A potent cocktail of data for predicting recession

A potent cocktail of data for predicting recession
By Simon Ward
Copyright The Financial Times Limited 2006
Published: August 17 2006 03:00 | Last updated: August 17 2006 03:00


The critical question now affecting investors in financial markets is whether or not the US economy is heading for a "hard landing" or worse. A growing minority of economists is warning of a recession later this year or in 2007. But historical research into leading indicators of recessions over the past 50 years suggests that such concerns are premature. The US economy has, however, entered a sustained slowdown in growth and if the Federal Reserve were to tighten monetary policy further,the risks of a recession would increase significantly.

Milton Friedman most famously argued that inflation was a disease of money - so are recessions, or at least they are in the absence of some external and unpredictable cataclysmic event such as a meteorite landing on Manhattan. Armed with this insight, it is possible to construct a recession warning indicator capable of flashing its red light about six months ahead of a downturn, assuming of course that such a downturn is monetary in its origins.

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There have been eight US recessions, each triggered by malign changes in monetary conditions, since 1955, according to the National Bureau of Economic Research, whose definition is "a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real gross domestic product, real income, employment, industrial production and wholesale-retail sales".

Using data about monetary conditions preceding these eight downturns, an economist can design the appropriate cocktail of monetary indicators that will flash up a warning light in the future. Four key indicators of monetary conditions, both lagged and current readings, are needed for this cocktail. They are: the relationship between the yield on three-month Treasury bills and Treasury bonds with maturities of more than 10 years; the Federal Funds Target Rate adjusted for inflation; the inflation-adjusted growth in the monetary base - currency in circulation plus deposits at the central bank; and the rate of change in US equity prices.

Blended together appropriately, these ingredients throw up a probability estimate, and this estimate has risen above 50 per cent in advance of all eight NBER-defined recessions since 1955. What is more, there have been no false signals. This is a better record than the stockmarket, which, Paul Samuelson, the Nobel Prize-winning economist once quipped, had predicted "nine of the last five recessions". The probability did, however, approach 50 per cent after the 1987 stockmarket crash and also in 1966. This has been the only year in which three-month Treasury bond yields have risen to the same level as 10-year-plus yields since 1955, a classic indicator of tough times ahead, without subsequently triggering a full-blown recession. US GDP growth did, however, come to a halt in early 1967 and to observers at the time that must have seemed like a hard landing.

What is the recession indicator saying now? It is flashing yellow, not red. The likelihood of a recession has risen since 2005 but remains at a little less than 20 per cent. Essentially, the cautionary message from the convergence in short- and long-term bond yields is counter-balanced by less negative data elsewhere. The recent increase should, however, not be dismissed. Were the US Federal Reserve to resume its programme of monetary tightening later this year in response to economic data that suggested further inflationary pressures and push the Fed Funds Target Rate up by another half a percentage point, the recession probability indicator would probably rise above 50 per cent, causing the red light to flash.

After this month's Federal Open Market Committee decision to call a pause after 17 consecutive rate rises, a half-point Fed Funds hike in the short term would seem unlikely. Even if the recession probability indicator peaks at around its current level, however, historical experience is worth noting.

On seven occasions in the past 50 years, the indicator rose above 5 per cent without breaching the 50 per cent threshold. In six of the seven instances, this preceded a slowdown in economic growth. In three of the seven instances, official short-term interest rates were subsequently cut and in a further three cases they remained stable for at least six months.

It is likely US economic growth will remain at or slightly below its trend rate from now into early 2007, allowing the Fed to hold official rates at close to their current level. Historical precedents, however, suggest the possibility of a sharper slowdown, something that to many people may feel like a hard landing, requiring the Fed to reverse its recent rate increases.

The writer is New Star Asset Management's investment strategist