Economic News & Analysis—July 20, 2012
Recession watchBy Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist, and John Manley, CFA, Chief Equity Strategist
Is the U.S. in a recession? It’s hard to say because there is no single definition of a recession. A recession is typically thought of as a decline in economic activity that is part of the business cycle. In introductory macroeconomics, students often learn that a recession is two consecutive quarters of a decline in real gross domestic product (GDP).
That’s not quite true. It’s a good shortcut, but not 100% accurate.
The National Bureau of Economic Research (NBER) has a “Business Cycle Dating Committee” that claims to be the official arbiter of peaks and troughs in the economy. The Conference Board is another group that publishes leading, coincident, and lagging economic indicators designed to point to peaks and troughs in the business cycle. The Organization for Economic Cooperation and Development (OECD) has its own business cycle indicator. In short, nobody can honestly say that one definition of a recession is universally accepted.
So is the U.S. in a recession? To take only one view, let’s look at the NBER, which states: “[A] recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.”
Even the NBER doesn’t provide a simple formula or list of variables that clearly point to a recession. Rather, the professional judgment of the committee members comes to bear on determining the dates of peaks and troughs. A nonexhaustive and nonexclusive list of variables the committee looks at includes: income minus transfer payments; nonfarm payrolls; industrial production; and manufacturing and retail sales. Keep in mind that the committee composition changes, so its members might have given certain variables more importance than others over time.
I looked at the relationship between these variables and the time periods in the past that the committee has called recessionary (from the peak date to the trough date). Because this past recession was so unusual in terms of its depth, I excluded it from my statistical analysis. Instead, I constructed something called a “probit model,” where I looked at the year-on-year and month-on-month changes of the four variables, along with all the interactions among them, to determine the probability of the economy being in a recession during any given month. The chart below shows the periods of recession identified by the NBER in blue and the probability of the economy being in recession from my model in red.
The probability that the economy is in recession as of the end of June 2012 may be 24%
The fit of the model is pretty good, with few false positives (that is, showing a recession when there wasn’t one) and no misses. As of the second quarter of 2012, the model shows an approximately 24% chance that the economy was in a recession. It was—and is—an environment a lot like 1997 to 1998, when the global economy was dealing with the Asian financial crisis, which originated in Thailand. The Thai government was effectively bankrupt and needed to let its currency depreciate rapidly. Then the crisis spread throughout Southeast Asia and Japan, where currencies and stock markets declined. The International Monetary Fund intervened with bailout packages that demanded the governments implement structural reforms, like austerity measures. The countries at the eye of the storm suffered slow economic growth and political upheaval as a result.
Does any of this sound eerily familiar?Although it was a painful process of adjustment, which had ripple effects on the rest of the world, the Asian financial crisis did not lead to a recession in the U.S. Perhaps the slowdown we’re seeing in the U.S. this summer is not a recession, but a situation that’s similar to what we saw back then. We’ll have to wait and see what the next quarter brings and what the NBER, The Conference Board, and the OECD all have to say about it.