Is That A Recession Or Just More Slow-Growth Turbulence?

The Economic Cycle Research Institute last week repeated its forecast that the U.S. is headed for a new recession, a prediction that the consultancy has been emphasizing since last September. There is some damning evidence to consider, starting with the slumping rate of growth in personal income, a danger sign that’s been with us for months.

Last December, for instance, I wrote that the deceleration in the pace of disposable personal income growth was “troubling… if it continues.” And it has, as ECRI notes in its May 9 commentary:

For the last three months, year-over-year growth in real personal income has stayed lower than it was at the beginning of each of the last ten recessions. In other words, this is what personal income growth typically looks like early in a recession.

Has personal income growth ever remained this low for three months without the economy going into recession? The answer is no.

There’s a fine line between declaring that a new recession is a done deal, a certainty, and arguing that a trend will continue and unleash a fresh round of contraction in the future. If ECRI’s recession forecast is correct, and it may be, then we will soon see clear evidence that all but confirms the prediction.
I’ve been looking for that evidence ever since ECRI first made its forecast back in September. So far, the confirmation in the data hasn’t risen to the critical level, a point I’ve been making all along. In January, for instance, I said that there was still enough forward momentum in the economic data to expect that recession risk in the immediate future was relatively low.
Has this basic outlook changed? Yes, but only on the margins, based on the numbers in hand. Trouble may be brewing, but there’s a strong case for arguing that the data through March still aren’t weak enough to compel the National Bureau of Economic Research at some point to declare that a new recession began in that month. We don’t yet have a full reading on the April reports, but what is available to date doesn’t look dark enough to expect that NBER will date last month as the start of a slump either.
When the next recession does arrive, what signs will provide unambiguous confirmation? Professor Ed Leamer of UCLA, in an NBER research paper from 2008, outlined a simple gauge for judging the major turning points in the business cycle: “Monthly US data on payroll employment, civilian employment, industrial production and the unemployment rate are used to define a recession-dating algorithm that nearly perfectly reproduces the NBER official peak and trough dates.” By that standard, the economy isn’t likely to be in a recession as of April. As the chart below shows, each of the three indicators continued to post year-over-year percentage changes at levels that are associated with economic expansion.

You can find a degree of confirmation for the chart above in various business cycle indexes. The Conference Board’s Leading Economic Index, for example, continued to anticipate growth through March. And while the Chicago National Fed National Activity Index weakened in March, its three-month moving average was still “above trend,” which suggests that a new recession isn’t imminent. The Philadelphia Fed’s Aruoba-Diebold-Scotti Business Conditions Index also looks sufficiently buoyant to raise doubts about expecting a new slump in the immediate future.
Another reason for keeping an open mind on the cyclical outlook until the data convince us otherwise is the message embedded in the output gap, or the ratio of real GDP to potential GDP (using a definition of potential GDP that’s estimated by the Congressional Budget Office). “It is not a technical ceiling on output that cannot be exceeded,” CBO explains. “Rather, it is a measure of maximum sustainable output—the level of real GDP in a given year that is consistent with a stable rate of inflation. If actual output rises above its potential level, then constraints on capacity begin to bind and inflationary pressures build; if output falls below potential, then resources are lying idle and inflationary pressures abate.”
As such, when the ratio of real 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. On the flip side, readings below 1.0 are a signal that the economy has spare capacity. In the first quarter of this year, the ratio was far below 1.0, as the chart below shows. It’s also worth noting that nine of the last 10 recessions have started with readings above 1.0. A reading under 1.0 by itself doesn’t insure that the economy will remain recession-free. But a reading so far below 1.0, as it currently is, raises questions about anticipating a new downturn when the economy appears to have so much capacity sitting idle.

Ultimately, predicting a new recession and finding overwhelming statistical support for the onset of the event are two different things. This much is clear: if ECRI’s forecast is correct, we’ll soon see much clearer warning signs in the numbers scheduled for release in the days and weeks ahead, including tomorrow’s April update on retail sales, Wednesday’s release of industrial production for last month, and the Conference Board’s Leading Economic Index update for April.
The jury, it seems fair to say, is still out on what happens next for the economy. There are danger signs, but it’s not yet clear that the cycle is destined to succumb in the near term to contraction. Then again, maybe the data updates for the week ahead will disabuse us of this optimism.