A Framework That Provides Clarity

During periods of “low visibility,” confusion reigns: for every indication of one trend, there seems to be a countertrend. The key is to glean from the collective wisdom of reliable leading indicators a clear signal that the economy is headed for a turn.



The Next Recession Is Coming. Big Deal.

In a Wall Street Journal survey, a group of economists “put the odds of the next downturn happening within the next four years at nearly 60 percent.”  Oh no.

Today, we will make another entry in the catalog of how worthless predictions tend to be, and more specifically why economists’ long-term forecasts are so uniquely useless.

Let’s start with the math: Saying a recession might occur within the next four years is a statement that contains almost no information. During the 20th century, there were 20 recessions, or one every five years on average. In other words, if you predict a recession within the next four years you will be accurate on average about 80 percent of the time.  It's only slightly more useless than your local weather forecaster predicting that temperatures will fall this winter and rise next summer. This prediction is, of course, absolutely true and of no value whatsoever.

Why do economists have a penchant for extrapolating current data series while ignoring the broader -- and more important -- context about economic cycles? Perhaps it is because they don't like admitting that they don't have any idea when the next recession will come. Almost without exception, economists failed to “anticipate the three most recent recessions of 1990, 2001 and 2007 (even after they had begun).”  Don't expect them to do any better the next time.

Instead, you might want to consider other ways to think about turns in the business cycle. I like the way Economic Cycle Research Institute describes it: Economists tend to use models that “reduce a complex economy to a rigid set of largely backward-looking relationships.” As ECRI notes, extrapolating from the recent past is a sure-fire recipe for being surprised by the next turn. ECRI's approach is to use the leading economic indicators to provide some insight into when the economy is first slowing its expansion, then tipping into contraction.

Rather than merely playing the statistical odds, another more useful approach to recession forecasting is to look at various data points that taken together have a strong correlation with the start of earlier recessions.

Some forecasting models have done better than others. Researchers at the Federal Reserve look at “17 monthly variables chosen to describe different aspects of the economy.” The Federal Reserve Bank of Cleveland also looked at statistical models that estimate 12-month-ahead recession probabilities. The Federal Reserve Bank of New York has developed its own model.

They all found that while many models can be improved by tweaking the indicators or metrics tracked, the limits of the forecasting models drop off a lot at time horizons of 12 months or more. The reason for this is that the standard economic measures they all use to predict recessions -- the yield curve, corporate profits, credit spreads and consumer confidence surveys -- change so much from month to month and quarter to quarter.

The present U.S. economic cycle is a long slow recovery from a deep recession that started in December 2007 and was aggravated by the credit crisis of 2008-09. The Wall Street Journal said the expansion "has now continued for 88 months, making it the fourth-longest period of growth in records stretching to 1854.” But expansions don’t just get old and die; something fundamental has to happen to arrest the progress. And remember, records get broken all the time.

So forecasts of a recession arriving during the next four years are just a waste of print and pixels. The only thing these predictions do accomplish is to remind us that yes, there is always a storm somewhere off in the future. But you can almost never know when it will strike.


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