These are humbling times for economists. The past four years of seismic events – a global pandemic, an inflation crisis and the end of near-zero interest rates – have unfolded in tough-to-predict ways. Central bankers have noted that higher borrowing costs are affecting the economy more slowly than they expected. Case in point: The United States is coming off a quarter of blistering annualized growth of 5.2 per cent, fuelled by spend-happy consumers.
As such, today’s economy is a minefield for prognosticators. Many tried-and-true recession indicators are flashing red, and have been doing so for many months, yet the Goldilocks scenario of a soft landing is in reach. To understand what’s going on, The Globe and Mail spoke with the people who created or maintain three of the most prominent indicators.
Here’s a deeper look at why those measures are struggling to explain the moment.
The inverted yield curve
The inverted yield curve is Wall Street’s most obsessed-over recession indicator, with a track record of foreshadowing every downturn since 1960 with no false signals. But since last year it’s been screaming downturn and no U.S. recession has come, leading some analysts to wonder if the metric is broken.
Not so fast, according to Duke University finance professor Campbell Harvey, the Canadian-born economist who pioneered it.
In simple terms, the yield curve shows how interest rates or yields on different maturities of government bonds compare. Yield is what bondholders are paid for their loyalty. Traditionally, the longer investors lock in, the more they expect to be compensated to account for risk and inflation. As such, when the economy is functioning well, rates on long-term bonds are higher than short-term bond rates.
Every so often, though, the relationship flips, or inverts, and short-term rates become higher. When that’s happened, recession has always followed. In the past four recessions (excluding the one brought on by COVID-19) the average lead time was 13 months from inversion to recession, but ranged between seven and 21 months.
Prof. Harvey was the first to discover the yield-curve dynamic, though the indicator’s Toronto roots are generally overlooked.
In 1982, he was a young master’s student at Toronto’s York University when he landed a summer placement at then Canadian mining giant Falconbridge Ltd. and his bosses tasked him with developing a model to forecast real U.S. economic growth. “They put a first-year intern with no background in mining or experience in charge of the single most important number for all of corporate planning,” he said.
Rather than try to emulate the forecasts put out by big-budget econometrics firms, with their squads of PhDs and complex models, he looked at what the bond market could say about future growth and began to notice the inverted yield-curve pattern.
Before he could present his findings about predicting future recessions, the recession that was already under way at the time caused Falconbridge to axe its whole corporate development team, including Prof. Harvey, to cut costs. He finished his research for his dissertation at the University of Chicago and the inverted yield curve was born.
In November, 2022, the yield on three-month U.S. Treasury bills rose higher than the yield on 10-year government bonds, and so the yield curve was said to have inverted. The curve between two-year bond and 10-year bond yields had inverted months earlier. But because that measure has sent false signals in the past, Prof. Harvey prefers his original model that uses three-month Treasuries.
Whatever the measure, yield-curve inversion was a big part of the recession angst that began last year. Yet this past January, Prof. Harvey was still in the camp that believed his indicator might be getting it wrong. That’s because of the strength of consumer balance sheets and the robust demand for labour as the pandemic has eased.
At the same time, the popularity of the inverted yield-curve indicator itself means it has begun influencing how companies behave. They are less likely to bet the firm on major investments after an inversion has occurred, and they may trim staff as a precaution. This has the potential to slow growth, but also means companies are less likely to find themselves in a crisis and forced to make large, painful job cuts later. These choices make a soft landing more likely.
“In the past, the yield curve was just reflecting what people thought was going to happen, but now the yield curve is a self-fulfilling prophecy,” he said.
When Prof. Harvey put all that together in January, he believed the inverted yield curve might register its first false prediction and the U.S. could skirt recession. But he warned that could all change if the U.S. Federal Reserve kept increasing rates.
Of course, the Fed did hike rates four more times in 2023 – misguidedly so, in Prof. Harvey’s view – and he now believes a recession, albeit a mild one, is coming. The consumer savings that powered the economy in 2023 are running out, delinquencies are mounting and job openings are vanishing, he said. Though it’s worth noting retail sales in November unexpectedly rose, providing more fuel to the notion of the resilient American consumer.
The indicator’s average lead time in past recessions of 13 months could mean a recession starts in the first quarter of next year, Prof. Harvey said.
“People sometimes say, ‘Don’t you want a recession so your model is nine out of nine?’” he said. “No one wants a recession and I’m okay with eight out of nine. But recessions are a natural phenomenon in our economy, so what we hope for is a minor recession.”
Conference Board leading economic index
Each month, the Conference Board in the U.S. updates its closely watched Leading Economic Index, and for 19 straight months the message it’s been sending is that the U.S. economy is recession bound.
