Recession probabilities for the Eurozone at the zero lower bound: Challenges to the term spread and rise of alternatives

Abstract

This paper examines the recession probability in the Eurozone within the next 12 months at the zero lower bound (ZLB) and explores two new perspectives: a revised measure of the traditional term spread and a modification to detect unstable dynamics driven by animal spirits. We find that the yield curve largely lost its forecasting ability at the ZLB. To remove the downward rigidity of short-term rates, we suggest a modified version of the term spread which uses a “shadow policy rate,” rather than the 3-month rate, as the front leg of the spread. We further show that a bivariate specification including both the current state of an indicator as well as its lagged deviation from its trend augments the predictive capability for most indicators significantly.