36.469
0.0000 *
0.0013 *
0.0000 *
17.571
12.499
29.184
0.0015 *
0.0140 *
0.0003 *
Five
Term Spread
15.672
T-Bill
10.023
Combined
26.664
0.0078 *
0.0746
0.0029 *
Four
Term Spread
T-Bill
Combined
T-bill rate Granger caused GDP growth at lags of three and four periods. It can also be
said that the interest rate term spread Granger caused GDP growth at a lag of three, four,
and five periods. The three-month T-Bill rate and the interest rate term spread combined,
Granger caused GDP growth at a lag period of three, four, and five lags.
set did not allow the analysis with more lags.
140
Table 89
Lag Period
F Statistic
1
9.18
1&2
5.40
1 to 3
5.73
1 to 4
2.40
Critical Value (5%)

1.90
2.00
2.12
2.33
Adjusted R2
0.4670 *
0.4945 *
0.4745 *
0.4015 *
explanatory variables. Only seven lag periods were considered. The size of the data set
did not allow the analysis with more lags.
Table 90
Lag Period
F Statistic
1
4.61
1&2
4.09
1 to 3
3.08
Critical Value (5%)

1.90
2.00
2.12
Adjusted R2
0.2791 *
0.4070 *
0.4182 *
did not allow the analysis with more than five lags.
Table 91
VAR Analysis, T-Bill Rate as the Dependent Variable, 1981-82 Recession
Lag Period
F Statistic
1&2
2.00
Critical Value (5%)

2.00
Adjusted R2
0.1825 *
141
causality test has been performed to identify whether or not the two explanatory
variables, the term spread of interest rates and the three-month T-Bill rate Granger cause
GDP growth. The results of this analysis are presented in Table 94 below:
Table 92
Lag Period
One
Term Spread
T-Bill
Combined
Chi Squared Value
Significance
12.903
17.847
18.894
0.0003 *
0.0000 *
0.0001 *
Three
Term Spread
T-Bill
Combined
2.274
2.250
23.556
0.5175
0.5221
0.0006 *
Four
Term Spread
T-Bill
Combined
2.906
3.228
20.787
0.5736
0.5205
0.0077 *
Five
Term Spread
1.042
T-Bill
1.775
Combined
23.282
0.9591
0.8793
0.0098 *
T-Bill Granger caused GDP growth at a lag of one period. It can also be said that the
interest rate term spread Granger caused GDP growth at a lag of one period. The threemonth T-Bill rate and the interest rate term spread combined, Granger caused GDP
growth at lag periods of one, three, four, and five lags.
142
completed for the data set from the 1980 recession. The results are presented in Tables
93, 94, and 95. Table 93 includes the results from the equation with GDP growth as the
dependent variable and the interest rate term spread and three-month T-Bill rate as the
explanatory variables. Only six lag periods were considered. The size of the data set did
not allow an analysis with more lags.
Table 93
VAR Analysis, GDP Growth as the Dependent Variable, 1980 Recession
Lag Period
F Statistic
1
4.97
1&2
2.18
Critical Value (5%)

1.99
2.11
Adjusted R2
0.3226 *
0.2278 *
explanatory variables. Only six lag periods were considered. The size of the data set does
Table 94
VAR Analysis, Term Spread as the Dependent Variable, 1980 Recession.
Lag Period
F Statistic
Critical Value (5%)
1&2
2.95
2.11
Adjusted R2
0.3272 *
not allow an analysis with more than five lags.
143
Table 95
VAR Analysis, T-Bill Rate as the Dependent Variable, 1980 Recession
Lag Period
F Statistic
1&2
2.13
Adjusted R2
Critical Value (5%)

2.11
0.2215 *
shows that there was bidirectional correlation between the variables, the Granger
term spread of interest rates and the three-month T-Bill rate Granger cause GDP growth.
Table 96
Granger Causality, GDP Growth as the Dependent Variable, 1980 Recession
Lag Period
One
Term Spread
T-Bill
Combined
Chi Squared Value
Significance
8.291
12.758
13.053
0.0040 *
0.0004 *
0.0015 *
3.108
0.023
11.214
0.2115
0.9887
0.0243 *
Six
Term Spread
9.985
T-Bill
9.908
Combined
36.094
0.1253
0.1286
0.0003 *
Two
Term Spread
T-Bill
Combined
T-bill Granger caused GDP growth at lags of one period. It can also be said that the
interest rate term spread Granger caused GDP growth at a lag of one period. The three-
144
month T-Bill rate and the interest rate term spread combined, Granger caused GDP
growth at lag periods of one, two, and six lags.
1973-1975 Recession . A VAR analysis was
set did not allow an analysis with more lags.
Table 97
Lag Periods
F Statistic
1
4.99
1&2
2.74
1 to 3
3.12
1 to 7
591.04
Critical Value (5%)

1.91
2.00
2.13
8.65
Adjusted R2
0.2997 *
0.2789 *
0.4230 *
0.9982 *
Table 98
Lag Period
F Statistic
1
20.77
1&2
11.80
1 to 3
7.92
1 to 4
5.54
1 to 5
3.90
Critical Value (5%)

1.91
2.00
2.13
2.51
2.74
Adjusted R2
0.6793 *
0.7058 *
0.7055 *
0.6855 *
0.6442 *
145
did not allow an analysis with more than seven lags.
Table 99
Lag Period
F Statistic
1
3.76
1&2
3.02
Critical Value (5%)

1.91
2.00
Adjusted R2
0.2282 *
0.3098 *
above shows that there is bidirectional correlation between the variables, the Granger
variables, the term spread of interest rates and the three-month T-Bill rate Granger caused
GDP growth. Based on the results as presented in Table 100 it can be said that the threemonth T-Bill Granger caused GDP growth at lags of three and seven periods. It can also
be said that the interest rate term spread Granger caused GDP growth at lags of one, two,
three, and seven periods. The three-month T-Bill rate and the interest rate term spread
combined, Granger caused GDP growth at lags of one, two, three, and seven periods.
146
Table 100
Lag Period
One
Term Spread
T-Bill
Combined
Chi Squared Value
Significance
7.885
0.740
10.407
0.0194 *
0.6908
0.0341 *
Two
Term Spread
T-Bill
Combined
7.885
0.740
10.407
0.0194 *
0.6908
0.0341 *
Three
Term Spread
T-Bill
Combined
15.556
8.279
19.688
0.0014 *
0.0406 *
0.0031 *
Seven
Term Spread
4326.701
T-Bill
4112.852
Combined
9451.818
0.0000 *
0.0000 *
0.0000 *
Tables 101, 102, and 103. Table 101 includes the results from the equation with GDP
growth as the dependent variable and the interest rate term spread and three-month T-Bill
rate as the explanatory variables. Only six lag periods were considered. The size of the
data set did not allow an analysis with more lags.
Table 101
Lag Periods
F Statistic
1
1.94
Critical Value (5%)

1.91
Adjusted R2
0.0944 *
147
Table 102
Lag Period
F Statistic
1
10.30
1&2
8.35
1 to 3
6.99
1 to 4
5.21
1 to 5
6.48
1 to 6
5.92
Critical Value (5%)

1.95
2.07
2.17
2.42
2.90
4.54
Adj. R2
0.5081 *
0.6290 *
0.6832 *
0.6778 *
0.7814 *
0.8009 *
Table 103 presents the results from the equation with the three-month T-Bill rate
as the dependent variable and the interest rate term spread and GDP growth as the
not allow an analysis with more than six lags.
Table 103
Lag Period
F Statistic
1
2.55
1&2
3.35
1 to 3
3.03
1 to 4
2.83
1 to 5
2.96
Critical Value (5%)

