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Blemishes Aside, a Still Solid Economy

This article was originally published in ECRI's Recession-Recovery Watch on April 6 at 10:00 a.m. EDT. It was republished as a bonus for readers.

Panic has passed and markets have recovered smartly in recent weeks, but recession fears linger in some quarters. With subprime problems and the industrial slowdown widely recognized, growth is now the obvious concern.

The economy's current performance is right in line with what I wrote based on the Economic Cycle Research Institute's leading indices in June 2006: that "home prices will keep falling" and "a cyclical slowdown in industrial growth is likely to hit in the coming months."

Remember, the dominant concern at the time was inflation, not growth, and the Federal Reserve was still in rate-hiking mode. It was not until early December, with the ISM manufacturing index dropping below 50, that the reality of the industrial slowdown dawned on most economists. Economic indicators that seem to predict the scariest outcomes often attract the attention of pessimists. One such indicator is the Conference Board Index of Leading Economic Indicators, whose growth rate has dropped to its worst reading since the last recession. Some forecasters point to this as a recessionary omen. But the factors behind the drop in LEI growth aren't widely understood.

Let's not forget that in 1996, the year after it took over the LEI's computation, the Conference Board altered it to include the yield spread. That was also the year the New York Fed's Arturo Estrella and Frederic Mishkin published a seminal paper relating the inversion of the yield curve to recession probabilities.

By spring 2005, thanks in part to a tighter yield spread, the LEI had declined in 10 out of 11 successive months. Typically, such a sequence of back-to-back declines would be followed by a recession. Against that backdrop, in July 2005, the Conference Board then replaced the yield spread with the cumulative yield spread as a component of the LEI.

What's that, and why use it in place of the regular yield spread? I don't know the theoretical rationale, but here's an example of how such a cumulative yield spread, or CYS, would work. Suppose that the yield spread is 0.5% in January and that the CYS is also 0.5%. If the yield spread falls to 0.4% in February, the CYS will actually rise to 0.5% plus 0.4%, i.e., 0.9%. So as long as the yield spread stays positive -- even if it continues to tighten -- the cumulative yield spread will keep rising. (see link above for related chart).

The logic of using the CYS, it seems, was that it would trend steadily upward in "normal" conditions when the yield spread was positive so that a mere tightening of the yield spread wouldn't drag the LEI down. But a year after the CYS was introduced, the yield curve inverted (see chart, bottom line). Now, what would that do to the cumulative spread? Let's take another example.

Say that by June 2006, the CYS had climbed to 560.20%. Now suppose the yield spread between 10-year Treasuries and the fed funds rate (which the Conference Board uses) fell in July to minus 0.15%. If so, the CYS would fall in July to 560.20% minus 0.15%, i.e., 560.05%. With the yield spread staying negative, it would drag the CYS down every month until, by March 2007, the CYS (see chart, top line) dropped to 555.57%.

Thanks in part to Alan Greenspan's "conundrum" of long rates staying stubbornly low in the face of rising short rates, the CYS has become, at least for now, a downward-trending variable. So the yield curve acts as an extra drag on the LEI every month it stays inverted.

If an inverted yield curve were still a good recession predictor, the LEI's weakness might be appropriate. But Mishkin, who co-authored that paper about yield curve inversions and recessions and is now a Fed governor, said at a private gathering that analysts could no longer rely on the relationship for predicting recession.

In fact, excluding the CYS, LEI growth probably bottomed last summer at a reading well above those seen during the 1994-95 soft landing. So if it hadn't been for the distorting effect of the cumulative yield spread, LEI growth wouldn't look nearly recessionary.

The LEI's decline this year is due almost entirely to weakness in its industrial components (which have a greater representation in the LEI than in the economy) plus a steady drag from an inverted yield spread. ECRI's Weekly Leading Index, which has a more balanced composition, presents a very different picture. (see link above for related chart)

Remember, the Weekly Leading Index helped us predict the 2001 recession six months ahead of time, while preventing us from crying "wolf" time and again. You'll see from the chart that while the WLI dipped a couple of weeks before the recent market correction, it's far above the kind of recessionary reading we saw in the lead-up to the 2001 recession. In fact, it has improved since last summer, suggesting that U.S. economic growth will firm in the coming months.

ECRI's Leading Home Price Index, which correctly predicted the current home price downturn, also bottomed last summer, implying that a bottom in home prices is now on the horizon. Separately, it isn't widely known that capital investment growth typically lags industrial slowdowns, and its weakness, which an ECRI study predicted a year ago, is not a signal of an imminent recession.

In other words, don't worry about the weakness in the LEI or other economic indicators that may not be good recession predictors. What the WLI and other ECRI leading indices are telling us today is that we still have a Goldilocks economy, but this is a Goldilocks with a couple of blemishes that some pessimists have mistaken for a bear.