Worries about the economy continue to pile up

Two weeks ago, we wrote about the relative performance of the Inland Empire with respect to the state and national economy. While we started by talking about the fear of “stagflation” (stagnation coinciding with inflation), we stressed that the joint economy of Riverside and San Bernardino counties is outperforming California and the U.S. The Inland Empire has not seen unemployment rates fall to this unprecedented current level. A “red hot” economy comes to mind.

Here, we focus more on the national outlook and the possibility we are now in recession or will be in the next several months.

A quick rundown of the relevant facts: the U.S. unemployment rate is extremely low (3.6%) while the inflation rate is high by recent historical standards (8.6%) — it was only higher prior to December 1981. Real Gross Domestic Product (GDP), the most general measure of what is produced in this country, fell at an annualized rate of 1.5% during the first quarter of this year. We will not know the growth rate for the second quarter of 2022 until the end of July, but there are some worrisome estimates out there. For example, the “GDPNOW” model of the Federal Reserve Bank of Atlanta predicts a drop of -2.1%, with investment declines overpowering expected modest consumption increases.

Former Treasury Secretary Lawrence Summers has pointed out repeatedly that there has not been a single episode during post WWII expansions where the unemployment rate has been below 5% and the inflation rate above 4%, which was not followed by a recession. However, that forecast seems to be on the extreme side given the consensus Blue Chip forecast (some of the premier forecast institutions) still predicts positive growth of slightly less than +3%. UCLA’S Anderson Forecast, for example, sees growth of 3.1%. We must point out that while Summers is correct, his criteria have only been relevant in three of the 12 post-world War II recessions, generally at the end of long-lived expansions. Does a two-quarter decline in GDP mean the economy is in a recession? The popular press defines a recession as two quarters of negative GDP growth. However, that is not the correct definition. Instead, it is the Dating Committee of the National Bureau of Economic Research that identifies when expansions end and recessions commence. Their definition of a recession is based on a number of indicators, not just GDP, and the NBER establishes the specific month when an expansion reaches its peak and when a contraction reaches a trough, signaling the end of a recession. For example, the Great Recession started in December 2007 and ended in July 2009, but according to the two-quarter definition, the Great Recession would not have started until July 2008. Bottom line, do we believe the national economy is in recession or about to enter one? No, and here’s why.

Economic forecast models come in different forms. Some are based on relatively large econometric models with dozens of equations and variables, others are so-called “Index of Leading Economic Indicators” (ILE) such as the one from the Conference Board. Yet another approach is to estimate the probability of an incoming recession. Our forecast uses this approach.

Similar to the ILE method, we select variables that during the previous post World War II episodes turned south before the economy did. The model generates probabilities of being in the last year of an expansion, meaning that there will be a recession by June 2023. Given the economic variables contained in our forecast, there is almost no chance that there will be a recession within a year. Out of the six variables we use to generate this forecast, only one strongly hints at a recession, and that is the University of Michigan’s index of consumer sentiment.

The two most important (heavily weighted) variables are the interest rate spread between a 10-Year Government Bond and the 30-Day Treasury Bill, basically a difference between a long-term and a short-term interest rate.

When this relationship inverts, meaning the shortterm interest rate becomes higher than the long term one, watch out. But we are currently far from that happening.

The second most important variable is called the Sahm index, named after a former White House economist, Claudia Sahm. Here you compare the average national unemployment rate over the last three months (currently 3.6%) with the average unemployment rate over the last year (currently 4.5%). Until the three-month average exceeds the 12-month average, you should not worry too much. Even an increase of the unemployment rate by almost a percentage point would be required to ring alarm bells here. Even pessimists do not see an increase of this magnitude in the near future.

The remaining “leading indicators come from the housing market (housing starts over the last 12 months and housing stock exceeding a threshold of cumulative housing starts since the start of the last expansion in July 2009), and employment in manufacturing. These indicators are basically neutral for the moment.

Bottom line, despite the repeated claims that a recession is a foregone conclusion, we do not see a recession starting within the next year. Note that we do not dare to forecast beyond that, as we remind ourselves that the trajectory of the economy from early 2020 through today is not a typical economic cycle but rather an economic disruption caused by noneconomic forces in the form of the coronavirus pandemic.