October 01, 2012
So says David Malpass in the WSJ:
Data released this week by the Commerce Department waved bright red recession flags—orders for durable goods fell 13.2% in August and inflation-adjusted personal income fell 0.3%. ... the new Commerce Department numbers, combined with his stay-the-course approach, point to recession in 2013.
And James Pethokoukis writes “GDP collapse puts U.S. economy into recession red zone.”
I think it’s at times like this it behooves one to consult the forecasting record; for instance, back in June 2008, David Malpass stated:
While many problems remain from the 2007-2008 financial crisis, the rebound from the two-quarter slowdown looks to have taken root. I expect 1-2% growth in the second quarter and 3% in the second half. Rising inflation and Fed rate hikes later in 2008 will bring periodic worries about the pace of rate hikes, causing occasional market jitters like the current one. But the low level of interest rates should win out for both the economic and equity market uptrends (as it did during the rate-hiking cycle in 2004-2006).
It’s also of interest to recall the eloquent title of the Pethokoukis piece in which the Malpass quote appears; it’s ”Dude, Where's My Recession? The Series”.
Even if the sources of these worries are less than fully credible, I will not “pull a Lazear” (or a Don Luskin, for that matter), and rule out a priori the possibility of recession. Rather, it seems appropriate to examine the indicators the NBER Business Cycle Dating Committee (BCDC) uses to determine peaks and troughs. As the NBER BCDC notes, the key indicators are GDP, nonfarm payroll employment, industrial production, personal income ex.-transfers, and manufacturing and trade sales. Figure 1 depicts official GDP from the BEA (3rd release for 2012Q2), and from Macroeconomic Advisers (the e-forecasting series is added for reference, since I have a longer series for that).
Figure 1: Official GDP (Ch.05$) SAAR (blue bars), monthly GDP from MA (green line), from e-forecasting (red line). NBER defined recession dates shaded gray. Source: BEA, 2012Q2 3rd release, Macroeconomic Advisers (9/18/2012), and e-forecasting (9/19/2012).
The e-forecasting series has flattened out, while MA’s series running through July is still rising.
Figure 2: Personal income ex. transfers (blue), manufacturing and trade sales (red), nonfarm payroll employment (green), and adjusted upward by CES benchmark revision for March 2012 (green triangles), and industrial production (purple), all in logs, normalized to 2009M06=0. Source: BEA, BLS and Fed via FRED, NBER, and author’s calculations.
Employment rose into August (and will likely be eventually revised upward, given the annual benchmark revisions that were reported last week ), while income and industrial production fell. Hence, it is conceivable that we are at a peak.
On the other hand, the term premium is signaling no-recession.
Figure 3: Ten year-three month spread (blue), and ten year-two year spread (red). September observations are for 9/26. NBER defined recession dates shaded gray. Source: FRED, NBER, and author’s calculations.
Both spreads are positive; this is suggestive of a still growing economy. Chinn and Kucko (2010) estimate for the US over the 1973-2009Q2 sample:
Δipt+1 = -0.037 + 1.630spreadt
So, industrial production growth over the subsequent one year period is predicted by the spread; a one percent higher spread is correlated with roughly one percentage point faster growth over the next year. This finding is robust to the use of real-time data:
Δipt+1 = 1.698 + 0.794spreadt
One can worry if historical correlations would still be informative with respect to current conditions, given the implementation of quantitative easing and Operation Twist, and the encounter with the zero interest bound. However to me, this suggests the spread would be much larger than is observed, in the absence of these phenomena.
Jim Hamilton’s indicator (for 2012Q1) remains at neutral, as it has since August 2009. Mike Dueker’s index remains positive, into August. The Aruoba-Diebold-Scotti business conditions index is around -0.5 for 2012Q3, which is comparable to levels in 2003.
I said I would not “pull a Lazear”. So I end by contrasting the distribution of forecasts of growth from the WSJ September survey of economists, with that recorded when Ed Lazear made his famous “no recession” forecast.
Figure 4: Distribution of forecasts for average q/q growth, 2012Q3-2013Q2. Source: WSJ, September 2012.
Moreover, there is not a single forecast of negative q/q growth in the entire survey. Compare with the May 2008 survey:
Figure 5: Quarter on quarter SAAR growth forecasts for 2008Q2, from Wall Street Journal May 2008 survey. Source: WSJ, as shown in this post.
So, given the dearth of forecasts of recession, and the fact that not all indicators are trending down, I rate the likelihood of imminent recession as low -- but of course the data could be revised down, going forward. Furthermore, crises abroad, or more likely failure to address the fiscal cliff could yet put us in a self-inflicted recession.
Update, 10/2, 7:20PM Pacific: Bruce Bartlett sends me some additional analytical gems that comform to the imminent-recession meme, from Richard Rahn and First Trust. I leave readers to assess for themselves their plausibility.
Update, 10/3, 2:09PM Pacific: Several commenters have argued that the yield curve fails to predict growth in the same way as it has in the past. I am sympathetic to this view, but thought it useful to quantify the extent to which the historical correlations fail to extend. I estimate:
Δyt+1 = 0.01 + 0.560spreadt + 0.049i3mot + 0.222 Δyt
Adj-R2 = 0.10, sample 1971-2011.
Where the interest rate data and growth rates pertain to end-of-year data (in order to eliminate overlapping observations).
A test for stability using one-step ahead recursive residuals indicates a break in 2008, but otherwise stability in recent years. In addition, CUSUM and CUSUM-squared statistics indicate stability.
Figure 6: One step ahead recursive residuals test for indicated yield curve regression. Source: author’s calculations.
This is not to say this regression explains a high proportion of variation; but the case that the correlations have changed statistically significantly is not obvious.
