If you just extrapolate the dynamics of past economic expansions, you’d say that a recession within the next few years is quite possible but by no means certain. The question is how much weight you want to attach to some of the other factors.
Barry Ritholtz of the Big Picture had a comment last week that caught my eye:
A possible recession in the 2006-07 time frame is hardly a stretch. Consider the past few contractions, and then fill in the blank: 1990, 1994, 2000, ______.
Barry clarified that although 1994 was not a recession, he included it because it was a bad year for the stock market.
The idea that recessions occur at regular intervals has long intrigued economists. I described a couple of ways one might look for evidence of periodicity in a paper that just came out in the Federal Reserve Bank of St. Louis Review. One approach uses spectral analysis, which basically tries to decompose the value of a variable like the unemployment rate at date t into a series of sine and cosine functions that are undulating up and down at different frequencies. If there was a specific periodicity to the business cycle– for example, if recessions usually arrive approximately every 5 years– then we’d expect to see strong weights in that decomposition attached to cycles that had a 5-year periodicity. In fact, when you estimate the spectrum for a series like the U.S. unemployment rate, you don’t find any extra weight on what would logically correspond to a business cycle periodicity.
| Start of contraction | End of contraction | Length of contraction | Length of expansion |
|---|---|---|---|
| November 1948(IV) | October 1949(IV) | 11 | 37 |
| July 1953(II) | May 1954(II) | 10 | 45 |
| August 1957(III) | April 1958(II) | 8 | 39 |
| April 1960(II) | February 1961(I) | 10 | 24 |
| December 1969(IV) | November 1970(IV) | 11 | 106 |
| November 1973(IV) | March 1975(I) | 16 | 36 |
| January 1980(I) | July 1980(III) | 6 | 58 |
| July 1981(III) | November 1982(IV) | 16 | 12 |
| July 1990(III) | March 1991(I) | 8 | 92 |
| March 2001(I) | November 2001(IV) | 8 | 120 |
Another thing you can do is try to estimate an equation summarizing the dynamics of a variable like the unemployment rate, and then examine that equation to see whether it implies any periodic or cyclic behavior in response to a shock. Again, when you estimate such a relation, you don’t find those cyclical dynamics.
The table at the right summarizes the dates at which U.S. recessions began and ended according to the National Bureau of Economic Research, along with the duration in months of the contraction and preceding expansion. One can perhaps see why the statistical methods described above fail to find much evidence of periodicity. U.S. recessions have sometimes come as close together as one year or as far apart as ten years.
Another question that has been investigated in academic studies is the following. Suppose that the economy has already been in an expansion (or a contraction) for n quarters. What is the probability of remaining in expansion (or contraction) in quarter n+1? If that probability turns out to depend on n, economists refer to that as “duration dependence.”
One of the first papers to study duration dependence was by Federal Reserve researcher Dan Sichel, published in the Review of Economics and Statistics in 1991. Sichel found evidence of duration dependence in the contractions since World War II– the longer a contraction has been continuing, the more likely we are to see the economy recover from it next quarter. This might be interpreted as evidence that the economy has natural mechanisms to get itself out of recession, or that Federal Reserve responses to recessions tend to be effective. On the other hand, Sichel found no evidence of duration dependence for expansions– it seems that no matter how long an expansion has been proceeding, that doesn’t change the probability of seeing a downturn soon.
Subsequent analyses with more data by
Chang-Jin Kim and Charles Nelson of the University of Washington in the Review of Economics and Statistics in 1998 and Thomas Zuehlke in the
Journal of Business and Economic Statistics in 2003 found some indication of duration dependence in expansions, though any such effect is very subtle if the economy is less than 5 years into an expansion.
To get one gauge on Ritholtz’s prediction of a recession sometime in 2006-2007, suppose you just picked a quarter at random between 1947:II and 2002:IV, and made a prediction that some time between the next 3 to 11 quarters the U.S. would experience a recession. If you made such a prediction out of the blue, historically you would have been right 48% of the time, simply by virtue of the fact that recessions occur fairly frequently and two years is a significant chunk of time.
