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ECRI's 2012 U.S. Recession Call Redux

ECRI’s 2011 recession call got the future direction of growth right, but even though the slowdown turned out to be the worst non-recession in U.S. history, it was not an outright recession and, in that regard, a false alarm.
Aside from lowering our batting average a little, does that missed call on an outright recession mean that recessions cannot be forecast? We’ve examined the episode in depth concluded that recessions can indeed be predicted.
The reason that the 2012-13 cyclical downturn turned out to be the worst “non-recession” in half a century – rather than a full-blown recession – is because of something that’s unlikely to be repeated. And no, we aren’t referring to the Fed’s extraordinary monetary policy actions, which closely reflected ECRI’s assessment of cyclical risk.

Windows of Vulnerability

ECRI’s recession forecasting approach is quite different from standard practice. Because our methods aren’t based on back fitted models, no re-jiggering of models is called for as the economy evolves. This is why we’re able to use our approach for economies around the world that may be quite different in structural terms.

Since most economists believe recessions are caused by shocks that then propagate through the economy, they often focus on “nowcasting,” i.e., being alert to the economy’s descent into recession following the shock. In contrast, our framework, based on three generations of research, postulates that endogenous cyclical forces periodically open up windows of vulnerability, as detected by multiple leading indexes.

Once the economy enters a state of cyclical vulnerability, an exogenous shock can easily tip it into recession. Because such shocks tend to arrive sooner or later, an economy’s entry into a susceptible state – as signaled by the endogenous cyclical forces subsumed in our leading indexes – is almost always followed by recession. It’s in this sense that our leading indexes allow us to “predict” recessions.

A recessionary shock, in principle, can arrive from any source. For example, in modern Japan, they’ve been both natural, like the Tohoku earthquake in 2011, and man-made, like the 1997 and 2014 sales tax hikes. Indeed, the continuing efficacy of ECRI’s approach was showcased by our 2014 recession call in the face of Abenomics (ICO, August 2014), following our earlier warnings, in stark contrast to the near-universal surprise at Japan’s relapse into recession.

So What Happened in 2012?

Even as endogenous cyclical forces propelled the U.S. economy into a window of vulnerability, a conspicuous absence of exogenous shocks meant that the period around late 2012 to early 2013 – which we had characterized as the “epicenter of recession” – was not classified as a recession because the key coincident indicators that define recession failed to decline in the pronounced, pervasive and persistent manner characteristic of a true business cycle recession.

Nevertheless, the downturn ECRI forecast did turn out to be the worst “non-recession” in U.S. history.

The key reason the U.S. avoided recession in 2012 was the fortuitous plunge in oil price volatility that resulted in a highly unusual absence of oil shocks, despite ongoing supply disruptions. A secondary factor was the “central bank put” squashing stock price volatility, as central banks around the world took turns with massive quantitative easing, exogenous shocks emanating from the stock market were effectively kept at bay; and still the worst non-recession ever took its toll on the U.S. economy.

Forewarning Beats Foreboding

Fed rate hikes’ lagged impact typically slow the economy to a point where endogenous cyclical forces could more easily open up a window of vulnerability, and recessions have often eventually followed. But, with or without Fed rate hikes, progressively lower trend growth has now made it easier to open up a window of cyclical vulnerability.

The critical implication – with secular stagnation or some variation thereof now being widely acknowledged – is that most major developed economies, including the U.S., are operating closer to the edges of their windows of vulnerability. So, unless the Greater Moderation ushered in by rock-steady oil prices becomes a reliable feature of the economic landscape, we may be closer to the next recession than many believe; the only question is when it will arrive.

This makes it more important than ever to judge the timing of their entry into those periods of heightened cyclical risk. While we’re all painfully aware that there’s no perfect forecasting method, ECRI’s approach to predicting cyclical turning points is better than any other we know about.

What counts in this environment is not foreboding, but forewarning: specifically, forewarning of the next time the cyclical window of vulnerability begins to open up.

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