Estimating Recession Risk Isn’t Getting Any Easier

Every recession is different and the next one, whenever it strikes, will likely continue the tradition. As a Bloomberg column reminded last week, the risk factors that may be aligning to deliver the next contraction are an unusual mix.

“This won’t be your father’s recession — if indeed the U.S. ends up tumbling into one,” Bloomberg’s Rich Miller writes.

Traditionally, US downturns are home-grown and household-led, triggered by spikes in interest rates and fueled by the unwinding of financial and economic excesses. None of that is arguably at work this time, at least for now.

Instead, what’s making investors nervous about a recession is a global, geopolitical shock to business sentiment that’s prompting US companies to curb spending amid uncertainties from the US-China trade war to Britain’s potential pullout from the European Union.

The confluence of these changes threatens to make the Federal Reserve’s job considerably more challenging in the months ahead. Simply put, the central bank’s usual bag of monetary tools – starting with interest-rate cuts – aren’t particularly well suited for minimizing the current run of challenges, especially if the economy continues to weaken.

Whatever the triggers for a new downturn, former Treasury Secretary and Harvard economist Larry Summers says US rates will fall back to zero, or lower, in the next recession. Entering a contraction with interest rates already low will pose new challenges. “We’ll have to think about stabilization policy. Institutions are going to have to think about their investment policy in a very different world when we have a black hole, zero interest rate world,” he told CNBC on Monday. “I fear that’s what we’re headed into.”

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Maybe, although the current macro profile for the US continues to reflect low recession risk, albeit from the vantage of looking into the rear-view mirror based on a range of data published to date. Last month’s business-cycle risk profile reaffirmed that 1) the odds that a recession has started remain low; and 2) an NBER-defined downturn in the immediate future is unlikely.

That’s still a reasonable view, according to this week’s update of the numbers via The US Business Cycle Risk Report. Notably, the newsletter’s primary index for monitoring recession risk – a proprietary mix of several business-cycle benchmarks – estimates the probability that a new downturn has started at roughly 1%, as shown in the chart below.

Growth has clearly slowed recently and so, in theory, the downshift raises the potential for trouble if a new economic shock strikes. Note, too, that near-term estimates of business cycle conditions continue to anticipate that the expansion will remain slow, perhaps even sluggish, for the foreseeable future. But for the moment, the threat that a recession is imminent appears low.

But conditions are constantly in flux and so the key question, as always: What should we focus on to assess a change in recession risk? The short answer: don’t focus. Instead, play it safe and measure macro stress via a broad set of indicators. That’s an unpopular idea in the media, and for many analysts and investors, too. The narrative plays better with a short list of numbers. But as Bloomberg’s Miller reminds, the next recession could be a very different animal than we’re used to. All the more reason not to bet the farm on a handful of indicators that worked in the past.

As with investing, the antidote to uncertainty – particularly when it seems to be higher than usual – is to hedge your bets with a broader sample. In fact, that strategy has worked well since the last recession ended in 2009. As shown on these pages via the monthly business-cycle updates (here and here, for instance), going broad for data analysis has an encouraging record of sidestepping the many false signals we’ve seen in recent years – false signals that have tripped up more than a few business cycle “experts”.

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The US Business Cycle Risk Report

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