Economic Letter: Predicting Recessions in the Euro Area: A Factor Approach

An Economic Letter by Robert Goodhead and Conor Parle assesses macroeconomic and financial downside risks by quantifying recession probabilities, using two empirical models. One model uses a range of macroeconomic, financial and global variables as predictors, while the other model is yield curve based.

The key findings are:

• In general, the factor model appears to outperform the yield curve model in predicting future contractions.
• The factor model points to a slightly elevated risk of recession in the euro area within one year, at 26%. This probability is slightly above the long run average, with the model suggesting a 10% probability of a recession at any given time. In 2008 Q2, ahead of the financial crisis, the model placed the probability of a recession at 62%.
• The recent increase in the probability of a recession, first seen in the factor model in 2016, can be mainly explained by movements in the financial and commodities factor, which itself is largely driven by movements in oil prices.

The views presented in Economic Letters are those of the authors and do not necessarily represent the official views of the Central Bank of Ireland.

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