1.95
2.07
2.17
2.42
2.90
Adj. R2
0.1472 *
0.3516 *
0.4217 *
0.4780 *
0.5608 *
148
Table 104
Lag Period
One
Term Spread
T-Bill
Combined
Chi Squared Value
Significance
5.186
0.701
5.772
0.0228 *
0.4025
0.0558
8.132
3.912
10.279
0.0434 *
0.2711
0.1134
Four
Term Spread
12.845
T-Bill
7.606
Combined
18.123
0.0121 *
0.1071
0.0203 *
Three
Term Spread
T-Bill
Combined
Based on the results as presented in Table 104 the three-month T-Bill did not
Granger caused GDP growth in any lag period. The interest rate term spread Granger
caused GDP growth at lags of one, three, and four periods. The three-month T-Bill rate
and the interest rate term spread combined, Granger caused GDP growth in the four lag
period.
Tables 105, 106, and 107. Table 105 includes the results from the equation with GDP
149
Table 105
Lag Periods
F Statistic
1
2.50
1&2
2.46
Critical Value (5%)

1.96
2.07
Adjusted R2
0.1476 *
0.2590 *
Table 106 includes the results from the VAR equation with the term spread of
interest rates as the dependent variable and the three-month T-Bill rate and GDP growth
as the explanatory variables. Only six lag periods were considered. The size of the data
Table 106
Lag Period
F Statistic
1
3.78
1&2
3.20
1 to 3
2.96
1 to 4
3.37
1 to 5
3.90
Critical Value (5%)

1.96
2.07
2.23
2.50
3.13
Adjusted R2
0.2427 *
0.3459 *
0.4240 *
0.5530 *
0.6642 *
Table 107 presents the results from the VAR equation with the three-month T-Bill
rate as the dependent variable and the interest rate term spread and GDP growth as the
150
Table 107
Lag Period
F Statistic
1
4.97
1&2
4.14
1 to 3
3.76
Adj. R2
0.3143 *
0.4294 *
0.5085 *
Critical Value (5%)

1.96
2.07
2.23
Table 108
Lag Period
Two
Term Spread
T-Bill
Combined
Chi Squared Value
Significance
8.622
6.520
9.812
0.0134 *
0.0384 *
0.0437 *
Three
Term Spread
10.752
T-Bill
7.354
Combined
12.669
0.0131 *
0.0614
0.0486 *
Based on the results as presented in Table 108 the three-month T-Bill Granger
caused GDP growth in lag period two. The interest rate term spread Granger caused GDP
growth at lags of two and three periods. The three-month T-Bill rate and the interest rate
term spread combined Granger caused GDP growth at lags of two and four lag periods.
151
109, 110, and 111. Table 109 includes the results from the VAR equation with GDP
Table 109
Lag Periods
F Statistic
1
3.54
1&2
2.76
1 to 3
2.65
Critical Value (5%)

1.96
2.08
2.23
Adjusted R2
0.2264 *
0.2972 *
0.3816 *
Table 110
Lag Period
F Statistic
1
3.98
1&2
4.44
1 to 3
5.15
1 to 4
3.94
Critical Value (5%)

1.96
2.08
2.23
2.51
Adj. R2
0.2561 *
0.4521 *
0.6086 *
0.6051 *
Table 111 presents the results from the equation with the three-month T-Bill rate
as the dependent variable and the interest rate term spread and GDP growth as the
152
explanatory variables. Only six lag periods were considered as the size of the data set did
Table 111
VAR Analysis, T-Bill Rate as the Dependent Variable, 1958 Recession.
Lag Period
F Statistic
1
2.99
1&2
3.30
1 to 3
3.20
Critical Value (5%)

1.96
2.08
2.23
Adj. R2
0.1870 *
0.3558 *
0.4520 *
153
Table 112
Lag Period
One
Term Spread
T-Bill
Combined
Chi Squared Value
Significance
6.856
2.655
6.955
0.0088 *
0.1032
0.0309 *
Two
Term Spread
T-Bill
Combined
12.054
7.635
12.191
0.0024 *
0.0220 *
0.0160 *
Three
Term Spread
T-Bill
Combined
19.445
12.172
19.803
0.0002 *
0.0068 *
0.0030 *
Four
Term Spread
T-Bill
Combined
19.621
11.049
22.055
0.0006 *
0.0260 *
0.0048 *
Five
Term Spread
T-Bill
Combined
12.905
8.581
17.720
0.0243 *
0.1270
0.0599
Six
Term Spread
12.956
T-Bill
8.899
Combined
16.811
0.0437 *
0.1793
0.1568
caused GDP growth at lags of two, three, and four periods. The interest rate term spread
Granger caused GDP growth in all six lag periods. The three-month T-Bill rate and the
interest rate term spread combined, Granger caused GDP growth at lags of one, two,
three, and four periods.
154
Table 113
Lag Periods
F Statistic
1
5.61
1&2
2.73
Critical Value (5%)

1.93
2.07
Adjusted R2
0.3389 *
0.2854 *
Table 114
Lag Period
F Statistic
1
13.28
1&2
11.97
1 to 3
7.03
1 to 4
5.78
1 to 5
9.27
1 to 6
20.05
Significant at the 0.05 level.
Critical Value (5%)

1.93
2.07
2.17
2.42
2.90
4.54
Adjusted R2
0.5770 *
0.7169 *
0.6846 *
0.7048 *
0.8435 *
0.9397 *
155
Table 115
VAR Analysis, T-Bill Rate as the Dependent Variable, 1953 Recession
Lag Period
F Statistic
1&2
3.33
1 to 3
2.99
1 to 4
8.13
1 to 5
3.14
1 to 6
6.61
Critical Value (5%)

2.07
2.17
2.42
2.90
4.54
Adjusted R2
0.3500 *
0.4169 *
0.4431 *
0.5823 *
0.8210 *
shows that there is bidirectional correlation between the variables, the Granger causality
test has been performed to identify whether or not the two explanatory variables, the term
spread of interest rates and the three-month T-Bill rate Granger caused GDP growth. The
results of this analysis are presented in Table 116 below:
Table 116
Lag Period
Chi Squared Value
Two
Term Spread
6.354
T-Bill
3.329
Combined
6.736
Significance
0.0417 *
0.1893
0.1505
Based on the results as presented in Table 116 the interest rate term spread
Granger caused GDP growth only at lag period two. The T-bill rate did not Granger cause
GDP growth for any lag period. The combination of the T-bill rate and the term spread
did not Granger cause GDP growth in any lag period.
156
Table 117
Lag Periods
F Statistic
1
8.66
1&2
3.35
Critical Value (5%)

1.96
2.07
Adjusted R2
0.4692 *
0.3601 *
set does not allow an analysis with more lags.
Table 118
Lag Period
F Statistic
1
44.61
1&2
17.22
1 to 3
9.27
1 to 4
5.76
1 to 5
3.82
1 to 6
4.17
Critical Value (5%)

