August 5, 2022
Last week we got the Q2 GDP numbers and the Bureau of Economic Analysis (BEA) confirmed that GDP has now declined for two consecutive quarters. What do I make of that? Are we in a recession now? Since several people asked me to comment on this issue, here are my thoughts…
In the United States, we use two different competing definitions of a recession:
- We’re in a recession if an independent panel of famous economics professors associated with the National Bureau of Economic Research (NBER) decides so.
- We’re in a recession if we experience two consecutive quarters of GDP declines.
Both definitions have their pros and cons. In academic circles, you’ll find more support for the first one. In Wall Street circles, most people follow the second one. And in political circles, people follow the definition that best suits their current needs, i.e., Democrats currently point out that because the NBER hasn’t called a recession, we can’t possibly be in a recession right now (false, because economic turning points are always backdated), while Republicans insist that the second definition is the only one we’ve ever used (also false).
The advantage of the 2-quarter negative growth definition is that you avoid the long delays when confirming the business cycle turning points. The first GDP estimates come out about four weeks after the end of the quarter (though they’d be subject to further revision). The simple two-quarter GDP definition is thus more useful for practitioners, i.e., folks on Wall Street. Academics, on the other hand, can be more “academic”; they can afford to wait a year or two to guarantee certainty about the business cycle turning points. As someone who’s worked in both academic and Wall Street circles, I can tell you that clocks run a bit slower in academia. I once submitted a paper to a journal in 2001 and it was published in 2006. Wall Street wants to move a bit quicker than that!
Waiting for the NBER to make their decision can be frustrating. Take, for example, the 2001 recession. The NBER didn’t announce the March 2001 recession start until November 2001. The timing is ironic because that month turned out to be the end of the recession. That’s like a pregnancy test where the result is available after the baby is born. And the November 2001 end of the recession wasn’t confirmed by the NBER until 2003. So, anyone who argued in the Summer of 2001 that there is no recession because the NBER hadn’t announced one yet, was wrong!
The 2001 recession was special in another way: That recession didn’t even satisfy the second criterion. In 2001, the first and third quarter GDP growth was negative, but the second quarter GDP number was ever so slightly positive. The same pattern, negative-positive-negative growth quarters, also occurred during the 1960-1961 recession. Also notice that the pandemic recession spanned only two months: March and April 2020. Just by dumb luck, the 2020 recession spanned two quarters and indeed produced the “magical” two consecutive quarters. Had the 2020 recession occurred just one month earlier or one month later, then the two recession months would have fallen into the same quarter. And we would have observed only one quarter of negative GDP growth, again falling short of the two consecutive quarters of decline criterion.
So, the two-consecutive quarters of negative GDP growth is certainly not a necessary condition for the NBER to eventually declare a recession. But is the second criterion a sufficient condition for the NBER to declare a recession? At least in recent history, there hasn’t been any 2-quarter contraction outside of an NBER recession.
In the rest of the post, let me try to look for indicators to support the two sides of the “recession or not” argument:
The case against a recession
First, for a recession, the labor market is still too strong. Normally, we see an increase in the unemployment rate and a decline in payroll employment. This morning (August 5, 2022) we just got another Nonfarm Payroll Employment release from the Bureau of Labor Statistics (BLS), and payrolls grew by another strong rate of 528,000 in the month of July. The unemployment rate dropped another notch to 3.5%.
In fact, before the slower-moving monthly numbers display signs of weakness, we normally observe a marked uptick in the weekly unemployment claims, which regular readers of my blog will remember is my preferred labor market business cycle indicator. Sure, there is a bit of an increase, but neither the level nor the slope of the unemployment claims is screaming “recession” right now.
Second, some of the other indicators the NBER will closely watch are not looking too shabby either. Industrial Production expanded during the first five months of the year. True, in June we saw a slight decrease but this is a volatile series and we don’t normally call a recession every time this indicator sees a small month-over-month decline. But watch this series going forward. Economic weakness normally shows up in IP before you see a payroll drop. So another 1 or 2 months of IP decline would certainly set off my recession alarm bells!
Real Personal Income also still looks solid. The usual disclaimer applies, that there are many households still hurting from the pandemic and/or inflation, but the macro picture – aggregating over all households – still looks solid, which bodes well for consumption going forward.