Posted by Menzie Chinn at October 1, 2012 09:25 PMdigg this | reddit
Menzie: I don't know if you're aware of this, but ECRI's Lakshman Achuthan claims we're already in a recession:
Posted by: Phil Rothman at October 2, 2012 07:33 AM
So tell me again... why must we give the 3rd world our jobs.. and then import their goods - tax free?
the giant sucking sound was REAL...and we lost.
This cannot end well. Too many people chasing too few clean rivers, open space and commodities.
So - a pox on world development. Fewer people means better lives for everybody and everything else.
The left and right will coalesce around a policy of xenophobia and misanthropy -- if we are to save ourselves and the planet.
and not a day too soon
Posted by: Noe Allen at October 2, 2012 07:48 AM
Looking at the money aggregates, one may wonder whether recession is just a vocabulary.
Money stock volatility. The lowest since 1950;
The inventory to sales ratios
When it comes to actual total production by country Fred is drawing on chartist’s sciences.
Those patterns hereunder, are a guide to mergers and concentration within industrial branches, even when knowing that very few are a success.
Industrial production index by country.
Looking at the ADS on the right hand side of Econbrowser window, a small inflexion point from the lowest low.
Are we still deemed to beleive in the predictivity of the yield curve.
Posted by: ppcm at October 2, 2012 07:58 AM
I believe ECRI has not climbed down from its recession call. And the ADS indicator is pretty weak and trending down. But initial unemployment rates were also down, the best we have seen for a while.
The oil statistics speak to a mini-recession ending in summer of this year.
I think this is a difficult call this time around because the traditional impetus for a recession--an overheated market of some sort--just isn't there. There is no bubble in housing, equities or debt (except government debt). There is plenty of slack in labor and many manufacturing markets. So why the slowdown?
Posted by: Steven Kopits at October 2, 2012 08:21 AM
If Menzie is going to attack David Malpass on something he wrote you would think he would at least read it in context.
The Malpass quote from Pethokoukis came from something David wrote in June 2008, before TARP, before the election of Barak Obama and before the massive Keynesian failure of the Obama stimulus of 2009.
In the Malpass piece he later wrote:
The U.S. also faces a severe tax risk beginning in 2009. At the end of 2010, tax rates on labor, dividends, capital gains, inheritance and the AMT are all scheduled to go up substantially. The increases are hard to stop, but are relatively easy to accelerate, creating substantial market uncertainty and risk. The November election process will shed some light on the extent and timing of this risk, though the election itself (both the presidency and the degree of congressional control) will probably be the key event in the tax risk.
This uncertainty was a major cause of the economic problems faced during the first two years of the Obama administration and was only averted at the 9th hour in December 2010 after the Democrat shellacking in the mid-term elections.
If the dollar is in a strengthening trend into 2009, as I expect due to economic rebound and the change in Fed language, it should offset some of the U.S. drag from inflation, taxes and rate hikes. In addition, the November election process should be dollar positive, either because the candidates explicitly state a preference for a stronger dollar (distinguishing them for the current administration) or simply because the change of Administration brings a sigh of relief.
The truth is that we did not get a president committed to a stronger dollar. I do disagree with David that McCain would not have been any better for the dollar than Obama but, the fact is that the dollar was devastated during this time.
Malpass is respected because he puts his neck and theory on the line and he has a strong track record. Menzie should stop hiding behind the projections of others and make his own predictions if he doesn't like what he hears. I guess we always need critics, but if that is all someone does, will they ever stand out?
Posted by: Ricardo at October 2, 2012 08:41 AM
The left and right will coalesce around a policy of xenophobia and misanthropy -- if we are to save ourselves and the planet.
Ask and ye shall receive.
Posted by: W.C. Varones at October 2, 2012 09:32 AM
Ricardo: On July 7, 2009, in your DickF incarnation, you wrote:
What is interesting is that many who rely heavily on econometrics are the strongest critics of the free market, but for econometrics to work there must be a free market. One reason that econometrics has such a poor record today is that the econometrician does not realize that there is no free market. Economic events are driven more by politics in today's world that ever before, consider GM and Chrysler and the bailouts of investment banks among so much more.
So the numbers and trends show a recovery while the politics of the situation show massive tax increases in the future. I wonder which will win out.
If you are able to download and analyze data from FRED, I would be happy to see your calculation of average q/q growth since 2009Q2.
Give my regards to the rest of the David Malpass/Don Luskin fan club.
Posted by: Menzie Chinn at October 2, 2012 09:48 AM
Setting aside whether we are in or even headed into a recession, the survey of economists has a laughable track record. Even 6-9 months into the last recession the vast majority insisted one hadn't started.
Also, using yield spreads seems pretty silly when the 2-year is at 23bps. If the 10-year dips blow that, we're probably headed into something an awful lot worse than a recession.
The best confirmation I've found--that is close to real-time and not distorted by current conditions--is unemployment claims. They seem to increase steadily ca. 10-12 weeks before every recession. Though there are false positives. If we are headed into an eminent recession, they should start rising rapidly. So far, that's not the case.
I've read the 2% payroll tax reduction is unlikely to be extended, regardless of how the fiscal cliff is resolved. That will be like losing 1million jobs January 1st. To absorb that, things need to pick up.
Posted by: Bob_in_MA at October 2, 2012 11:31 AM
(1) Regardless of whether we're in a GDP-recession or not, the personal income ex-transfers data you've plotted shows that there wasn't even a real income recovery for most people. They're still in the 2007-20xx Income Depression. From a political and economic standpoint, that fact is far more important to more people than whether we're about to enter a GDP recession.