1.96
2.07
2.23
2.51
3.13
5.79
Adjusted R2
0.8342 *
0.7956 *
0.7562 *
0.7130 *
0.6580 *
0.7311 *
157
Table 119
Lag Period
F Statistic
Critical Value (5%)
1
2.46
Adjusted R2
1.96
0.1437 *
Table 120
Lag Period
Chi Squared Value
One
Term Spread
0.496
T-Bill
4.677
Combined
6.318
Significance
0.4814
0.0306 *
0.0425 *
Based on the results as presented in Table 120 the three-month T-Bill did not
Granger cause GDP growth at any lag period. The interest rate term spread Granger
caused GDP growth in lag period one. The three-month T-Bill rate and the interest rate
term spread combined Granger caused GDP growth in lag period one.
158
Table 121
Lag Periods
F Statistic
1
14.48
1&2
26.08
1 to 3
9.42
1 to 4
5.78
1 to 5
3.79
1 to 6
8.24
Critical Value (5%)

1.96
2.07
2.23
2.51
3.13
5.79
Adjusted R2
0.6087 *
0.8576 *
0.7594 *
0.7138 *
0.6550 *
0.8612 *
set does not allow an analysis with more lags.
Table 122
VAR Analysis, Term Spread as the Dependent Variable, 1945 Recession.
Lag Period
F Statistic
1
43.28
1&2
23.71
1 to 3
12.48
1 to 4
7.99
1 to 5
5.36
1 to 6
36.71
*Significant at the 0.05 level.
Critical Value (5%)

1.96
2.07
2.23
2.51
3.13
5.79
Adjusted R2
0.8299 *
0.8450 *
0.8115 *
0.7847 *
0.7481 *
0.9684 *
159
explanatory variables. Only six lag periods were considered as the size of the data set did
not allow the analysis with more than six lags. All six of the lag periods were statistically
significant.
Table 123
Lag Period
F Statistic
1
34.43
1&2
21.40
1 to 3
11.52
1 to 4
8.15
1 to 5
5.75
1 to 6
49.88
Critical Value (5%)

1.96
2.07
2.23
2.51
3.13
5.79
Adjusted R2
0.7941 *
0.8304 *
0.7978 *
0.7885 *
0.7640 *
0.9767 *
identified that there was bidirectional correlation between the variables, the Granger
GDP growth. The results of this analysis are presented in Table 124 below.
caused GDP growth at lag periods of five and six. The interest rate term spread Granger
caused GDP growth in lag period five. The three-month T-Bill rate and the interest rate
term spread combined Granger caused GDP growth in lag periods five and six.
160
Table 124
Lag Period
Five
Term Spread
T-Bill
Combined
Chi Squared Value
Significance
13.353
13.152
21.984
0.0203 *
0.0220 *
0.0152 *
Six
Term Spread
7.456
T-Bill
20.793
Combined
30.994
0.2807
0.0020 *
0.0020 *
For the full data set and for all but the 2001 recessionary period the VAR analysis
identified one or more lag periods that showed a statistically significant relationship
between the two explanatory variables, the T-bill rate and the term spread, and the
dependent variable, GDP growth. Table 125, below, presents the lag periods for each
recession period that were statistically significant. It also presents the lag period for each
recession that had the highest adjusted R2 value.
161
Table 125
Vector Autoregression, GDP Growth as the Dependent Variable, All Periods
Significant Lag Periods
Lag Period With

Highest Adjusted R2
Adjusted R2
1, 2, 3, 4, 5, 6, 7, 8, 9,
10, 11, & 12
0.6425
1, 5, & 6
0.5631
None
NA
NA
1990-1991
1, 3, & 4
0.6802
1981-1982
1, 2, 3, & 4
0.4945
1&2
0.3226
1973-1975
1, 2, 3, & 7
0.9982
1969-1970
0.0944
1960-1961
1&2
0.2590
1958
1, 2, & 3
0.3816
1953
1&2
0.3389
1949
1&2
0.4692
1945
1, 2, 3, 4, 5, & 6
0.8612
Recessionary
Period
Full Data Set
2007-2009
2001
1980
The Granger causality test identified lag periods for each recession period that
were statistically significant. For every recession period except the 2001 recession one or
more of the explanatory variables Granger caused GDP growth. Table 126 presents
which lag periods were statistically significant for each explanatory variable and for the
combination of both explanatory variables.
162
Table 126
Granger Causality, GDP Growth as the Dependent Variable, Summary of All Periods
Recessionary Period
Lag Periods with Granger Causation