But as with the inverted yield curve, many analysts are wondering if the LEI has lost its predictive ability. At the very least, it’s clear the weird confluence of economic forces brought on by the pandemic has messed with the compass.
The LEI is a composite of 10 data points that cover the job market, manufacturing, housing, financial markets and consumer expectations. Each has its own ability to indicate turning points in the economy, to varying degrees, but combining them makes the LEI more broadly accurate.
Over the past six decades, any time the LEI has fallen more than 4 per cent over a span of six months, a recession followed. After the index began to fall last year, the Conference Board noted that the LEI historically anticipates turning points in the business cycle by around seven months, and the initial call in the summer of 2022 was for a recession to begin around the end of that year, as higher borrowing costs sapped investment and spending.
Justyna Zabinska-LaMonica, the senior manager of business cycle indicators at the Conference Board, said what economists everywhere didn’t anticipate was the resilience of the American consumer.
“We’ve been adjusting our forecast considering the resilience we’ve been seeing, and we now see a relatively short-lived and shallow recession,” she said, noting that weakness in the LEI’s underlying components is not widespread.
Looking at each month’s LEI release, one subcomponent in particular stands out for its outsized declines and may explain part of the LEI’s misfire so far: consumer expectations for business conditions. It accounts for more than 40 per cent of the index’s decline. Yet consumer surveys as the pandemic has eased have generally painted a gloomy picture of the economy, even though shoppers kept right on spending.
To that point, Ms. Zabinska-LaMonica said the consumer resilience of the past year is not sustainable, citing the rollback in student loan forgiveness and the near depletion of pandemic-era savings.
But she said it can take a year or more for the National Bureau of Economic Research, the official arbiter of U.S. recession dates, to officially call the start of a downturn.
“It’s hard now to see if this is a false signal but that is a possibility, and if that happens, we’re definitely going to be transparent about it,” she said. “But I don’t think the LEI is telling us there’ll be a pseudo recession. We’re pretty convinced one is going to happen.”
The Sahm rule
The Sahm rule is arguably the recession indicator du jour. As the U.S. unemployment rate has drifted higher in recent months, economists and journalists have eyed this relatively new metric for signs that the world’s largest economy was succumbing to higher interest rates.
The appeal of the Sahm rule is its track record and its simplicity. Named for its creator, the American economist Claudia Sahm, it states the U.S. is in a recession when the unemployment rate (as measured by its three-month moving average) has risen at least 0.5 percentage points above its prior 12-month low. The rule was introduced in a 2019 book, and would have identified every recession since 1970 in the downturn’s early stages – often before policy makers knew the gravity of the situation.
As the Sahm rule has gained prominence, economists and journalists could be credibly accused of losing sight of its purpose. Dr. Sahm’s goal was to create a trigger for sending automatic payments to vulnerable households when economic conditions are souring – something that could minimize the damage from a downturn.
“Small increases in the unemployment rate are a bad sign,” Dr. Sahm said in an interview. “Once it gets going, it can create a spiral.”
As it stands, the Sahm rule is not pointing to a recession. The U.S. added nearly 200,000 jobs in November, which helped to stop an upward climb in the unemployment rate, which fell to 3.7 per cent from 3.9 per cent.
Still, the recent increase in the jobless rate – 0.3 percentage points, based on the Sahm rule’s formula – is within spitting distance of signalling a recession.
Even so, Dr. Sahm cautions that her eponymous rule is “not a law of nature. It’s just an empirical pattern that works in the United States.” Put another way, this economic cycle could prove the exception to the rule.
In recent months, people have joined the labour force at faster rates than companies can hire them, Dr. Sahm noted. The unemployment rate is climbing because of stronger labour participation (a good thing) rather than widespread layoffs (a bad thing). Furthermore, the Federal Reserve is projecting the U.S. unemployment rate will peak at 4.1 per cent, which is still remarkably low by historical standards.
The downside: The U.S. economy is clearly weakening. The Federal Reserve Bank of Atlanta projects annualized growth of gross domestic product of 1.2 per cent in the fourth quarter, a sharp deceleration from 5.2 per cent in the third quarter.
But nearly two years after the start of interest-rate hikes, the U.S. has managed to thwart an onslaught of recession predictions and draw closer to a soft landing. It’s a scenario that very few people envisioned.
“The dynamics in the economy have been so unusual,” Dr. Sahm said. “Any attempt at forecasting, or even telling a story based on the data, has to be taken with a mountain of salt.”
Jason Kirby
Matt Lundy