(2) Comparing forecasts from May 2008 (six months into an NBER-defined recession) and now (not clear if a recession has just started or lies ahead) is not the most reasonable comparison... unless you are in the ECRI camp and think the recession has already started. It would have been more telling to show the September 2007 or December 2007 forecasts... but those wouldn't make your point, would they? To me, what is most interesting about the May 2008 forecast chart is that even six months into the 2007-2009 recession, more than half the forecasters were on the wrong side of the line. (26 vs. 23) This is yet more documentation that economic forecasters have a hopelessly poor track record of predicting recessions. (c.f. Ritholtz or CalculatedRisk.)
(3) The term premium (yield curve inversion) technique is irrelevant in the current circumstance, given contemporary Fed policy vs. historical policy, the different nature of the 2007-2009 recession vs. the other postwar recessions, and the precarious financial position of the U.S. government this time around. The U.S. yield curve sits where the Fed has positioned it, long term yields are propped up by high issuance and low demand, and short term yields are depressed by strong liquidity preference and capital flight from other nations that are known to be in or entering recessions. (Note that some of these other nations have had inverted yield curves, but some haven't.)
Posted by: Wisdom Seeker at October 2, 2012 12:13 PM
David Malpass fan club - yes, absolutely!
Don Luskin - A friend with whom I often disagree.
And just for the record, Pethokoukis - not a friend but sometimes I agree and sometimes disagree.
Thanks for playing! :-)
Posted by: Ricardo at October 2, 2012 12:36 PM
Durable goods just signalled the Asian slowdown. In otherwords, what recession?
Durable goods were outpaced by investment and service sector growth increasing core consumption. Which also means durable goods will rise again after the adjustment. Yawn.
They remind me of people in 1993 sure a recession was coming.
There may be a recession, but it won't be 2012.
Posted by: The Rage at October 2, 2012 12:47 PM
The slope of the yield curve is not a reliable leading indicator given the complete artificial nature of the yield curve at both long and short ends at the present. Moreover, the compression of the curve due to the never before historic inflow of funds from Europe makes the shape of today’s curve even less comparable to the past (though a flattening curve is in line with weakness). Jim Hamilton’s leader lags the cycle a bit too much from my recollection of its performance at the last cycle peak. Leamer, though he has valuable insights, is much too monotonically attached to housing as “the” leader. Building permits are indeed a reliable indicator, but are hardly the be all or end all.
Historic comparisons are fraught with difficulty right now since the nature of this recovery is unlike any other in the postwar period. Caution must be taken in relying on a rule like Pethokoukis’s: “when year-over-year real GDP growth falls below 2%, recession follows within a year 70% of the time.” When normal growth is 4% as it was in the early postwar period, a decline from 4% to 2% meant something. Because of the secular decline in economic growth since then, the quantitative veracity of such triggers has changed. Much like the very meaning of money has changed over time because of innovations in credit; M2 cannot possibly be in the same relationship to the economy as it was 35 years ago. The ADS indicator is not a leading indicator. Its timid drop prior to the Great Recession is sufficient to rule it out as having any kind of reliable real time efficacy. Quite correctly stated, the WSJ consensus has not a single negative print for 2013. But do not forget that only 5% of the consensus called recession a month before the 2008-9 recession began. That is, the consensus is a thin reed on which to play any tune. Rahn gets carried away in saying Obama’s reelection will lead to recession by the first quarter next year. However his larger message is dead on. The probability of recession sometime in the next 2 years is a far better than even odds bet, and for many of the very reasons he states. The Westbury piece, also, is very well reasoned. Futures markets have the probability of recession in 2013 at 25%. And overregulation, uncertainty, and economic incompetence at the highest level are definite contributing factors. Read the NFIB surveys, and the responses to the latest ISM survey where one respondent makes it abundantly clear that Obamacare is the cause of their firm’s sales slowdown. This extrapolates economy-wide.
Posted by: JBH at October 2, 2012 05:14 PM
"So, given the dearth of forecasts of recession, and the fact that not all indicators are trending down, I rate the likelihood of imminent recession as low -- but of course the data could be revised down, going forward."
Yes, all the usual caveats apply. But a broad reading of the indicators, based on the last full month of availalble data -- August 2012 -- does indeed suggest that recession risk is low. For a look at the details, see the table here:
History suggests that when most of the indicators are trending positive (defined primarily as year-over-year growth rate), the odds that the economy's in recession are low.
Let's see if September tells us something different.
Posted by: James Picerno at October 2, 2012 05:25 PM
Phil Rothman: Yes, I do know that ECRI has called a recession. I guess I should've mentioned that, but for the life of me, I don't know how well their predictions hold up in real time. I am open to learning more, e.g. how many false positives over time.
Bob_in_MA, Wisdom Seeker and JBH: I'm not sure I understand. In the absence of inflows and Fed operations, wouldn't the long end of the maturity spectrum have higher rates? And in the absence of the zero interest bound, wouldn't the short end be lower? Hence, in the absence of both phenomena, wouldn't the spread be larger?
JBH: You are extrapolating one respondent on the ISM survey regarding Obamacare to an overarching indictment of the ACA? Gee, the weather is nice here in Madison. Must be true nationwide...
Posted by: Menzie Chinn at October 2, 2012 09:49 PM
CFNAI has been progressively more negative since February, 2012. Rate [not mass, not share] of nonfinancial corp profit has been declining, the BLS U-6 unemployment rate - while having improved slightly - came in at 14.6 [SA] and 14.7 [NSA].
Most importantly, we exist in a global economy, one in which China and India are slowing and the EU is verging on [another] recession [virtually guaranteed by the multiple austerity policies].
Yet the U.S. is imagined to be immune?!
Posted by: Juan at October 3, 2012 12:52 AM
Notice that those who do not see the coming disaster ahead in January 2013 are looking in the rear view mirror. Their "proof" is data from the past.
Posted by: Ricardo at October 3, 2012 05:03 AM
In response to Mr. Kopits, who writes:
If Menzie is going to attack David Malpass on something he wrote you would think he would at least read it in context.
