In a depression, recession calls are even harder to make

The flattening of the yield curve has generated heated discussions about a coming recession. Some like Bullard, for example, caution the FOMC´s appetite to raise rates. Others like Deutsche Bank, say yield curve flattening belies strong growth outlook for U.S:

“The risks of overheating and inflation are much higher than the risks of a recession. And the irony of this discussion is that the low level of long rates, and hence, the flatness of the curve, is increasing the probability of overheating even further.

Lower long-dated yields keep financial conditions loose, heightening the risk of an upsurge in growth, not a slump.”

These opposing views only confirm the idea that predicting recessions is a “fool´s game”.

Usually, it takes a long time, frequently more than one year, for the NBER, the official business cycle dater, to say a recession has occurred. It is useful, therefore, to have on hand a good lagging indicator of recessions since it may indicate a recession has begun sometime before, and ahead of the official NBER call.

One such indicator is the 6-month moving average of industrial production growth. As the chart indicates, for the past 100-years only once before it gave a false positive, a negative reading on industrial production growth that was not followed by a recession call.

The 1934 false positive signal reflected the N.I.R.A interventions. What does the more recent 2015/16 false positive signal reflect?

From looking at the chart below, which graphs industrial production around the 1990/91 and 2001 recessions and what transpired in 2014/18, it is hard to fathom why there was no recession call in 2015/16.

My conjecture is that in an already weak or depressed economy, a further weakening does not necessarily result in a recession.

The charts below depicting nominal spending (NGDP) growth illustrate. In both cases, NGDP growth falls to similar levels, but the drop is much higher in 2000/03 than in 2014/18. In addition, in both cases, industrial production goes back to the initial level when spending growth returns to the initial level.

Bottom line: In the depressed state the economy finds itself, a recession will only be called when nominal spending growth drops significantly, probably to negative levels. We have to hope the Fed does not repeat the mistake of 2008 (or 1937). If it doesn´t, the economy will continue to chug along the depressed path it has travelled since 2010, unless it changes the framework to NGDP Level targeting.


Leave a Reply