Formula Forecasts Economy : Professor Calls Model Simple and Accurate

Finding an accurate method to forecast the cyclical swings of the U.S. economy is somewhat like searching for the elusive Holy Grail, but a Duke University professor claims to have found an unusually simple one that any investor can use.

Finance Prof. Campbell Harvey says only a pocket calculator, a newspaper and some easily available government data are necessary to use the model, which is based on the spread between interest yields on short-term and long-term U.S. Treasury bonds.

Harvey, 31, favors bonds over stocks to gauge future economic activity because the bond market is less volatile.

Prices of U.S. Treasury securities usually are not prone to the wide swings that stocks are.

His formula, he said, is the first formal model based on the so-called “yield curve” between short- and long-term rates.

Harvey said the yield curve--a line that shows how returns vary on debt securities of different maturities--reflects individuals’ expectations about the business cycle.

Consumers, he noted, account for about two-thirds of U.S. gross national product and are “perhaps the most important force in the economy.”

If individuals expect a slowdown or a recession, they will shift their money into longer-term investments, like bonds, as a hedge against possible wage or investment losses, driving up their price and lowering their yield.

Short-term interest rates, which usually are below yields on long-term bonds, thus advance as the long-term bond yields decline. The yield curve, as a result, flattens, or even inverts its slope, which is something of the case today.

Conversely, signs of an economic revival spur current consumption, given belief that the future will bring added funds. To accommodate the higher consumption, investors shift money from bonds into short-term bills. Short-term prices rise and long-term prices fall.