"The Malpass quote from Pethokoukis came from something David wrote in June 2008, before TARP, before the election of Barak Obama and before the massive Keynesian failure of the Obama stimulus of 2009.
In the Malpass piece he later wrote:
The U.S. also faces a severe tax risk beginning in 2009. At the end of 2010, tax rates on labor, dividends, capital gains, inheritance and the AMT are all scheduled to go up substantially. The increases are hard to stop, but are relatively easy to accelerate, creating substantial market uncertainty and risk."
Which is to say, "what context are you talking about? The point of the piece was that Pethokoukis, as well as other demagogues who pass themselves off as "economists," were dead wrong and missed the greatest economic implosion of our generation. Your argument puts the history through the wrong end of the telescope. The quote may have been made before TARP. It was also made before Lehman Brothers collapsed and AFTER Bear Stearns imploded.
To not see the warning signs as late as June 16, 2008 represents a triumph of wishful thinking based on rank ideology over reason. Which is the AEI's main product.
We're also given the fall back position on every reason why we don't have a 2% unemployment rate by now. "Uncertainty." Ah, yes.
As far as being impossible to measure as an economic metric, at no time has the Obama Administration ever suggested dialing back to the entire set of Clinton era tax rules, so the fear Mr. Malpass is trying to dial in- as well as the specious assumption that this was why the "shellacking" took place- is really without basis.
Pethokoukis' job is to sling mud, and not inform.
Here's another expert forecast:
Posted by: Max Planck at October 3, 2012 05:37 AM
I do apologize, Mr. Kopitz did not write that, it was "Ricardo."
Posted by: Max Planck at October 3, 2012 06:55 AM
While Malpass and Kudlow were stunningly wrong and are optimistic ideologues, they are not in official positions of power.
Ben Bernanke said what Malpass and Kudlow said and more, yet he is still in power as chief central planner.
Why focus on a couple of dopey commentators rather than the buffoon in charge?
Posted by: W.C. Varones at October 3, 2012 08:31 AM
Rothman In September 2011, Lakshman forecast a recession to begin in the first quarter. He was wrong. That number will not be revised down enough, if it is revised down at all, to make him correct about Q1. He has since bumped the forecast date forward, emphasizing that revisions will make him correct. The preliminary benchmark payroll employment upward revision just out makes the odds of him being correct in the course of time even less likely. As does the stock market and the Conference Board’s coincident index being on their highs at latest reading.
Allen You have put your finger squarely on one of the greatest problems this country has.
Kopits Yours is a perspicacious question. Why indeed the slowdown? The proximate causes are: declining disposable income growth, the inability of consumers to augment purchasing power by drawing on credit since the long credit cycle has now turned, slowing global growth, overextended government which at the state and local level has to get budgets back in balance, and waning business confidence to put hard-earned capital on the line to fund new projects. And now for the deeper answer. Each of these proximate causes has lines of causation running from deeper levels. I will not do you the injury of cataloging all these. Rather I will cite two dominant causes that run through the rest. One, Western Civilization’s era of expansion is drawing to an end because we as a culture have not attended to our surplus (national saving as a percent of GDP). We have frittered it away on redistributional entitlements, goods imported from currency-manipulating China, McMansions (non-productive use of capital), and wars. Two, revolving door corruption in Washington enabled by the dumbing down of America by its public education system and the media which, unlike in the days of Walter Lippmann, no longer pay homage to delivering unvarnished facts to the American public.
Ricardo Malpass must be read with a grain of salt. Let us drop the dollar through the cracks where for the moment it belongs, as Malpass is wrong about the need to maintain a strong dollar. In fact, the dollar needs to come down to remedy the current account deficit. The US is running a half-trillion dollar deficit that’s consuming the seed corn. Action by the United States to get its fiscal house in order will speak volumes more to the world than the utterances of a long string of Treasury Secretaries (Democrat and Republican) who have talked the dollar up. That said, Malpass otherwise often has cutting edge ideas; and he has the courage to state them.
Menzie The economy grew at a rate of 2.2% for the 3 years starting from the recession trough. This 3-year rate of growth will probably be the peak for the current expansion. The 2-year growth rate is 2.1%, similarly the 1-year rate. Fiscal cans are being kicked down the road by Congress and by a president whose budgets have been soundly rejected by his own party. This has weighty portents, including a sequence of lower growth rates in the years ahead. Consider this a forecast.
Bob Your perception accords with the statistical record. Unemployment claims is a leading indicator par excellence, though it is of relatively short lead time in comparison to some other leaders. Claims as you say are not signaling recession.
Wisdom Seeker Per your points: (1) the historic all-time low of wage growth was touched in May (1.2% in nominal terms) vindicating your point; (2) let me restate your second point – Neoclassical Keynesian Economics has been delivered a coup de Grace; (3) see my above comments validating this point. I am impressed by your understanding.
Picerno I applaud your contribution. Let me dissect the table you present. First, you cannot go by 1-year changes. The universe operates on the margin. The margin is an elusive creature; she will alight only with the sprightly caution of a butterfly. Scratch all the yearly changes and start over. Scratch next all but leading indicators. If you are interested in the future, 12-month changes in coincident indicators do not cut the mustard. At least 7 of the indicators in the table fall into this category. There is a trap here. The trap is more is better. Most professors go from student years to teaching without gaining any real world experience and therefore often don’t have the foggiest clue, and so the trap is laid. More is not necessarily better. Read Daniel Kahneman on this.
