How close are we to the next recession?

Summary: How close is the US economy to a recession? Here we review the evidence and draw a firm conclusion. {1st of 2 posts today.}

The financial press overflows with confident forecasts about everything from individual stock prices to the fate of the overall economy. It’s usually difficult to reliably predict such things with useful accuracy; since the crash it’s become far more so. My prediction each year since 2010 has been for slow growth (in the low 2%’s); that’s proven correct. Let’s try for something more ambitious.

Contents

1. How close are we to a recession?
2. The Econbrowser Recession Indicator Index.
3. Looking at Q1 GDP.
4. How fast can GDP fall?
5. The current numbers: how are we doing?
6. Conclusions
7. For More Information

(1)  How close are we to a recession?

Let’s start with the big picture and move to the details. GDP was moderately strong in Q3 and Q4 at aprox 2.6%. Economists expect a strong economy (as usual). Looks good.

But some (not all) indicators show slowing. That’s sparked excitement from the bears, like this from Zero Hedge: Two More Harbingers Of Financial Doom That Mirror The Crisis Of 2008.

But before examining the data, we need some context. Surveys of consensus opinion of economists have never predicted a recession (correctly or incorrectly). So their sunny forecasts tell us little.

Second, the economy has experienced unprecedented distortion from six years of fiscal and monetary stimulus — including maintaining the short-term risk-less interest rate at zero, long-term government bond yields below the inflation rate (aka negative real rates), plus three rounds of quantitative easing. These have made many of the usual forecasting tools less effective.

(2)  The Econbrowser Recession Indicator Index.

For useful perspective see a tool developed by James Hamilton, Professor of Economics at UC-San Diego. His Econbrowser Recession Indicator Index is an indicator of contemporaneous data — its quarterly indexes are not changed as data is revised. See his article describing it. It now reads 1.6% — low odds of a recession, slowly falling.

 

(3)  Looking at Q1 GDP.

Real GDP was aprox 5% SAAR in Q2 and Q3 of 2014, slowing to 2.6% in Q4. The Atlanta Fed gives a “NowCast” for current quart GDP, showing the estimates of their model and the Blue Chip Forecast. As of Feb 12: 2.2% (2.7% by the Blue Chips) for Q1. Not great, but typical since the crash. Note the wide and widening range of economists’ forecasts; estimates usually narrow during the quarter.

(4)  How fast can GDP fall?

Could we have a recession in 2015? We could easily fall into a recession if there was a sufficiently large shock to the system. Rapid drops into recession are common from our current growth rates.

There have been 260 quarters since 1950. There were 29 quarters (11%) with falls of over 500 bps (i.e., 5 percentage points) in a single quarter (i.e, the difference between QoQ SAAR GDP changes), with 4 quarters having falls of over 1,000 bps. The worst quarter of the recent crash was -630 bps in Q4 2008. A commonplace shock could kick us into a Q2 recession; there’s a long list of candidates.

Real GDP increased 2.4% in 2014. In the 260 quarters since 1950 there were 12 quarters (5%) that had trailing 4 quarter drops of 250 bps or more. The worst 4 quarters of the crash ended in Q4 2008 with a 2.5% drop. So a long recession starting in 2015 is quite possible.

(5)  The current numbers: how are we doing?

The data is often confusing. At inflection points in the business cycle the data are even more so than usual, which is why accurate forecasting is difficult. People tend to create strong-sounding forecasts by selective citation of indicators. That’s easy these days, since the data is so noisy.

New Claims for Unemployment, a strong leading indicator, are flat. Manufacturers’ New Orders, another leading indicator, have fallen for the past 3 months.

Weak Retail Sales has generate much clickbait, having fallen for the past 2 months — but it’s a a coincident indicator.

The jobs numbers for January excited the bulls, but that’s a lagging indicator.  The jump in the Total Business Inventories/Sales Ratio excited the bears, rising to the highest since July 2003 (excluding the recession) — but that’s also a lagging indicator.

(6)  Conclusions.

The US economy is of almost unimaginable complexity, rapidly changing and linked to an even larger and more complex world economy. So accurate forecasting has always been difficult. But in 2008 the economy — both domestic and global — began a process of rapid change — met by extraordinary responses by governments. We’ve seen the effects in Europe and Japan. China has successfully coped, but many experts question for how long this can continue.

Forecasting relies on models built on historical data and past relationships among economic variables. When those relationships change, then the models no longer work.

Forecasters sell what we want, which is confident guesses about the future. In times like now we value reassurance more than usual, and they provide it.

Manipulating public opinion is a powerful tool of government, especially as a means to maintain confidence — so that Keynes’ animal spirits boost spending and investment. Central banks have done this brilliantly since the crash, boasting of their influence over a range range of factors — from interest rates to asset prices. We love it, especially the libertarians of the investment industry.

What comes next? How long will this cycle continue? What comes next? I don’t know. The data is confusing, as it has been since 2010 (after the bounce-back from the recession).

I doubt that anyone can predict with any accuracy. All we know is that the economy remains stuck in slow, and hence vulnerable to a recession. Many people — including me — fear that the next recession might be unusually bad. There is as yet insufficient evidence to declare that one approaches.

Stay tuned for more updates.

(7)  For More Information

(a)  The big question: Are we following Japan into an era of slow growth, even stagnation?, 18 November 2013

(b)  Posts about “stall speed”:

1. The dilemma of the US economy: can’t take off & too close to the brink, 9 July 2014
2. Has America’s economy entered the “coffin corner”?, 10 July 2014

(c)  Posts about forecasts:

1. Did anyone predict the 2008 crash? Will anyone predict the next crash?
2. Lessons from WWI about “markets” ability to see the future (spoiler: they don’t do it well)

(d)  Posts about our current economy:

• Dreams of a boom fade & attention turns to secular stagnation., 4 February 2015.
• Listen to the slowing US economy, hear echoes of Japan, 6 February 2015.