At this point the U.S. has been in an expansion for 14 consecutive quarters. There are 70 quarters over the last half century for which the economy had been in an expansion for at least that long. If you again picked one of these completely at random, and predicted that the U.S. would be in a recession some time between the next 3 to 11 quarters, you would have been right 54% of the time, a manifestation of the very slight duration dependence mentioned above.
Of course, Ritholtz bases his prediction of a recession in 2006-2007 on more than just the regularity of business downturns. One factor is the ever-rising price of oil, which has often been a precursor of economic recessions. A second is the narrowing spread between the yields on short- and long-term securities, another common warning that a recession may be coming, as both Barry and I have emphasized. And a third is the unstable situation in the real estate market, particularly in conjunction with statements like the one made yesterday by Michael Moskow, president of the Federal Reserve Bank of Chicago:
If we do not remove that accommodation, or raise rates, then you risk significantly higher inflation in the economy.
Berkeley researchers Christina and David Romer came up with a particular set of historical episodes in which the U.S. Federal Reserve intentionally adopted a contractionary monetary policy. A large number of academic studies have used these Romer and Romer dates because they seem to have strong predictive power for whether the U.S. experienced a recession. What is sometimes forgotten is that the way that an episode came to be included in the Romer and Romer dates was when Fed officials made exactly the kinds of statements like the one quoted from Moskow above.
Now, one can always argue that this time things are different. For example, the oil shocks may be different this time because they have been caused by demand growth rather than supply reductions, so they will not be as economically harmful. Or the flattening yield curve may have a different connotation this time because it is the result of foreign purchases of long-term U.S. securities. And the Fed contraction may be different this time because– somebody help me out with that one, I’m stumped for the moment.
Maybe Barry’s prediction of a recession in 2006 or 2007 isn’t so reckless.
I’ll try: “The Fed contraction may be different this time because rates are still accommodative.” With the median CPI at about 2.3%, the real FED Funds rate is still only 1.2% … well below the usual real rates that preceded recessions.
Very interesting. Best Wishes.
If the Fed stops now, then I agree with you, CR. But it doesn’t look as if the Fed is anywhere near stopping, and that’s my concern.
You rhetorically ask whether the purchases of long term US securities is a factor making things “different this time”. Maybe we won’t have to consider that question if they have begun to avoid such purchases: “Should we be concerned that central bankers were again net sellers of treasuries?”: http://guambatstew.blogspot.com/2005/08/for-every-day-turn-turn-turn.html. I’m not an economist and truly would like an educated guess.
Thanks for your consideration. John Thos. Brown aka Guambat Stew http://guambatstew.blogspot.com/
And with oil prices continuing to go through the roof and increasingling starting to filter through to the inflation rate, the Fed is not going to be able to stop without risking inflation getting out of hand.
Stuart: “oil prices … increasingl[y] starting to filter through to the inflation rate”
Have you looked at the last 4 CPI reports? I agree that the danger of such filtering increases as oil prices continue to rise, but so far there is no hard evidence of any filter-through. That points to exactly what is different this time, compared to other oil shocks: the others hit at times when the economy was already tight; this time the economy (particularly the labor market) has been fairly soft to begin with, so firms couldn’t manage to pass on price increases. Ironically, it is just because the economy was soft that we may be able to avoid a recession this time. When I read statements like Moskow’s, though, I’m not so sure.
If 1994 gets included because it was a bad year for the stock market, don’t we also have to include 2002?
Interesting analysis, JDH. To paraphrase, in a recession, policymakers (the Fed and sometimes the legislative and executive branches) work overtime to get us out, hence the duration dependence. In an expansion, momentum carries the economy forward, hence mimimal duration dependence. Exogenous shocks cause recessions, such as oil supply interruptions, Fed policy mistakes, or maybe financial contagion (resulting from bursting bubbles in either the financial markets or the real economy — telecom /internet boom/bust ca 2000; residential real estate now?), are what sets off recessions. The timing of and magnitude of exogenous shocks are unpredicable, so early warning systems are tough to design.