Posted by: JBH at October 3, 2012 09:36 AM
Menzie The 2012 NFIB survey of the nation’s small businesses asked that 75 potential problems be ranked. Here are the top 10 in rank order as perceived by a representative sample of the nation’s job creators: Cost of Health Insurance, Uncertainty over Economic Conditions, Cost of Natural Gas, Uncertainty over Government Actions. Unreasonable Government Regulations, Federal Taxes on Business Income, Tax Complexity, Frequent Changes in Federal Tax, Laws and Rules, Property Taxes. If someone were to opine from this that much of the country’s job problem emanates straight from 1600 Pennsylvania Avenue, you’d ignore the nine other balls in the urn and drag the red herring of natural gas across the path. The response from the latest ISM survey I quoted makes a crucial point. Poor sales are due in part to perceptions about the impact of Obamacare on business.
You choose to belittle my extrapolation which has much basis in statistical and anecdotal evidence, starting with but not limited to the above survey response that places health care cost concerns at the very top of the list. Next you will say Obamacare will contain costs because the CBO said so, conveniently ignoring the more recent $17 trillion cost estimate produced by the Senate Budget Committee’s minority staff using the long-term model of the Office of the Actuary at the Centers of Medicare and Medicaid Service. Businesses instinctively understand this. And in reaction to the uncertainty created by Obamacare – who yet knows what the rules will be? – businesses are far more cautious about hiring and will remain so for a long time.
Posted by: JBH at October 3, 2012 09:39 AM
JBH: But cost of health insurance will be arguably lower under ACA than the alternative. So...? I will also note (which you did not) that the NFIB index rose in August.
The document notes the index is in recessionary territory, but of the 93 observations below 100, 43 have been in the post 2009M06 period defined as recovery by NBER. So take what you want out of that.
Finally close inspection of this research document from NFIB indicates that in recent periods, the NFIB optimism index has underpredicted GDP growth.
Posted by: Menzie Chinn at October 3, 2012 10:53 AM
The research document you cited also says: "The NFIB Optimism Index outperforms both the Conference Board’s Consumer Confidence
Index and the University of Michigan’s Index of Consumer Sentiment as a predictor of changes
in real GDP."
Of course, the Obama regime has consistently overpredicted GDP growth (and stimulus efficacy).
As far as the index turning up, maybe they just smell a Romney victory. Enjoy President Obama's visit to Madison tomorrow!
Posted by: Rich Berger at October 3, 2012 12:33 PM
Menzie, you write: In the absence of inflows and Fed operations, wouldn't the long end of the maturity spectrum have higher rates? (etc.)
My Answer: nobody knows. My point wasn't to argue about what factors are raising and lowering the two ends of the curve. There are always such factors on both sides. But the economy doesn't play ceteris paribus; everything is interlinked in a manner far more complex than illustrated in textbooks, so the entire balance shifts when one factor shifts.
My point was that we're not necessarily still in the same economic regime in which the yield spread was a reliable leading indicator. So many metrics are at or beyond historical extremes, and so many policies are being tried for the first time, that one needs to question whether historical relationships remain valid.
In the not so distant past, long term yields were relatively free to move, and declining long-term yields reflected flight-to-safety behavior. Meanwhile, short-term yields reflected Fed policy which historically has lagged economic conditions. So a high short-term yield indicated an optimistic, tightening Fed (and a credit supply peak), and the low long-term yield indicated pessimistic investors. The yield-spread indicator "worked" in the past because the investors were right and anticipated Fed lowering of rates (easing of credit) when economic metrics went into decline.
In the current environment, neither end of the curve is free to move, so one cannot make the same sort of inferences as before.
Fortunately there are other tools one can use to make those inferences. In my opinion those worried about a recession are right to be very worried, but countering that deflationary environment we have the most inflationary monetary and fiscal policy ever seen in this country, so the outcome is still much in doubt. However, the high overall debt levels in the country are a negative for long-term growth prospects in general.
Posted by: Wisdom Seeker at October 3, 2012 12:45 PM
A weak dollar always brings disaster. Any study of the 1970s will show you the horrors of a weak dollar. Jimmie Carter was savaged because of weak dollar policies put in place by Richard Nixon.
Volker's strong dollar position stopped the rampant inflation of the 1970s but he over did it and created deflation that led to the 1981-2 recession. The most telling period of stable dollar success can be seen during the early Greenspan era leading to the prosperity of the 1990s.
When Greenspan then Bernanke began to destabilize the dollar in the late 1990s the economy began to decline. The Bush tax cuts helped some in the 2004-6 period but after that the massively weak currency simply wrecked the economy. The unstable dollar is still jerking the economy around. That is one of the main reasons we have such stagnation. Traders can't trust the unit of account from day to day.
Posted by: Ricardo at October 3, 2012 01:22 PM
Appreciate your comments. My reaction:
As to scratching 1-year changes, the question is what to replace them with? 1-month, 3-month, 6-month, some average of several? No one really knows what's the best mix is for monitoring/forecasting/analyzing the cycle, nor is it clear that any other mix always has an edge over any other time frame. I use 1-year (mostly) for several reasons, including a) it removes seasonal distortion; b) it provides some intuitive framework for measuring how the cycle evolves.
The inclusion of leading and non-leading indicators is intentional. Again, several reasons, including: a) leading indicators don't always live up to their reputation; and b) the coincident indicators provide a fair amount of information over 1-year changes.
Each of these indicators suffer less-than-stellar histories as signals for measuring the cycle. If we knew which ones would work best, we could simply focus on those. Of course, that's impossible.
Also, I'm less interested in the future than in clarifying the present or the recent past. That's worth a lot more than one might think. Looking 12 months into the future is close to hopeless if you want a high level of confidence in the outlook.
Finally, I recognize your point that more isn't always better. At some point, diminishing returns takes a toll. But I've chosen the indicators carefully, i.e., I'm looking for representative data from different corners of the economy. I might ad that the vintage data I'm able to find suggests that my index is relatively robust for indentifing, as early as possible, that a recession has recently started. The signal comes with a lag, but that's the nature of the beast. Again, I'm not trying to forecast per se; rather, merely trying to cut through the fog in the here and now. Clarity, to cut to the chase, is extremely rare in macro analysis re: the cycle in real time. I'm simply trying to enhance that clarity. Easier than it sounds, and far more valuable than most folks recognize.