Term Spread
T-Bill
Combined
Full Data Set
None
2, 3, 4, 5, & 6
2007-2009
6&7
5, 6, & 7
5, 6, & 7
2001
None
None
1990-1991
3, 4, & 5
3&4
3, 4, & 5
1981-1982
1, 3, 4, & 5
1980
1, 2, & 6
1973-1975
1, 2, 3, & 7
3&7
1, 2, 3, & 7
1969-1970
1, 3, & 4
None
1960-1961
2&3
2&3
1958
1, 2, 3, 4, 5, & 6
2&3
1, 2, 3, & 4
1953
None
None
1949
None
1945
5&6
5&6
Evaluation of Findings
Three explanatory variables were analyzed to determine their relationship with
GDP growth, the dependent variable. The first variable was the interest rate term spread.
The second variable was the first difference of the three-month T-bill rate. The third
analysis used the combination of the term spread of interest rates and the three-month Tbill rate as the explanatory variable. With all three variables a statistically significant
163
relationship was identified. A leading correlational relationship existed between GDP
growth and all three explanatory variables for the time period examined.
With the term spread of interest rates the results of this analysis are consistent
with and add new knowledge to the existing research. This study identified the positive
correlation between the term spread of interest rates and GDP growth in the U. S. for the
period of time between 1942 and 2012. Dotsey (1998) found a similar correlation for the
period of 1957 to 1998 and Ang et al. (2006) found a similar correlation for the period of
1960 to 2005. Other studies have also identified a positive correlation in international
economies. For example, Diebold et al. (2008) and Panopoulou (2009) identified a
positive correlation in the economy of the European Union. Similar results were obtained
by Estrella (2005) for Canada and Germany; Bianchi et al. (2009) for the United
Kingdom; Esteve et al. (2012) for Spain; and Suardi (2010) for Australia.
Several prior studies also identified the interest rate term spread as a predictor of
recessions. Dotsey (1998) studied the recessions between 1950 and 1998 and concluded
that a sharp drop in the interest rate term spread, often resulting in a negative term spread,
was a signal of an impending recession. Powell (2006) examined six recessions that
occurred between 1969 and 2002 and concluded that a sharp drop in the term spread
resulting in a negative term spread was a signal of an impending recession. Powell
determined that the best signal was a negative term spread of 100 basis points or more.
Estrella (2005) examined all U. S. recessions between 1950 and 2002 and came to
essentially the same conclusion as Dotsey (1998) and Powell (2006) that a negative term
spread was a signal of an impending recession. Estrella (2005) also concluded that the
164
key factor was not a drop in interest rates, either long-term or short-term, but rather it was
a drop in the level of the interest rate term spread. With research question one, this study
looked at the term spread of interest rates not to try to forecast the beginning of a
recession like Dotsey (1998), Estrella (2005), or Powell (2006), but rather to try and
forecast the ending of a recession. The idea being that if the term spread of interest rates
could be used forecast the beginning of a recession perhaps it could also be used to
forecast the ending of a recession.
With the first difference of the three-month T-Bill rate the results are consistent
with and add to the knowledge found in the existing research. This study identified the
positive correlation between the three-month T-bill rate and GDP growth in the U. S. for
the period of time between 1942 and 2012. Similarly, Ang et al. (2006) studied shortterm interest rates for the period of 1960 to 2005 and concluded that there was a positive
correlation between short-term interest rates and GDP growth. In addition, Harvey (1989)
looked at the correlation between short-term corporate bond rates and GDP growth for
the period of 1953 to 1989 and concluded that the short-term bond rates had a significant
positive correlation with economic growth. Moreover, Moersch and Pohl (2011)
examined short-term interest rates for the period of 1970 to 2008 and also identified the
positive correlational relationship between short-term interest rates and economic growth.
This relationship has also been confirmed in international economies by Diebold et al.
(2008) who examined the economies of Germany, Japan, the United Kingdom, and the
U. S. for the twenty year period from 1985 to 2005.
165
With the combination of both the term spread of interest rates and the three month
T-bill rate a statistically significant correlational relationship was identified for the full
data set and for eleven of the twelve recessionary periods. No correlational relationship
was identified for the 2001 recession. While prior research had identified the
correlational relationship between the term spread of interest rates and GDP growth as
well as between the three month T-bill rate and GDP growth no prior studies were
identified that compared the combination of the tow with GDP growth.
Summary
In an effort to answer the research questions both an ADL regression analysis and
a VAR regression analysis were performed. Research question number one asked
whether or not the term spread of interest rates can be used to predict GDP growth, which
could then be used to predict how long a recession might last or when a recession might
end. The ADL regression which analyzed the individual term spread lags identified that
for the full data set and for every recession period there was a statistically significant
relationship between the term spread of interest rates as the explanatory variable and
GDP growth as the dependent variable. When looking at the individual recessions
between two and seven of the lag periods were significant for each recession. The
adjusted R2 for the recession periods varied with values between 0.1187 and 0.3849. The
results, for the recession periods, were summarized in Table 19 and Table 33.
The ADL regression analysis that analyzed the combination of two or more lag
periods of the term spread identified a statistically significant relationship between the
term spread as the explanatory variable and the GDP growth rate as the dependent
166
variable for the full data set and for every recession period. These results are also
summarized in Table 33. The adjusted R2 values varied between 0.2285 and 0.8853.
Research question number two asked whether or not the short-term interest rate,
(the three-month T-bill rate) can be used to predict GDP growth which could then be
used to predict how long a recession might last or when a recession might end. The ADL
regression, which analyzed the individual T-bill rate lags identified that for the full data
set and for every recession period there was a statistically significant relationship
between the T-bill rate as the explanatory variable and GDP growth as the dependent
variable. When looking at the individual recessions between one and five different lag
periods were significant for each recession. The adjusted R2 for the recession periods
varied with values between 0.0400 and 0.2842. The results, for the recession periods,
were summarized in Table 47 and Table 60.
The ADL regression analysis that analyzed the combination of two or more lag
periods of the T-bill rate identified a statistically significant relationship between the Tbill rate as the explanatory variable and the GDP growth rate as the dependent variable
for the full data set and for eleven of the twelve recession periods. Only the 1945
recession did not have a statistically significant result. These results are also summarized
in Table 60. The adjusted R2 values for the eleven statistically significant recessionary
periods varied between 0.3805 and 0.6975.
Research question number three asked whether or not the combination of shortterm interest rates, (the three-month T-bill rate) and the term spread of interest rates can
be used to predict GDP growth, which could then be used to predict how long a recession
might last or when a recession might end. This question was analyzed first using the ADL
167
regression method and second using the VAR regression method. The ADL regression
analyzed the combination of the T-bill rate and the term spread of interest rates as the
explanatory variables. The ADL regression identified that for the full data set and for
every recessionary period, there was a statistically significant combination of the two
explanatory variables that identified a relationship between those two explanatory
variables and the dependent variable, GDP growth. The results of this analysis were
summarized in Table 74. The adjusted R2 for the recession periods varied with values
between 0.3089 and 0.8788.
The results of the VAR analysis were summarized in Table 125. For the full data
set and for eleven of the twelve recessionary periods the VAR analysis identified one or
more lag periods that had a statistically significant relationship between the two
explanatory variables and the dependent variable. The one recession where there was no
statistically significant relationship was the 2001 recession. The adjusted R2 for the
eleven statistically significant recession periods varied with values between 0.0944 and
0.8612.
The VAR analysis identified that a bidirectional correlation existed between the
two explanatory variables and the dependent variable. Because of this bidirectional
relationship, a Granger causality analysis was completed to determine whether or not the
term spread of interest rates, the T-bill rate, or the combination of the two, Granger
caused GDP growth. A summary of the results of this analysis are presented in Table
126. The analysis identified that the term spread of interest rates Granger caused GDP
growth for ten of the twelve recessionary periods. It did not Granger cause GDP growth
for the full data set or for the 2001 and 1949 recessions. The T-bill rate Granger caused
168
GDP growth for the full data set and for ten of the twelve recessions. It did not Granger
cause GDP growth for the 1969-1970 and the 1953 recessions. The combination of the
term spread and the T-bill rate Granger caused GDP growth for the full data set and for
ten of the twelve recessions. They did not Granger cause GDP growth for the 2001 and
1953 recessions.
Chapter 5: Implications, Recommendations, and Conclusions

