The Economic Trend Usually Looks Positive When Recessions Start

Recognizing when a recession starts in real time is, for all practical purposes, impossible. The one exception to that rule is if you’re willing to endure a high number of false signals in your model. In that case, you’ll see lots of new recessions starting, but only a handful will be the genuine article. But if reliability with a low error rate is required — as it should be – the usual routine won’t suffice. Instead, you’ll need a methodology that focuses on a broad set of key indicators. No less critical is how you define the analysis of the dataset. An optimal set of indicators won’t mean much if you’re running the analysis with a shaky modeling framework.

Consider the so-called Big Four Indicators – payrolls, personal income, industrial production, and consumer spending. This quartet has been identified by some analysts as the foundation of the US economy. If you had to choose just four indicators, the Big Four set is arguably at the top of the list. There’s no reason why you should limit analysis to just four datasets – in fact, there’s a compelling case to go deeper and wider. But given the popularity of using the Big Four as a rough proxy of economic activity, it’s important to point out that it’s easy to develop a false sense of security by looking at levels rather than rates of change – year-over-year change in particular.

The danger is that looking for recession risk in real time via levels rather than rates of changes is destined for failure. Why? Two reasons. First, it’s hard to model trend changes with levels, which move too slowly to reveal timely warnings. This is an even bigger challenge when you consider that reliable recession-risk warnings will arrive after a new downturn has started.

As an example, consider how the Big Four stack up at the moment, with data through May 2017. As the chart below shows, all looks well. The trends are healthy with all four indicators showing upside bias. But looking for recession risk through this lens — via levels — is problematic since history tells us that the trends are apt to remain positive through the early months of a downturn. In other words, a chart such as the one below has little value for business-cycle analysis, at least if you’re trying to decide — with a high degree of confidence before it’s obvious to the world — that a new recession is underway.

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Author: Travis Esquivel

Travis Esquivel is an engineer, passionate soccer player and full-time dad. He enjoys writing about innovation and technology from time to time.

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