Posted by: James PIcerno at October 3, 2012 04:54 PM
I was surprised no mention of the 1/1 tax/spending deadline looming? One of the added links makes the argument that a vote for Obama means no compromise because the House will be run by the GOP and that means a vote for Obama is a vote for recession. (It's the Washington Times, so I don't expect a lot of intelligence and they didn't disappoint.)
If you're a business and Congress is so dysfunctional, then it might be prudent to wait on large orders, particularly of durables.
Posted by: jonathan at October 3, 2012 06:32 PM
Sorry, but for the 1000000000th time. LONG TERM YIELDS ARE DOWN BECAUSE FLIGHT TO SAFTEY IS NUMERO UNO.
The FED wants a steepening yield curve....got it? Everything they say when it comes to interest rates is a lie. That is the point. It is amazing the media is to dumb to figure it out.
When the yield curve steepens, that is a good sign the economy is bouncing faster. Notice the Obama stimulus provided that for 12-18 months which was the point as the yield curve steepened.
Posted by: The Rage at October 3, 2012 08:17 PM
Wisdom Seeker: See the update I've added, documenting evidence on instability in the predictive equation, including lagged growth.
Posted by: Menzie Chinn at October 3, 2012 09:44 PM
Ricardo It is hard to know where to begin. Let’s start with the trade deficit. Moving it to surplus will do two things: raise GDP growth and halt the drain of our surplus abroad. This will not happen without a decline in the dollar. Period.
Arguing from the 1970s is myopic. The dollar had just been cut loose from gold after having been tethered to it for nearly all of US history since 1776. The 70s are a poor period to draw conclusions from, at least the conclusions you draw. In point of fact, the essence of the seventies is a preview of what happens to fiat money when it is untethered, that is, a preview of what’s coming.
Volcker did not create deflation. Disinflation yes, deflation not at all. Given the political context of those days – and context must always be taken into account when doing analysis – Volcker was correctly perceived by market participants at the time as doing exactly what needed to be done. He broke the back of inflation, and recession was the unavoidable byproduct. Just as there is going to be a byproduct of turning the budget deficit around in the period ahead. For one, you can’t even conceive of the abysmal growth rate of the coming decade. And if the deficit is not dealt with immediately, the consequences will be even worse in the out years than the abysmal already baked in the cake. Read Reinhart and Rogoff, and don’t stop there.
Greenspan and Bernanke were causal of one of the greatest economic crises in US history. The dollar did not decline in the 1990s. It did not decline until after 9/11, and that grand historic peak was not coincidental. The globe was awakened to the underlying weakness of the global superpower, and currency markets acted accordingly. Soon came 2008 and the near collapse of the global financial system. Flight to safety at that time and during the euro crisis today are all that are keeping the dollar from descending in value once again in line with the ineluctable downward trajectory which began in Feb 2002. The weak currency did no such thing as wreck the economy. You are not even in the ballpark. Read Minsky, Steve Keen, and cast your net wider from there if you really want to understand.
Traders don’t trust, they trade. How can you be so ill-informed frequenting this blog as you do? The dollar is not causing uncertainty. The ineptness of economic policy years prior to Obama, and the the even greater ineptness of the past 4 years, are the source causality. Belief systems preclude understanding what is going on. Here’s a litmus test. How accurate have your own forecasts of critical variables like GDP, gold, inflation, the dollar, bond yields, etc. been? Please excuse my directness. Thanks.
Posted by: JBH at October 4, 2012 10:11 AM
Picerno Let’s separate your issue into two parts. Part I. If your aim is to confirm the coincident movement of the economy, and in particular to confirm in hindsight after a couple short months that the economy has fallen into recession, then you would have one kind of composite. For this purpose, you have done a pretty good job. And further I commend you on your continual search for how to do it better. It is clear you are open to suggestions for improvement. In this case I would experiment with the data and find which percent change (3-mo, 1-yr, etc.) does the best job over time. Best job is maximizing true signals while minimizing false ones. As a sub-component of this, even the criteria you use to balance max true with min false is an art, and dependent on your objective. My instinct stands. The universe operates on the margin, and for the business cycle measured in monthly units, some span of months shorter than a year is going to give better results over time. The one-year change is too long and not at the margin. One-month is too short (unless a catastrophic plunge). So perhaps it is a 4-month change. No one ever does a 4-month change, but that does not mean you can’t. (Use all raw data already seasonally adjusted.)
Part II. I am reticent to mix coincident with leading. I want purity in my petri dish. That said, imagine two cases. Leading indicators going down for some months in advance, while your composite coincident indicator falls say 3% from its peak which you judge from history is a good signal that recession has begun. The other case is identical but for the fact that leading indicators are plateauing not falling. This must add probabilistic information of a Bayesian nature that would weaken your confidence in an already predetermined rule for calling recession with your coincident composite. Your imagination can take it from here. This is exactly how I make these calls, and though my approach is quite quantified, over the years I have never found a way to forecast that did not require judgment as well as numbers. There is a reason for this. The economy evolves and each historic moment brings a new constellation to the table. This is where the art comes in.