The problem that was addressed by this study encompasses the economic
hardships of recessions and the lack of effective tools for forecasting recessions (Jiang, et
al., 2009). Because of this inability to effectively forecast recessions there are significant
inefficiencies in any efforts to effectively plan for a recession or to make effective
decisions to minimize the negative effects of a recession. The purpose of this study was
to determine whether or not two of the interest rate variables of the yield curve, the term
spread of interest rates and the three-month T-bill rate, could be used to forecast GDP
growth which could then be used to forecast how long a recession might last or when a
recession might end. Prior research has identified that these two variables could be used
to forecast whether a recession is probable and when a recession might begin (Ang et al.
2006; Dotsey 1998; Estrella & Mishkin 1996; Moersch & Pohl, 2011; & Powell, 2006).
The question in this study was could these same variables also be used to forecast the
length or ending of a recession.
To answer the research questions two regression analysis methods, the
autoregressive distributed lag regression (ADL) method and the vector autoregressive
(VAR) method, were applied to the data. There were two major limitations in this study.
The first was the possibility of historical bias as historical data was used in an effort to
forecast future data. The second was that regression analysis is used to measure
correlation and not to identify causation. This chapter is organized around the three
research questions. First, the implications of the analysis and how the results of the
analysis apply to the research questions are discussed. Second, how the results of the
170
study might affect the practitioners, theory, and the literature in the area of recessions and
business cycles is addressed. Finally the conclusions of the study are presented.
Implications
The purpose of this study was to identify whether or not the term spread of
interest rates and the three-month T-bill rate could be used to forecast GDP growth which
could then be used to forecast the length or ending of a recession. The single and multiple
regression analyses presented in Chapter Four identified that there was a statistically
significant predictive relationship between: (1) the term spread of interest rates and GDP
growth; (2) between the three-month T-Bill rate and GDP growth; and (3) between the
combination of both explanatory variables and GDP growth. The lead time of the
relationship varied from one recessionary period to another but it was statistically
significant in all recessionary periods.
The results of the analysis is consistent with the historical literature that identified
the predictive relation between the variables (Ang et al. 2006; Dotsey 1998; Estrella &
Mishkin 1996; Moersch & Pohl, 2011; & Powell, 2006). The study also adds to this body
of knowledge and extends it. The prior research addressed forecasting if a recession was
probably and when it might begin this research addressed forecasting when a recession
might end. In the discussions of research questions below a conversation is included as to
whether or not it is possible to identify a signal that could be used to quantify the
predictive ability of the variables and create actual forecasts of when a recession might
end. The results of this study have important implications for scholars and practitioners.
With a signal that could forecast when a recession might end governments, investors,
171
businesses, and families could use this tool to assist in their efforts to minimize the
negative effects of a recession.
While the results of this analysis are significant it is important to remember that
the results are based on historical data and analyses, which may or may not hold up in the
future. Historical relationships often change with time. Changes in economic policy,
monetary policy, or the structure of the economy could significantly change the
relationship between the variables (Emara & Hassan, 2010). It is also important to
remember that while a correlational relationship exists the regression analysis does not
measure causal relationships. It can only be said that there was a relationship between the
variables.
The Term Spread of Interest Rates: Research Question Number One. The
first research question of this study reads:
To what extent, if at all, can the term spread of interest rates be used to predict
GDP growth, which can then be used to predict how long a recession will last or
when a recession will end?
The results of the two regression analyses presented in Chapter Four identified that there
was a statistically significant explanatory relationship between the term spread of interest
rates and future GDP growth. A detailed examination of the results (summarized below)
identified that the term spread of interest rates can be used to effectively forecast when a
recession might end. The signal identifying when a recession might end was the moment
in time during the recession when the term spread of interest rates increases to the level
of 100 basis points. In the recessionary periods analyzed the term spread of interest rates
172
increased to the level of 100 basis points typically about seven months before the end of
the recession.
The results of this analysis are consistent with and add new knowledge to the
existing research. This study identified the positive correlation between the term spread
of interest rates and GDP growth in the U. S. for the period of time between 1942 and
2012. Dotsey (1998) found a similar correlation for the period of 1957 to 1998 and Ang
et al. (2006) found a similar correlation for the period of 1960 to 2005. Several
international studies have also identified a positive correlation between the term spread of
interest rates and economic growth in international economies. Diebold et al. (2008) and
Panopoulou (2009) identified a similar correlation in the economy of the European
Union. Similar results were obtained by Estrella (2005) for Canada and Germany;
Bianchi et al. (2009) for the United Kingdom; Esteve et al. (2012) for Spain; and Suardi
(2010) for Australia.
Several prior studies also identified the interest rate term spread as a predictor of
recessions. Dotsey (1998) studied the recessions between 1950 and 1998 and concluded
that a sharp drop in the interest rate term spread, often resulting in a negative term spread,
was a signal of an impending recession. Powell (2006) examined six recessions that
occurred between 1969 and 2002 and concluded that a sharp drop in the term spread
resulting in a negative term spread was a signal of an impending recession. Powell (2006)
determined that the best signal was a negative term spread of 100 basis points or more.
Estrella (2005) examined all U. S. recessions between 1950 and 2002 and came to
essentially the same conclusion as Dotsey (1998) and Powell (2006) that a negative term
spread was a signal of an impending recession. Estrella (2005) also concluded that the
173
key factor was not a drop in interest rates, either long-term or short-term, but rather it was
a drop in the level of the interest rate term spread.
With research question one, this study looked at the term spread of interest rates
not to try to forecast the beginning of a recession like Dotsey (1998), Estrella (2005), or
Powell (2006), but rather to try and forecast the ending of a recession. The idea being that
if the term spread of interest rates could be used forecast the beginning of a recession
perhaps it could also be used to forecast the ending of a recession. As stated above and
explained below, an examination of the results of this analysis identified a term spread
signal that could be used to forecast when a recession might end. The signal was the point
in time when the term spread of interest rates increases to the level of 100 basis points. In
the recessionary periods analyzed the term spread of interest rates increased to the level
of 100 basis points on average seven months before the end of the recession.
Identifying the Signal. The efforts to determine if an interest rate term spread
signal existed began by looking at what lag period lead times for the interest rate term
spread were statistically significant. For the full data set the only statistically significant
lag period was a lag of two quarters. This means that for the seventy year time period
from 1942 to 2012, the relationship between the term spread of interest rates and GDP
growth was such that the term spread was significant in explaining the GDP growth
figures two quarters or six months in advance. However, when the individual recessions
were examined there was no consistency in the lag period lead time. In all twelve of the
recessions there was more than one significant lag period lead time and the significant lag
periods varied from one recession to another. All twelve of the lag period lead times were
175
recession then will a reversal, a sharp increase in the term spread, precede the ending of
the recession? An examination of the change in the term spread prior to each of the
twelve recessions was conducted and the results identified that in 11 of the 12 recessions
the term spread dropped significantly before the recession began and then rebounded
significantly before the end of the recession. The term spread of 100 basis points was
identified as a signal that successfully predicted the ending of eleven of the twelve
recessions. In ten of the twelve recessions the signal was triggered when the term spread
increased to more than 100 basis points. A summary of this analysis is presented in Table
127 below.
The range of the lead time of this 100 basis point term spread signal varied from a
low of two months to a high of eighteen months. The median was seven months and the
average was 7.5 months. The standard deviation was 4.6. These results are consistent
with the regression analyses where it was shown that most frequent statistical significant
lead times fell within the range of six to nine months.
The two longest lead times were for the 2007-2009 recession and the 1981-1982
recessions. Of all the recessions analyzed these two recessions were the longest and most
severe (Labonte & Makinen, 2002; NBER, 2011). There may be a relationship between
the seriousness of the economic downturn and the length of the lag time. This could be an
interesting area of future study.
176
Table 127
Changes in the Term Spread of Interest Rates during Recessionary Periods
Recession
2007-2009
Term Spread Activity

Recession End Lead Time
Turned negative in April of 2007, 8 months before the recession
18 months
started. Rebounded to over 100 in December of 2007, 18 months
before the recession ended.
2001
Turned negative in August of 2000, 7 months before the recession

started. Rebounded to over 100 in April of 2001, seven months before
the recession ended.
7 months
1990-1991
Dropped from 104 to 13 from December of 1988 to June of 1989.

Recession started in July of 1990. Rebounded to over 100 in August
of 1990, seven months before the recession ended.
7 months
1981-1982
Turned negative in January of 1980, 9 months before the recession

started. Rebounded to over 100 in October of 1981, 13 months before
13 months
1980
Turned negative in December of 1978, 13 months before the

recession started. Rebounded to over 100 in May of 1980, three
months before the recession ended.
3 months
1973-1975
Turned negative in June of 1973, 5 months before the recession

started. Rebounded to over 100 in January of 1975, tow months
before the recession ended.
2 months
1969-1970
Turned negative in January of 1969, 11 months before the recession

started. Rebounded to over 100 in May of 1970, six months before
6 months
1960-1961
Dropped from 147 to 20 from May of 1959 to December of 1959.

Recession started in April of 1960. Rebounded to over 100 in April of
1960, 10 months before the recession ended.
1957-1958
Dropped from 137 to 24 from June of 1955 to February of 1957.

Recession started in August of 1957. Rebounded to over 100 in
February of 1958, three months before the recession ended.
3 months
1953-1954
Dropped from 115 to 64 from April of 1952 to April of 1953.

Recession started in July of 1953. Rebounded to over 100 in
September of 1953, nine months before the recession ended.
9 months
1949
Dropped from 195 to 114 from June of 1947 to January of 1949.