Without reliable objective ‘early warning systems’, Greenspan relies instead on a more intuitive ‘risk management approach” to monetary policy as described in today’s WSJ, p A2 (sorry, haven’t learned how to do URL links yet), where he directs policy to avoid the risk “most likely to create significant damage”. If he’s right, kudos, if he’s wrong, we’re toast. He’s currently focused on removing excess stimulus from the last reflation, and based on the the still low level of real rates observers such as Calculated Risk (and me) think the Fed is not done. You fear in contrast that the risk of a fed policy mistake is rising given a) the large cumulative increase in nominal rates to date b) the potential unwinding of a residential real estate bubble and c) increased odds of an oil supply shock given rising demand. To that I might add the increased risk of a fed policy mistake given our dependence on the intuition of the chairman, and the fact that we will have a newbie in six months. How’s that for a summary?
It would sure be nice to have a more objective approach to recession odds, given the odds of independent (or jointly occuring) exogenous shocks. Perhaps you should skip the fall semester and come up with this! 🙂
A few reasons to be concerned. 1.With oil at $67 plus consumers will feel the pinch. $3 a gallon makes the average 30 mile trip to work and back expensive.(8% of a $40,000 a year average income.)When oil doubles in value on a year to year basis the stock market turns into bear.
2.A real eatate glut approaching from over expansion. (Example: 10 year supply of condos in Florida alone) National ownership at saturation levels 69%, speculation at record levels 25%. 3.Soft employment. 4. Rising interest rates. If the stock market and the real eatate market turn at the same time look out 2006 could be scary remember Japan in the 90’s.
Tom Leeman
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It would sure be nice to have a more objective approach to recession odds, given the odds of independent (or jointly occuring) exogenous shocks. Perhaps you should skip the fall semester and come up with this! 🙂
::::
What does ‘objective’ mean in this context? The most objective approach to recession odds, to my mind, is just looking at the history of th US economy and seeing how often a recession occurs and how often an expansion occurs — a kind of ‘unconditional’ probability.
But we don’t want that here; we want to use the present information about where we’re at now to help us figure out where we are going tomorrow — a kind of ‘conditional’ probability.
In so far as the economy is not a controlled environment and reasonably contains more variables than we possibly can program into a computer, the search for a ‘conditional’ probability statement is going to rest on some theory (for it to be defensible) and thus on some intuition (that helps fuel the idea that put together with deductions becomes the theory). This is likely what Greenspan does. Is this not ‘objective’ because of the ‘conditional’ nature of the prediction, or because we think Greenspan might not have a formal ‘conditional’ framework that he could hand the new chairman?
professor:
http://www.raisethehammer.org/index.asp?id=133
i recently encountered this article regarding the creation of the Iranian Bourse in March 2006 – a trading clearing house for euro denominated oil.
can you open up a discussion on what this means to the US economy, to the oil futures prices on the NYMEX, on the IPE (all of which trade in US denominated oil futures).
Knzn:
I agree completely – excess capacity first has to be removed before sectors have pricing power and can pass their increased costs onto their customers. I was listening to this NPR piece in the car last night, which suggested that point was being reached for the trucking industry (but not yet
for farmers).
Stuart.
Oops sorry – I guess this blog software doesn’t let me include anchors in my comments. The NPR story is:
http://www.npr.org/templates/story/story.php?storyId=4815943
From sp, “Is this not ‘objective’ because of the ‘conditional’ nature of the prediction, or because we think Greenspan might not have a formal ‘conditional’ framework that he could hand the new chairman?”
Great question. It might be that that underlying reality is is too difficut to model objectively. But it also the case that the markets apparently do not perceive that Greenspan has a cookbook that he can pass on to his successor.