I wouldn’t use “hopeless” to describe looking 12 months out on the horizon. Difficult, perhaps. The difficulty is in calling the turning points of the cycle … not so much the lower turning point but the decline from the peak. Leading indicators are the only known way to do this. Economic models are very poor at this, though ARIMA has value because the notion of momentum is important in economics. For your stated objective which is accuracy in understanding coincident movement, I still believe you will benefit by being a student of leading indicators. Suppose you sliced the economy 7 different ways and then looked for an indicator for each. Very logical. But in practice this method doesn’t really pan out. I don’t know why not. A much better strategy is simply to find any indicators that work – whether leading or coincident – that will let you obtain your objective. Notice that the four components of the CB’s coincident index are economy-wide data series, as is the next candidate, GDP itself. The level of GDP has too much reporting lag for your purposes, though monthly indicators are timely enough if you want to say, yes, a recession began a month ago with high probability, or 2 months ago, or 3. Of course that is valuable as the NBER will announce an eon after you. You may want to work up a monthly GDP series, or use the two mentioned in the post. You need to become a student of revisions also, if you work mainly with coincident indicators. Also a wave of the future is tapping into Google search.
Financial variables are indispensable, but more as leaders than as coincident. And note that financial variables will not work with the same degree of accuracy or dependability today as they did prior to the peak of the credit cycle in 2007-8. Post-2008 is in important ways different than pre-2008, and we will never revert back. Historic context is vital. Also, do not be afraid to throw away data. The peak quarter of the cycle and the trough quarter are very different in terms of what’s going on beneath the surface. Ditto for all cycles not just the most recent. By treating the peak and trough quarters as equivalent – as OLS estimation knows not one from the other – you are actually contaminating your results. If you could tag expansion and peak quarters with one tag, and recession and trough quarters with another tag, you would in general find different results, including specific indicators that would rise to the surface as cream, and for those indicators that do pass your hurdle, different ways to weight and/or interpret them. A way around this is to realize that less is better than more sometimes because in the process of arriving at “less” you hopefully are discarding “contaminated” data. This of course is considered heresy. My belief is that not making this kind of classification prior to analysis is the real heresy. Here you are on virgin ground like Darwin, and following in his footsteps will put you ahead of many of your peers. Think about it this way: In what ways can I exploit the non-instantaneity of the economic process? All of this is grounded in scientific method not theoretical ideology. One more thing. I believe a confluence of things happening is an indicator in and of itself. I’m not here talking about a composite, but a deeper reasoned out confluence of this, that, and something else happening in some chronological order because that is the way the economy works. Press the brake petal and only later will there be friction between the vehicle and the road. A close cousin is the strange phenomenon that some grouping of indicators often performs better than the individual parts. As one or more indicators fail this time, other indicators as though by magic pick up the slack and fill in the holes so to speak. Your quest might be for sets of indicators that work well together, starting with pairs, then triplets, and so forth. This exploits the concept of emergence in a crude way. Higher level laws (patterns) come into being that were not evident at lower order levels because in fact they didn’t exist there. Read some Feynman (the physicist) on this.
Do your best indicators come to the edge of the cliff traveling at normal speed and then plunge straight off? Or do they tip their hand, slowing some months in advance of cliff’s edge? If the latter, then they have decelerated. So a derivative beneath the level of first differences something is already happening. This is information that can be exploited. Are you taking account of this by thinking of the second or third derivative as an entirely different variable? What patterns out there have you not yet discovered in those variables you already have in hand? Good luck!
Posted by: JBH at October 4, 2012 04:26 PM
I think you are looking in the wrong places for clues about the future. Ben's short-sighted policies are providing short run palliatives, but at the expense of some possibly dramatic adverse global consequences. Spain's troubles could be materially ameliorated by a 15% depreciation in its currency, which is about the current over-valuation of the euro caused by Ben's QE. If the results are as I expect, I suppose we can claim 'who coulda knowed,' just as we did for the housing bubble. The Fed was short of wisdom on that issue, too and (if I and Krugman-Wells have the story right) that episode had international roots as well.
Posted by: don at October 4, 2012 08:16 PM
But cost of health insurance will be arguably lower under ACA than the alternative. So...?So that statement assumes facts not in evidence.
2slugs will assure me that the problem is lack of demand not uncertainty.
The weakness of that argument is uncertainty can absolutely drive lack of demand. The example below shows this as the ACA that has been asserted to reduce costs has likely increased costs to the extent that it could easily bankrupt the business shown below.
The new health care law appears (the implementation is still hazy) to impose a $2000 penalty per employee for not having a corporate health care plan (all my employees are retired, so they already have health care plans, but that does not affect the penalty).
With a bit over 400 employees, that makes the penalty something north of $800,000 a year.
This is larger than my annual net income.
Posted by: Duracomm at October 7, 2012 07:17 AM
Comments as brief as possible.
Your views on the trade deficit are text book mercantilism, but not reality. A weak currency often does increase GDP but that is because of the flaw in GDP. A weak currency does not increase exports. It decreases both exports and imports but if it decreases imports more than exports it adds to GDP even though overall trade declines.
I don't know how old you are but I lived through the 1970s and they were a disaster. I would not wish that on anyone.
Volker did the right thing when Carter nominated him by ending the monetary pumping, but when Reagan was elected the Reagan supply side economists warned him very explicitly that if he continued his money supply targeting rather than watching what the price of gold was telling him about the value of money he would create a deflationary recession. They warned him that the Reagan tax cuts would increase business activity and the demand for money. The monetarists told Volker to keep watching the money supply because velocity was of no concern. But the recession of 1981-82 tells you who was right. BTW, the recession essentially ended when Volker left his money supply targeting to prop up the Mexican peso (the bank loans actually). He increased the money supply to the level being demanded by the economy and the 1980s are history.
