Estimating Recession Risk With Potential GDP

There are countless ways to quantify the risk of a new recession. Unfortunately, every methodology is flawed, which implies that it’s essential to analyze the beast from multiple angles. Monitoring the ratio of potential GDP to actual GDP deserves to be on the short list. It’s a timely topic because the Congressional Budget Office recently updated its estimate of potential GDP. The good news is that comparing this metric with reported GDP suggests that recession risk is still low, or at least it was through 2013’s fourth quarter.

The theory here is that when the ratio of actual to potential GDP is above 1.0, that’s a sign that the economy is bumping up against its growth limit for the near term. Meantime, readings below 1.0 are a signal that the economy has spare capacity. In last year’s fourth quarter, the ratio was slightly below 1.0, as you can see in the chart below. History suggests that recession risk is higher when the ratio is above 1.0.


A reading under 1.0 by itself doesn’t insure that the economy will remain recession-free. It’s one risk factor to consider out of many, and so it’s not the holy grail for macro. That said, Q4’s ratio of 0.96 suggests that the economy still has a fair amount of spare capacity and so the danger of overheating and falling off a cyclical cliff is low.

It’s true that a growing amount of that spare capacity has been put back to use in recent years, or so the rising ratio in the chart above shows. Par for the course for an economy that’s been on the mend after a recession. But the healing process is ongoing, and it’s fair to say that idle capacity remains an ongoing issue. In turn, the idle capacity implies that the odds are low that a new recession is imminent.

Yes, that’s a statement that applies through last year’s fourth quarter. Does the recent run of weak data in 2014 paint a darker picture? No, at least not yet, based on last week’s update of the US Economic Profile. Then again, the one thing you can count on with the business cycle is change. The implication: crunch the numbers regularly for signs that the tide is turning. For now, the trend still looks positive, but tomorrow’s another day.