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Fed Has Trouble Spotting Recessions

Fed, Economists Have Trouble Spotting When Recessions Start

Forecasting economic growth is a tricky business, occasionally ending in embarrassment for even the most experienced prognosticators.

The Federal Reserve last week cut its economic growth forecasts for next year but reiterated its longstanding view that the economy will expand at a "moderate" pace in the coming quarters.

Yet stocks have struggled and futures traders overwhelmingly expect the Fed to cut interest rates again next month amid fears of a looming recession.

Why the disconnect between the Fed's statement and the market's reaction? Perhaps it's because the Fed has been wrong before.

On Oct. 2, 1990, then-Federal Reserve chief Alan Greenspan told his central bank colleagues: "At the moment it isn't raining. The economy has not yet slipped into a recession."

But it was later revealed that a recession had actually begun three months earlier, in July. Why didn't Greenspan, or economists in general, see it coming?

Economists are "very good at extrapolating a trend, which almost by definition will hide a turning point," said Lakshman Achuthan, managing director of the Economic Cycle Research Institute. "If you're looking in the rearview mirror, you don't see the curve."

Third-quarter economic growth came in at a healthy 3.9% annual rate, which will probably be revised up to at least 4.5% due to stronger-than-expected exports, economists say.

But Fed chief Ben Bernanke has acknowledged that the economy has slowed "noticeably" in the fourth quarter.

The housing slump, rising oil prices, plunging consumer confidence and the credit crunch are taking a toll.

The holiday shopping season, which kicked off Friday, is expected to be the weakest in years.

A sudden shock, such as a terror attack or the collapse of a major financial institution, could tip the U.S. into recession, many economists say.

"We tend to look at fundamentals, but it's not always the fundamentals that push us into recession," said Mike Schenk, vice president of economics and statistics at the Credit Union National Association.

On the other hand, he said, "We have such a large, diverse, vibrant economy... a lot can go wrong and we'll still be OK."

Fed policymakers signaled Nov. 20 that they see fourth-quarter GDP growth of about 1.5%. Two recent surveys of private economists also have come up with similar forecasts.

The central bank cut its 2008 growth forecast to 1.8%-2.5% from its June estimate of 2.5%-2.75%.

There are forecasters predicting a recession, but many of them have been bearish for years.

After The Fact

Past experience suggests that few will see a slump until well after the economy has started to contract.

A recession is typically defined as two straight quarters of the economy contracting. But the private-sector National Bureau of Economic Research, the official arbiter of U.S. business cycles, defines it more broadly as a "significant decline in economic activity spread across the economy, lasting more than a few months."

The last recession began in March 2001, but NBER waited until November to make it official following massive job and stock market losses and shocks from accounting scandals and the 9/11 attacks.

It also waited until April 1991 to declare that the 1990 recession had begun in March of that year.

"It's very difficult to identify whether you're in a recession or not in real time," said Keith Hembre, chief economist at First American Funds.

But that hasn't stopped forecasters from trying.

ECRI said Wednesday that its U.S. leading index fell 0.7 point in the week ended Nov. 16 to 139.2.

The annualized growth rate declined for a fifth straight week, falling to -1.2% from -0.9%. That's the weakest since September 2006, but short of the -5% or -6% reading that would point to a recession.

The index's components include housing activity, job growth, interest rates, investor confidence, money supply growth, corporate profits and productivity.

"When we compare the leading indicators with how they looked in the previous recession, they still fall short of recessionary readings," Achuthan said.

However, "We reserve the right to turn on a dime if the leading indicators turn down or up," he added.

ECRI's growth index hit -5% in November 2000, successfully predicting the last recession four months before it began.

In Feb. 2001, private forecasters in a Philadelphia Fed survey predicted first-quarter growth of 0.8%, followed by 2.2% the second quarter and picking up even more later in the year.

But GDP actually shrank 0.5% in the first quarter, grew 1.2% in the second and dropped 1.4% in the third as the 9/11 attacks further stalled economic activity. A sluggish recovery began at the end of the year.

Economists say their forecast models are only as good as the numbers they plug into them. And the data — from exports to consumer spending and job growth — are often hard to pin down.

"There's always ambiguity in the data," Hembre said, adding that many numbers are "subject to revision, sometimes large revisions."

"Economic behavior has so many shades of gray," said Ellen Hughes-Cromwick, president of the National Association for Business Economics.

Recent Recessions Mild

However, economists say forecasting has improved over the past 20 years due to improved monetary policy and globalization, which have helped keep a lid on inflation.

"Central banks have figured out that you need to tackle inflation," Hughes-Cromwick said. "If you bring inflation down, economic growth will be better and volatility will be lower."

As a result, recessions now tend to be milder on average, she said.

Still, Greenspan's successor, Bernanke, has so far resisted getting into the recession debate.

"We have not calculated the probability of recession," Bernanke said in congressional testimony earlier this month. "Our assessment is for slower growth, but positive."