BPEA | Spring 2020

When is growth at risk?

The final numbers of the day are shown above the floor of the New York Stock Exchange in New York, U.S., February 5, 2018. REUTERS/Brendan McDermid
Editor's note:

This paper is part of the Spring 2020 edition of the Brookings Papers on Economic Activity, the leading conference series and journal in economics for timely, cutting-edge research about real-world policy issues. Research findings are presented in a clear and accessible style to maximize their impact on economic understanding and policymaking. The editors are Brookings Nonresident Senior Fellow and Northwestern University Professor of Economics Janice Eberly and Brookings Nonresident Senior Fellow and Harvard University Professor of Economics James Stock. Read summaries of all five papers from the journal here.

The data and programs for this paper are available here.

Do financial market participants, collectively, possess special wisdom about when economies are at risk of falling into a recession?  When is Growth at Risk, a paper to be discussed at the Brookings Papers on Economic Activity conference March 19, suggests the answer is, “Probably not.”

“The results presented in this paper indicate that financial variables have very limited predictive power,” conclude the authors—Mikkel Plagborg-Møller of Princeton University, Lucrezia Reichlin of the London Business School, Giovanni Ricco of the University of Warwick, and Thomas Hasenzagl of the University of Minnesota.

Financial markets and the real economy (the production of goods and services) interact.  Their movements are highly correlated, and financial indicators can, of course, provide useful information about current economic conditions.  They also reflect market participants’ expectations of where the real economy is headed.  The question the authors examine is whether financial indicators provide extra predictive power, more so than indicators of the real economy such as surveys of corporate purchasing managers.

“The results presented in this paper indicate that financial variables have very limited predictive power.”

“People in financial markets can obtain high returns if they can predict recessions but they are not able to do it—at least not better than anyone else.  They cannot anticipate the timing of recessions and they price the risk of one only once they see it,” Professor Reichlin said in an interview with Brookings.  “This blindness suggests that information bearing on the economy’s near-term path is rapidly available to all, but rare events such as recessions are fundamentally unforecastable.”

“Information bearing on the economy’s near-term path is rapidly available to all, but rare events such as recessions are fundamentally unforecastable.”

Policymakers should still pay attention to financial variables, even if they offer disappointingly little power to forecast recession risk—and they should seek to limit the accumulation of financial fragilities since those fragilities likely amplify the damage to the real economy once recessions occur, she said.

The authors use econometric techniques to analyze financial data back to 1973 and its ability to predict risks to gross domestic product (the economy’s output of goods and services) in both the very short term (within a quarter) and the medium term (four quarters).  They examined both the predictive power of a compilation of financial variables in the United States (the Federal Reserve Bank of Chicago’s National Financial Conditions Index) and individual variables.  They also looked at data for 12 other advanced-economy countries and found very similar patterns.

The message for policymakers and economic forecasters at central banks and elsewhere is that they cannot mechanically use financial indicators to provide a reliable early warning sign of a recession.  For instance, the findings may have implications for the more-than-year-long debate in the United States over the predictive power of the Treasury securities yield curve, Reichlin said.  Usually, longer-term securities pay a higher yield than shorter-term securities.  When the gap disappears or inverts, a recession often, but not always, follows.

“You cannot say the yield curve is a good predictor in general.  Sometimes it is, sometimes it isn’t,” Reichlin said.  “That may reflect that the nature of the relationship of financial markets and the economy changes over time, possibly from the effect of monetary policy or financial innovations, and you cannot rely on it for forecasts.”

David Skidmore authored the summary language for this paper.


Hasenzagl, Thomas, Mikkel Plagborg-Møller, Lucrezia Reichlin, and Giovannie Ricco. 2020. “When is growth at risk?” Brookings Papers on Economic Activity, Spring, 167-229.

Conflict of Interest Disclosure

Mikkel Plagborg-Møller is an assistant professor of economics at Princeton University; Lucrezia Reichlin is a professor of economics at the London Business School, Chair and co-founder of Now-Casting, an advanced statistical model to monitor macro conditions, a non-executive director for the UK-based auto and home insurance company AGEAS, a non-executive director for Eurobank (Greece), a non-executive director for the Italian publisher and holding company Messaggerie Italiane Group; Giovanni Ricco is an assistant professor of economics at the University of Warwick and an associate researcher OFCE-Sciences Po (Observatoire français des conjonctures économiques, an independently and publicly funded research center), and a research affiliate at the Center for Economic and Policy Research; Thomas Hasenzagl is a PhD student in Economics at the University of Minnesota. Beyond these affiliations, and a grant from the National Science Foundation, the authors did not receive financial support from any firm or person for this paper or from any firm or person with a financial or political interest in this paper. They are currently not officers, directors, or board members of any organization with an interest in this paper. No outside party had the right to review this paper before circulation. The views expressed in this paper are those of the author, and do not necessarily reflect those of the University of Minnesota, the London Business School, Now-Casting, AGEAS, Eurobank, Messaggerie Italiane Group, the University of Warwick, Sciences-Po, or Princeton University.