Recession started in November of 1948. Rebounded to 130 in July of
1949, five months before the recession ended.
1945
10 months
5 months*
No significant drop. The term spread was 198 at the beginning of the
NA
recessions and 186 at the end of the recession.
* During the 1949 recession the term spread never dropped below 100. It did drop from 195 to 114 and
then rebounded to 130, 5 months before the end of the recession.
178
What is the Answer to Research Question One? Based on the analysis as
summarized above it was concluded that the relationship between the term spread of
interest rates and GDP growth was statistically significant in the recessionary periods that
were analyzed and that the term spread of interest rates successfully forecast the point
when GDP growth turned from negative to positive signaling the end of the recession. It
is therefore concluded that the answer to the research question is yes, the term spread of
interest rates can be used to forecast GDP growth, which can then be used to forecast
when a recession might end. The null hypothesis was rejected and the alternative
hypothesis was accepted.
Short-Term Interest Rates: Research Questions Number Two. The second
research question of this study reads:
To what extent, if at all, can the level of short-term interest rates be used to
The results of the two regression analyses presented in Chapter Four identified that there
was a statistically significant explanatory relationship between the three-month T-bill rate
and future GDP growth. A detailed examination of the results (summarized below) also
shows that the three-month T-bill rate can be used to forecast when a recession might
end. The signal identifying when the recession might end is the point in time, either
shortly before or shortly after the beginning of a recession, when the three-month T-bill
rate stops increasing, peaks, and then starts to fall. In the twelve recession periods
analyzed the three-month T-bill rate peaked and started to decline about twelve months
before the end of the recession.
179
These results are consistent with and add to the knowledge found in the existing
research. This study identified the positive correlation between the three-month T-bill
rate and GDP growth in the U. S. for the period of time between 1942 and 2012.
Similarly, Ang et al. (2006) studied short-term interest rates for the period of 1960 to
2005 and concluded that there was a positive correlation between short-term interest rates
and GDP growth. In addition, Harvey (1989) looked at the correlation between short-term
corporate bond rates and GDP growth for the period of 1953 to 1989 and concluded that
the short-term bond rates had a significant positive correlation with economic growth.
Moreover, Moersch and Pohl (2011) examined short-term interest rates for the period of
1970 to 2008 and also identified the positive correlational relationship between shortterm interest rates and economic growth. This relationship has also been confirmed in
international economies by Diebold et al. (2008) who examined the economies of
Germany, Japan, the United Kingdom, and the U. S. for the twenty year period from 1985
to 2005 and concluded that the positive correlation between short-term interest rates and
economic growth is applicable in both the global economy and the U.S. economy. Of the
prior studies identified above only Moersch and Pohl (2011) presented any results that
could be used as a signal to forecast either the beginning or ending of a recession. They
identified that prior to a recession there is a significant increase in the level of short-term
interest rates and that either shortly before or shortly after the start of the recession the
short-term interest rates peak and begin to fall and continue to fall through the end of the
recession.
With research question two, this study looked at the level of the three-month Tbill rate not to try and forecast the beginning of a recession but rather to try and forecast
180
the ending of a recession. The idea presented by Moersch and Pohl (2011) that interest
rates rise before a recession starts and then fall during a recession was examined in an
effort to find a signal that could be used to forecast the ending of a recession. A signal
was found. The signal identifying when the recession might end is the point in time,
either shortly before or shortly after the beginning of a recession, when the three-month
T-bill rate stops increasing, peaks, and then starts to fall. In the recession periods
analyzed the three-month T-bill rate peaked and started to decline about twelve months
Identifying the Signal. The efforts to determine if a three-month T-Bill rate signal
existed that could be used to forecast the end of a recession began by looking at what lag
period lead times were statistically significant. For the full data set two lag periods had
statistically significant results, a lag period of two quarters and a lag period of five
quarters. For the sixty year time period from 1942 to 2012, the relationship between the
three-month T-bill rate and GDP growth was such that the T-bill rate was effective at
explaining the GDP growth at a lag of two periods (six months) and at a lag of five
periods (fifteen months) in advance. However, for the individual recession periods the
results were very different. There was no consistency and a wide variation in which lead
times were significant. Eleven of the twelve lag periods were significant in one or more
recessions. In four of the recessionary periods (2001, 1973-75, 1958, and 1945) there was
only one significant lag period. An examination of which lag period lead times were most
frequent identified that the lag periods of one, five, eight, and ten quarters were all
significant in four recessions. No lag periods were significant in more than four
recessions. Unlike the interest rate term spread analysis, this three-month T-bill analysis
182
prior to a recession was used in this analysis to search for a signal that might identify the
ending of a recession.
In eleven of the twelve recessionary periods the T-bill rate increased prior to the
recession and then peaked either shortly before or shortly after the recession began. The
T-bill rate then fell through the remainder of the recession. Two recessions, 1973-1975
and 1981-1982, had double peaks. The T-bill rate peaked, fell for a few months and then
peaked again at a lower rate than the first peak and then fell throughout the remainder of
the recession. The only potential signal that could be identified was the time period from
the T-bill rate peak to the end of the recession. This time period was measured for each
recession and is shown in Table 128 below. The range of this time period varied from a
low of four months to a high of twenty-eight months. The median time period was twelve
months and the average was 12.1 months. The standard deviation was 5.9.
While the identification of a consistent signal, the peak and then fall of short-term
interest rates, supports a positive answer to this research question the wide range and high
standard deviation were disappointing. The twenty-four month variance between the high
and low observations was a very wide range that makes the practical application of this
signal difficult. Having a signal that could vary over a period of two years was
disconcerting when the average length of the twelve recessions was eleven months and
the longest recession was only eighteen months.
183
Table 128
Changes in the T-bill Rate during Recessionary Periods
Recession
2007-2009
T-bill Rate Activity

Recession End Lead Time
Peaked at 5.03% in February of 2007 nine months before the
28 months
recession began. Rates began to fall 28 months before the end of
the recession.
2001
Peaked at 6.17% in November of 2000 four months before the

the recession.
12 months
1990-1991
Peaked at 7.9% in March of 1990 four months before the

the recession.
12 months
1981-1982
Peaked at 16.3% in May of 1981 two months before the recession

started. Rates began to fall and then rose to a second peak of
15.51% in August 1981. The first peak was 18 months before the
end of the recession. The second peak was 15 months before the
end of the recession.
15 months
1980
Peaked at 15.2% in March of 1980 three months into the

recession. Rates began to fall four months before the end of the
recession.
4 months
1973-1975
Peaked at 8.67% in August of 1973 three months before the

recession began. Rates began to fall and then rose to a second
peak of 8.33% in April of 1974. The first peak was 18 months
before the end of the recession. The second peak was 10 months
10 months
1969-1970
Peaked at 7.87% in January of 1970 in the second month of the

recession. Rates began to fall 10 months before the end of the
recession.
10 months
1960-1961
Peaked at 4.49% in December of 1959 four months before the

recession started. Rates began to fall 14 months before the end of
the recession.
14 months
1957-1958
Peaked at 3.58% in October 1957 three months into the recession.