Fortunately, greater minds than mine are considering this issue at this very moment. Per the referenced WSJ Online article (might be subsription only, sorry) Alan Blinder thinks that while Greenspan was the “greatest central banker who ever lived.”, he presided over “the extreme personalization of monetary policy”. As a result, “The coming replacement of Alan Greenspan by a mere mortal in January 2006 will not … be like changing dentists,” and “It may in fact prove to be a traumatic experience for the markets. We will soon learn whether the Greenspan era has created a deep reservoir of faith in the Federal Reserve, or just in Alan Greenspan.”
Presuming that the markets agree with both with Blinder’s assessment of Greenspan’s record (and I know that this view is hotly disputed in some quarters), and with the low odds of finding someone equal or better in terms of skill set, and given our current dependence of the skillfullness of the chairman in the current monetary policy regime, my point is that a changing of the guard will probably be considered by the markets as another source of increased odds of a monetary policy mistake.
Sorry, my reference was dropped, It is: http://online.wsj.com/article/0,,SB112506733853924183,00.html?mod=home_whats_news_us
On the other hand there is a body of thought that the stability of the economy has improved.
Just to look at the stock market. Prior to WW II stocks were in a bear market almost 50% of the time. By 1960 this had fallen to out 25%
and this lasted until the 1990s. But from 1980 to 2000 stocks were in a bear market only about 12% of the time. Moreover, something similiar has happened to the economy with the US only having two minor recessions over the last 20 years.
I will not go into the reasons usually advanced, but it does imply that this change
should be kept in mind
spencer, you hit the right button.Since 1983, the economy has been 50% less volatile than in the 30 preceding years. Just check when the Dow started climbing (mid 1982) after having fluctuated (sometimes wildly) around 850 points for the previous 17 years, just when inflation started taking off.
The link here
http://www.nytimes.com/2005/08/27/business/27greenspan.html
says that Greenspan isn’t so keen on the idea of a permenant reduction in volatility.
Not being an economist, I look for more “close to home” signs for for economic barometers. This morning I got a good one. I live in West Houston (TX), out in the exurbs surrounded by neighbors who all drive very large SUV’s (all with W’04 stickers in the windows). While walking my dog, I started talking to one of my neighbors. He was test driving a 2003 Acura coupe. I asked why. He said the weekly gas burden on his Suburban was getting to be too much. He was hoping to cut his gas costs from $320/month to $160 per month.
This is the first tangible sign that I have seen, other than people bitching, that the recent runup in gas prices is taking a toll on the economy. Sounds like bad news for car companies who have bet big on large SUV’s and Trucks (GM, Ford). Also, I expect the value of 2nd hand SUV’s to depreciate in value as more and more come into the used car market.
Housing is the single largest component in the reported CPI calculation provided each month by the BLS. (42+%, in contrast energy specifically only accounts for 7% of the overall CPI). Breakout the housing component and the single largest component input is Owners Equivalent Rent (OER) at 23.4% of the 42+% total reported . So, when the CPI calculation is being made, 23.4% of the entire CPI number is picking up the “housing cost inflation” experience of only 31% of the total US population (as of year end 2004, the actual homeownership rate in the US stood at 69.2%).. The housing cost inflation experience of the other 69% is largely being ignored.
CPI? With a grain of salt.
“Since 1983, the economy has been 50% less volatile than in the 30 preceding years.”
oddly coincidental that this coincides with a timeframe of very cheap oil (after 85 anyway).
eh, maybe its not odd and i’m just a novice…
Professor,
The WSJ reports today that 1-2 million people have become regufees from the Gulf Coast, and that 4 million or so people live in the severely affected counties in LA, MS, and AL. If we are talking recession: how much of the nation’s labor force has been idled? And given that New Orleans is the nation’s largest port by tonnage, how much economic activity has been taken offline, when we add the effects of idling of the region’s labor force to those of shutting the port? How close does this temporary subtraction of economic activity, take us to recession before we even get to calculating the effect of energy price increases on consumer budget constraints? Does there exist a useful interregional input output table that could give us some clues?
How badly is the Gulf oil infrastructure damaged?
And how much of a hit will the US economy take as a result of that damage? Watching CNN last night and reading various press accounts of the hurricane aftermath, we’ve noticed that little of the coverage has dealt with…