A new toolkit to predict soft-landings, stagflation and recessions – Part three
Summary
In the third installment of this series, we introduce a probit framework to generate four-quarter-out probabilities of three scenarios: recession, stagflation and soft-landing.
Instead of relying on one regression with one set of predictors, we create several regressions with different sets of predictors to capture information from major sectors of the economy. We therefore have better chances of predicting likely growth scenarios.
Our probit framework accurately predicted periods of recession, stagflation and soft-landings in the post-1980 era using a threshold of 33%.
As of Q2–2024, the soft-landing probability is the highest, indicating that the chances of a soft-landing are higher during the next four quarters. However, the persistently higher stagflation and recession probabilities of the past few years may cloud the near-term policy path.
We believe our framework can help decision makers determine the magnitude and duration of upcoming monetary policy by providing the probabilities of different growth scenarios occurring.
The next installment of the series will provide a framework to predict monetary policy pivots using the probabilities of the three growth scenarios.
The probit framework to predict four-quarter-out probabilities of growth scenarios
Traditionally, a probit approach is utilized to predict the probability of a near-term recession. We have updated the probit framework to generate probabilities of stagflation and soft-landings in addition to predicting the probability of a recession. The new framework is known as the ordered probit approach.1
We deviate from traditional probit modeling in the sense that instead of relying on one regression with one set of predictors, we create several regressions. Multiple sets of predictors allow greater chances of predicting likely growth scenarios—in comparison to just one set of predictors—by capturing more information from major sectors of the economy. Additionally, as the economy evolves, so do economic risks. For example, higher inflation and interest rates are the current cycle’s major risk to the economy, while the housing boom/bust was linked to the Great Recession. Therefore, in our view, different probit regressions more accurately capture the evolving nature of risks than a single regression. Our probit regressions generate the probability of a soft-landing, stagflation and/or recession occurring in the next four quarters. We created eight different regressions using a unique mix of predictors, as described below. Each regression generates a probability of soft-landing, stagflation and recession as determined by the unique set of predictors. We average all the probabilities to represent the chances of a soft-landing, stagflation and recession as predicted by the major sectors of the economy.
Author
Wells Fargo Research Team
Wells Fargo