The best indicator of the value of the currency is the price of gold. In 1988, Greenspan's first full year in office, gold averaged $437. That was still high historically. In 1994 the price of gold was $384. Over a 7 year period the price of gold dropped about 12% on the average $7 per year. From 1994 to 2000 the price fell to $279, in 6 years the price fell 27%. That was a huge decline. Greenspan was warned as early as 1995 by supply siders that he was allowing deflation but he ignored the warnings. By the time the economic pundits started recognizing deflation right before the turn of the century, the 2000 deflationary recession was alread baked into the cake. Then in a knee jerk reactino by the time Greenspan retired in 2006 he had pushed the price of gold up to $603 or 116% from 2000. As an aside, I believe that Greenspan knew what he was doing. He knew was going to retire and so he created an artificial boom with huge monetary expansion. He knew exactly the consequences of an artificial boom but he thought he could get out before the bust. When the crash came he would take credit for the boom and give speeches on why he was so brilliant. He was attempting to build his legacy on the backs of the American people. Ironically his scheme backfired and most give him as much blame for the bust as Bernanke.
Your statement on traders is absure. Traders do not trade in a vacuum. Traders will sit on the sidelines if they do not trust their trades. Now you may be playing some semantic game with the term "trader" but that in no way helps in any discussion. You say the dollar is not causing uncertainty, can you name one major company that does not have an entire department analyzing exchange rates and inflationary expectations? When we were on the gold standard the only companies who worried about the exchange value of the dollar were banks, gold traders and currency traders. Commercial businesses trusted the dollar to be as good the next day as the day of their trade. Not today. Exchange rate fluctuations have wiped out the entire profit from what appeared to be a cound trade.
Perhaps you have spent too much time on this site and not enough time considering alternatives.
Posted by: Ricardo at October 8, 2012 05:29 AM
I very well understand the economy, thank you. A lower (value) of the dollar will make imports more expensive producing a shift in US demand to import-competing firms here. Correspondingly, US exports will be more in demand abroad. This is not mercantilism by the US; but there is mercantilism on the part of China. Trade with China is not free trade. Not addressing China’s currency manipulation puts the US at an ongoing disadvantage, Ross Perot’s giant sucking sound.
I am hands-on familiar with the 82 episode. In my judgment the 82 recession was inevitable given the Volcker policy of monetary targeting (keeping the M1 money supply within the range of the M1 growth cones). Volcker operated with those cones as his guide so he could point to the market as moving interest rates and thus take the political heat off the Fed -- brilliant strategy that achieved the goal of breaking inflation. Of course there was a cost (the back to back recessions), and unintended consequences for the dollar. Eventually in the summer of 82 the Mexican debt problem entered into Volcker’s decisions, but by then inflation had fallen nearly 2/3rds from its 1980 peak and there was much more to the relaxation of policy than the currency issue. Of course Nixon’s severing of the dollar from gold in 71, and the Fed’s easy money reaction, were why later in 79 Volcker had to act.
I agree that over the long run the price of gold is the best store of liquid purchasing power. This is not the same, however, as the best indicator of the value of a currency. Suppose all nations grew their economies at the same rate, maintained balanced trade, had extremely high inflation with similar interest rate regimes, etc. Exchange rates would then remain essentially unchanged, and exchange rates are what you seem to be concerned about. Real world currency differentials between countries mask a more fundamental underlying relationship: the price of gold moves in direct proportion to the confidence in global fiat money. Volcker reduced the growth of fiat money. The price of gold fell. From 1994 to 2000, Greenspan ran a tight money policy and this took gold down further to a double-bottom ending in 2001. But there was no deflation in the general price level. Then from mid-2001 to the present, Greenspan and later Bernanke engineered easy money (but for the years 06 and 07). Yet core inflation is unchanged since 2001 whereas the price of gold has gone exponential. If gold goes exponential for a decade while inflation remains roughly constant – for whatever reason – gold is hardly a nuanced enough measure of inflation. However just as the surge in the price of gold from 71 to 80 foreshadowed the thing that turned out to be the severe 82 recession, so today the surge in the price of gold since 2001 is foreshadowing something. Fiat money inclusive of all financial instruments (credit, European sovereign debt, etc.) has gone ballistic around the globe. Ergo today’s price of gold. It foreshadows an impending crisis of fiat money of some magnitude.
“Traders can't trust the unit of account from day to day,” you say. To the contrary, traders want to see the currency unit of account fluctuate so they can trade it! Trust doesn’t enter into a trader’s equation; risk, return, and trading profits do. Different story entirely for the currency department of a multinational. Your argument over many postings, if I understand it, is that the US ought not to have gone off the gold standard. I’m in sympathy with that view myself. Unknown calamity lurks ahead -- this gold is saying.
Posted by: JBH at October 9, 2012 06:56 AM
A lower (value) of the dollar will make imports more expensive producing a shift in US demand to import-competing firms here. Correspondingly, US exports will be more in demand abroad.
This is the text book theory I was talking about. It mirrors the theory Bastiat and others refuted about 200 years ago. It also is not supported by data. It is simply theory.
Your comments on Volker are very close. Volker did the right thing to draw down the money supply but he continued it too long after the Reagan economic policies began recovery. Volker did not understand the relationship between the recovery and velocity. Even Milton Friedman at the end of his life said his major regret was that he didn't pay more attention to velocity.
I do not define inflation and deflation in terms of prices but in terms of monetary value. If asset values are falling, but prices remain the same there is not "inflation" as defined by price increases, but the currency is declining in value. The price of gold is your best indicator of currency value decline.
You are correct that currency traders do love fiat currencies so they can trade them. FOREX is simply an international casino that produces nothing. I distinguish between gambling and investing. In gambling someone always loses when another wins. In investing everyone can win because there is actual production of new goods or services in society. FOREX is gambling becasue if someone wins another must lose. It is simply betting on a numbers game where players pretend it is sophisticated economics. It is the monetarists and the Keynesians who provide the facade of academia to the FOREX illusion. I guess I have to admit that FOREX does create something; it creates unnecessary costs and losses, but it produces nothing.
Posted by: Ricardo at October 10, 2012 12:08 PM