Rates began to fall six months before the end of the recession.
6 months
1953-1954
Peaked in April of 1953 at 2.19% three months before the

the recession.
13 months
1949
Peaked at 1.17% in January of 1949 three months into the

recession then fell through the end of the recession. Rates began to
fall nine months before the end of the recession.
9 months
185
three-month T-Bill rate for the full data period of 1942 through 2012. Also included is a
bar chart identifying each recession period. A close look at the T-bill rates in comparison
with the recessionary periods identified that shortly before a recession there was a
significant increase in the T-bill rate. This increase was then followed by a sharp drop in
the T-bill rate. This rise and then fall in the T-bill rate could be seen for the nine
recessions from the 1958 recession to the 2007-2009 recession. It does not occur in the
earlier 1945, 1949 and 1953 recessions.
What is the Answer to Research Question Two? Based on the analysis
summarized above it can be concluded that the relationship between the three-month Tbill rate and GDP growth was statistically significant in the recessionary periods that
were analyzed and that the T-bill rate successfully forecast, for these recessions, the point
when GDP growth turned from negative to positive signaling the end of the recession.
While the variance in the lead time was large the signal was effective. It is therefore
concluded that the answer to research question number two is yes, short-term interest
rates can be used to forecast GDP growth which can then be used to forecast the end of a
recession. The null hypothesis was rejected and the alternative hypothesis was accepted.
The Combination of the Interest Rate Term Spread and the T-bill Rate:
Research Question Number Three. The third research question reads:
To what extent, if at all, can the combination of the term spread of interest rates
and the level of short-term interest rates be used to predict GDP growth, which
can then be used to predict how long a recession will last or when a recession will
end?
186
The results of the regression analysis presented in Chapter Four identified that there was
a statistically significant correlation between the combination of the interest rate term
spread and the three-month T-bill rate as explanatory variables and GDP growth. A
detailed examination of the results leads to the conclusion that the combination of the two
variables can be used to effectively forecast when a recession might end. The signal or
signals that were found to be most effective were the combination of the two signals
identified with research questions one and two. For the term spread that signal was when
the term spread increases to the level of 100 basis points. In the recessionary periods
analyzed the term spread of interest rated increased to the level of 100 basis points
typically about seven months before the end of the recession. For the three-month T-bill
that signal was when the three-month T-bill rate stops increasing, peaks, and then starts to
fall. In the twelve recession periods analyzed the three-month T-bill rate peaked and
started to decline typically about twelve months before the end of the recession.
These results are consistent with and add to the knowledge found in existing
research. While none of the prior research identified signals for the combination of both
variables, the research did identify the positive correlation between the variables,
economic growth, and recessions. Ang et al. (2006) concluded that both the term spread
of interest rates and short-term interest rates had value as a predictor of economic growth.
They also concluded that short-term interest rates had more predictive power than the
term spread. This conclusion is different from this analysis where the term spread
analysis was shown to have a higher predictive power. The term spread had higher
adjusted R2 values and more lag periods that were statistically different. The results of
this study were different than Ang et al. (2006) because of the different methodologies
187
used. This study considered historic figures and calculated the historic relationships while
Ang et al. created a forecasting model and measured the power of the model. In this
study it was concluded that a forecasting process that used both the interest rate term
spread and the three-month T-bill rate would be effective because of the significant
relationship between the two variables. This can be seen by looking at the recession
length, term spread signal, and T-bill signal for the past twelve recessions as presented in
Table 129 below.
Table 129
Recession End Lead Time, Interest Rate Term Spread and Three-Month T-Bill Rate
Recessionary Period
Recession Length
Term Spread Signal
T-Bill Rate Signal
18 months
18 months
28 months
2001
8 months
7 months
12 months
1990-1991
8 months
7 months
12 months
1981-1982
16 months
13 months
15 months
6 months
3 months
4 months
1973-1975
16 months
2 months
10 months
1969-1970
11 months
6 months
10 months
1960-1961
10 months
10 months
14 months
1958
8 months
3 months
6 months
1953
10 months
9 months
13 months
1949
11 months
5 months
9 months
1945
8 months
NA
NA
2007-2009
1980
188
An examination of Table 129 identifies the pattern of the relationship between the
T-bill rate, the interest rate term spread, and recessions. The pattern can be described as
follows. Prior to a recession there was a significant increase in the three-month T-bill
rate. As there was no corresponding increase in long-term interest rates the interest rate
term spread began to decline. As the three-month T-bill rate continued to rise, the term
spread continued to fall and typically turned negative. This was the signal of an
impending recession. Sometime near the beginning of the recession (either shortly before
or shortly after) the T-bill rate peaked and then started to fall. When the T-bill rate started
to fall it was a signal that economy was on a path to recovery and the recession would be
ending, typically about twelve months after the peak. As the T-bill rate fell the interest
rate term spread started to rise. This was also a signal that the economy was moving
towards recovery. Typically, the term spread increased to 100 basis points approximately
seven months before the ending of the recession.
The combination of the two variables results in a two stage signal. First, the threemonth T-bill rate peaks and starts to decline. Typically this occurs about twelve months
before the end of the recession. This is followed by an increase in the term spread of
interest rates. The term spread increases to the signal level of 100 basis points about
seven months before the end of a recession. This two stage signal was observed in eleven
of the twelve recessions examined. Only in the 1945 recession was the pattern different
than the two stage signal.
What is the Answer to Research Question Three? Based on the analysis
summarized above it can be concluded that the relationship between the combination of
the term spread of interest rates and the three-month T-bill rate as the explanatory
189
variables and GDP growth as the dependent variable was statistically significant in the
recessionary periods that were analyzed and that the combination of the term spread of
interest rates and the three-month T-bill rate successfully forecast, for these recessions,
the point when GDP growth turned from negative to positive signaling the end of the
recession. It is therefore concluded that the answer to research question number three is
yes, the combination of the term spread of interest rates and the three-month T-Bill rate
can be used to forecast changes in GDP growth which can then be used to forecast when
a recession might end. The null hypothesis was rejected and the alternative hypothesis
was accepted.
Recommendations
In this study two new predictive tools have been identified that can be used to
forecast when a recession might end: the point in a recession when the term spread of
interest rates increases to 100 basis points and the point in the recessionary cycle when
the three-month T-bill rate peaks and starts to decline. These tools have applications to
both scholars and practitioners.
Academic Applications. The forecasting tools identified in this study could be
used by scholars in two ways. The first would be in the testing and verification of the
tools. It would be appropriate to conduct additional tests to confirm the effectiveness and
consistency of the tools in the U. S. economy and also in economies outside of the U. S.
Once the tools are verified then these tools can be used as components of future research
in a variety of areas such as business cycle theory, recessions, and investment theory
especially as it applies to asset allocation decisions.
190
Practical Applications. For practitioners these tools could be used in an effort to
minimize the negative effects of a recession. They could be used to prepare for what
would happen at the ending of a recession. Governments could use the signals to assist in
the timing of monetary and fiscal policies that are used during recessionary times
(Bernard, 2010). Businesses could use the signals to identify when to begin to prepare for
the growth and expansion that occurs after a recession ends (Ouyang, 2009). Investors
could use the recessionary signals as an asset allocation tool to identify when to move
from lower risk to higher risk investments at the end of a recession (Peck & Yang, 2011).
Theoretical Contributions . The business cycle theory with which this study is
most closely aligned with is the Austrian business cycle theory. Austrian theory states
that when economic growth is funded by an increase in savings the growth is sustainable,
but when economic growth is funded by monetary policy or an increase in debt the
growth is not sustainable and an economic contraction or recession will result (Adrian &
Hyun, 2009). The contraction will occur because the interest rate charged on the debt
used to finance the economic growth will be at below market rates (Templeton, 2010).
These low interest rates will result in inefficient higher risk investments during periods of
high economic growth. High risk business ventures will be entered into because they can
be financed with low interest rates. As growth continues there will come a point when the
demand for loans reaches a saturation point and the market becomes overheated resulting
in a rise in interest rates. As interest rates rise inefficient investments become
unprofitable and begin to fail resulting in a period of economic contraction or recession
(Salerno, 2012).
191
The results of this study support the Austrian business cycle theory. The study
identified that periods of economic expansion have lower interest rates followed by a
period of rapid increase in interest rates prior to the start of a recession. This is followed
by a period of declining interest rates prior to the ending of the recession. The
recessionary period is when the inefficient business ventures fail and go out of business
and interest rates fall to levels more appropriate for sustainable economic growth
(Salerno, 2012).
Future Research . As the implications and effects of this research are considered a
number of potential research areas have been identified. This study analyzed only data
from the U. S. An obvious question is whether or not the relationships and signals
identified here also exist in other economic markets? Are there similar relationships and
signals in the European Union, Canada, Japan, China, or other economies?
Another potential area for future research is to examine the relationship between
the length of the lag period and the severity of the recession. The 1980-1981 recession
and the 2007-2009 recession had the longest lag periods. Both of these recessions
occurred during the most turbulent times in the U.S. economy since the depression. The
1980-1981 economy experienced the highest interest rates and the highest inflation rates
(Labonte & Makinen, 2002). The 2007-2009 recession was the longest and had the
largest drop in GDP of all the recessions since World War II (NBER, 2011). Both the
1980-1981 and the 2007-2009 recessions had the highest unemployment rate, at 10.2%,
of all the recessions studied. The question is whether or not there is a relationship
between the severity of the recession and the length of the lag periods.
192
Another exciting possible area of research is in the investment applications of the
study results. Can the signals identified in this study also be used to identify the peaks
and valleys in the stock market cycle? Can they be used in tactical asset allocation
decisions of when to invest portfolio assets in higher risk equity investment or when to
invest in lower risk debt investments? Can investors earn a higher rate of return by using
the signals identified in this study as part of their asset allocation decisions?
These three ideas: are there similar results in other economies; what is the
relationship between the severity of the recession and the lead times; and, can the
identified signals be used for tactical asset allocation, are appropriate next step research
studies in this area.
Conclusions
In this chapter, the statistical analysis of the data and the results of the analysis
have been tied back to the original purpose of this study. The identified problem
addressed by the study was the economic hardship that is caused by a recession and the
lack of effective forecasting tools that could be used to forecast the timing of recessionary
events, specifically how long a recession might last or when it might end. The purpose of
the study was to analyze three variables, the term spread of interest rates, the three-month
T-bill rate, and the combination of both variables to determine whether or not these
variables could be used to forecast GDP growth which could then be used to forecast
when a recession might end.
Three research questions were used, one for each of the two individual variables
and one for the combination of both variables. The basic question was could that variable
be used to forecast GDP growth, which could then be used to forecast the ending of a
193
recession. For all three research questions the answers were positive and significant.
There is a significant correlational relationship between the term spread of interest rates
and GDP growth. There is a significant correlational relationship between the threemonth T-bill rate and GDP growth. There is a significant correlational relationship
between the combination of the term spread of interest rates and the three-month T-bill
rate and GDP growth.
Two simple signals were identified that could be used to forecast when a
recession might end. With the term spread of interest rates it was found that when the
term spread increases to 100 basis points the end of the recession was nearing. For the
twelve recessionary periods examined this signal occurred, on average, seven months
prior to the end of the recession. With the three-month T-bill rate the signal was the peak
in a rising interest rate trend and the subsequent decline in the three-month T-bill rate.
For the twelve recessionary periods, this signal occurred on average twelve months
before the end of the recession. The three research questions were examined and
answered, all in the affirmative. For all three questions the null hypothesis was rejected
and the alternative hypothesis was accepted.
The research found that prior to a recession there was a significant increase in the
three-month T-bill rate. As there was no corresponding increase in long-term interest
rates the interest rate term spread began to decline. As the three-month T-bill rate
continued to rise the term spread continued to fall and typically turned negative.
According to the prior research, this was the signal of an impending recession. Sometime
near the beginning of the recession (either shortly before or shortly after) the T-bill rate
peaked and then started to fall. This fall in the T-bill rate continued until after the
194
recession was over. When the T-bill rate started to fall it was a signal that economy was
on a path to recovery and the recession would be ending, on average twelve months after
the peak. As the T-bill rate fell the term spread would start to rise. This was also a signal
that the economy was moving towards recovery. On average the term spread increased to
100 basis points seven months before the ending of the recession.
The research presented in this study about the relationship between the term
spread of interest rates and GDP growth is consistent with the prior research that has been
published. The research presented in this study about the relationship between the threemonth T-bill rate and GDP growth is consistent with the prior research that has been
published. The research presented in this study identifying the relationship of the two
combined explanatory variables (term spread and T-bill rate) and GDP growth is new
research that adds to the literature. The identification of the interest rate term spread and
three-month T-bill rate signals that can be used to forecast the end of a recession is new
research that adds to the literature.
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A Quantitative Analysis of the Yield Curve:

