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Explaining the Recession Call

The U.S. recovery wasn’t much to begin with, and now it’s dead.

That is the news from the widely respected Economic Cycle Research Institute that said the U.S. has already or is about to tip into recession. The announcement, made public Friday, was met with skepticism by other economists who are more hopeful the U.S. and the world will skirt recession.

Lakshman Achuthan, co-founder of ECRI, however says the hope is misplaced. He says the call is based not just on the weekly leading index that is disseminated to the public, but also on dozens of other ECRI leading indexes that are available mainly to ECRI’s clients.

Growth in the weekly leading index, released on Fridays, began to decelerate in April and turned negative in mid-August.

Economists downplay the WLI because of its high correlation with movements in the stock markets that have been volatile lately. Joseph LaVorgna, chief U.S. economist at Deutsche Bank, calculates a correlation coefficient of 90% between the WLI and the S&P 500 stock price index.

“Essentially, so goes the S&P 500, so goes the ECRI,” he says.

The WLI, however, is not the only hammer in ECRI’s toolbox, says Achuthan.

To capture the macro-view, ECRI also puts together a long leading and short-leading index. The long-leading index, which has no exposure to equities, started falling back in December 2010 and is still falling.

In addition, ECRI puts together sector-specific indexes that cover areas including manufacturing, nonfinancial services, housing, credit and exports. These indexes are “overwhelmingly showing recession patterns,” says Achuthan.

In particular, the ECRI indexes are signaling the 3 “Ps” of a contraction: the decline has to be “pronounced, pervasive, and persistent.”

Achuthan makes clear that a recession is a “process” in which a negative loop feed backs on itself: Slowing demand lowers productions which results in dropping employment and incomes which in turn weaken sales further.

Ominously, Achuthan says policymakers will not be able to stop this recession.

“Once the feedback loop starts, it’s more powerful than any policy response,” he says, adding policymakers’ challenge is not to make the situation worse.

Currently, the ECRI indexes do not signal when this recession ends. “We’re on an upturn watch,” says Achuthan. But a contraction is sure to mean unemployment will get higher and the federal deficit will worsen.

I have known and respected Lakshman and his work for years. But I hope his latest call is dead wrong.

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