Forecasting the Length and End of a Recession

DOCTOR OF BUSINESS ADMINISTRATION

UMI Num b e r: 3701529

All rig hts re se rve d

Chapter 2: Literature Review

growth an  

recession (Labonte & Makinen, 2002; NBER, 2011).

The recession began shortly after

The recession followed a tightening

Monetary policy was tightened

Monetary policy was tightened

The recession coincided with a fiscal

This recession included both rising

This was a relatively brief and mild

The Iranian crisis in 1979 led to

The recession followed the Iraqi

This was a relatively short and mild

This was the worst and longest

ideas, education, or other intellectual abilities could be applied (or invested) in an

investment made by stockholders and long- 

Three-Month T-Bill Rate

Term Spread of Interest Rates 147.32

Standard Error Minimum Maximum

multicollinearity and imperfect multicollinearity (Koop, 2009). Perfect multicollinearity

Phillip Peron Test

* Statistically significant at 0.01 level.

Phillip Peron Test Zivot Andrews

* Statistically significant at 0.01 level.

* Statistically significant at the 0.05 level

T-Stat Significance Adjusted R2

1. Term Spread {6 lags}

2. Term Spread {7 lags}

3. Term Spread {8 lags}

4. Term Spread {9 lags}

5. Term Spread {10 lags}

* Statistically significant at the 0.05 level.

1. Term Spread {8 lags}

2. Term Spread {9 lags}

3. Term Spread {10 lags}

* Statistically significant at the 0.05 level.

1. Term Spread {3 lags}

2. Term Spread {4 lags}

3. Term Spread {5 lags}

4. Term Spread {6 lags}

5. Term Spread {7 lags}

* Statistically significant at the 0.05 level.

1. Term Spread {2 lags}

2. Term Spread {3 lags}

3. Term Spread {5 lags}

* Statistically significant at the 0.05 level.

1. Term Spread {2 lags}

2. Term Spread {5 lags}

* Statistically significant at the 0.05 level.

1. Term Spread {1 lag}

2. Term Spread {2 lags}

3. Term Spread {3 lags}

4. Term Spread {4 lags}

5. Term Spread {10 lags}

6. Term Spread {11 lags}

7. Term Spread {12 lags}

* Statistically significant at the 0.05 level.

2. Term Spread {2 lags}

growth an

investment made by stockholders and long-