My preferred manufacturing indicator is the Purchasing Managers Index (PMI), both the headline index and the “New Orders” component. Both indicators have indeed declined recently but they still look too strong for an outright recession. The headline (overall) PMI index stands at 53 in July, still solidly in the expanding region (above 50). The slightly more leading New Orders subcomponent indeed slipped below 50, indicating a slight contraction in business activity. But we’d occasionally see levels slightly below 50 even during economic expansions. I’d get worried if we fall below 45.
Also notice that financial markets have been holding up. True, the S&P 500 index dropped by more than 20% between January 3 and June 16 this year but has recovered about half of the loss since. We’re now only about 13% below the all-time-high (8/4/2022 S&P 500 close). And just to be sure, this doesn’t mean that we’re in a new Bull Market again. See my 2020 post about this topic!
Also, a reliable financial stress indicator is the interest rate spread that corporations must pay over and above safe government bonds. The OAS (option-adjusted spread) of High-Yield bonds spiked a little bit in June this year but has moderated again. What’s more, even that spike was nowhere near what we’ve observed in other recessions (2001, 2008-9, 2020). That little blip on the screen didn’t even come close to some of the other false alarms (1998 LTCM, 2011 downgrade, 2016 Fed scare) that never even came close to a full-blown recession.
But all that said, not everything looks rosy either. Next, let me make the pessimistic case…
The case for a recession
Most prominently, the yield curve recently inverted again. As you remember from previous blog posts, this indicator is on the top of my list as one of the most reliable early warning signs of a slowdown. What makes me worried about the current yield curve today is that the 10-2 yield curve slope didn’t just dip below zero by a few basis points but by a full 37 basis points (August 3, 2022). The bond market tells us that after the Fed slashes the inflation dragon, it must subsequently lower interest rates again (and aggressively!) to deal with the ensuing recession. The 10-year yield has dropped from 3.49% (June 14) to now well under 3%. That’s not a good sign. I always say that the smartest people on Wall Street are the Fixed Income Folks. They seem to know something that the rest of us didn’t figure out yet!
Another concern: Can the Fed really accomplish its goal of reducing inflation with modest interest rate hikes? Maybe not. Thus, complacency about rate hikes is another risk factor. If you remember, the Federal Reserve rate hike forecast published in June stood at 3.4% and 3.8% by the end of 2022 and 2023, respectively (and then 2.5% long-term, which I interpret at December 2026 in the chart below). Since then, interest rate forecasts have come down from even these modest levels. Fed Funds Futures markets now stand at 3.0% for December 2023 ( as of 8/3/2022).
What’s the reason for everyone predicting that the Fed will take it easy with the rate hikes? There is mounting evidence that the July CPI numbers, to be published in mid-August will see a marked decline. But is that one-time decline enough for inflation pressures to miraculously reverse? Even if the Y/Y CPI reading drops from 9.1% to 8% or even 7%, that’s still unsustainably high. For as long as inflation is elevated, it’s much more likely that the FOMC will keep raising rates. At 50-75bps every meeting we’ll easily get well above the levels currently predicted by the interest rate forecasts.
As I wrote in my post a while ago, people at the Fed will probably breathe a sigh of relief if we entered a mild recession that will ease the price pressures sooner rather than later. That’s preferable to the Fed going into Paul-Volcker mode necessitating a positive real(!) Fed Funds rate, which would currently imply a nominal policy rate of, say, 12.1% if targeting a 3% real rate. That would do a trick on the economy!
Another issue that’s not fully appreciated is that the labor market, despite recent gains, is still massively underwater from the pandemic shock. In other words, people pointing to the healthy labor market say that the trajectory is fine. But the level is still severely depressed. More than two years into the economic recovery, nonfarm payrolls just passed their February 2020 peak. If we were to apply a 125,000 monthly trend job growth rate to keep up with population growth, after 2.5 years we’re still 3.75 million jobs underwater, relative to the trend growth path extrapolated forward from the February 2020 peak. So, maybe this could be the first recession where employment doesn’t drop or doesn’t drop much because employment never really recovered from the previous recession.
So, what’s my verdict? I’m more aligned with the NBER economists: It’s too early to tell. The economy doesn’t display the typical recession pattern yet, but not all is well in the macroeconomy. In other words, we appear to be in that limbo state where the economy certainly shows signs of weakening, but it’s too early to call an outright recession. Think of today’s economy as in the same condition as the stock market in the Spring of 2022. It was already down, but not enough to call it a bear market. It could have recovered again and it would have been a false alarm. But when the market finally hit the -20% mark, the Bear Market was called and its starting point was then backdated(!) to January 4, the day after the all-time high on January 3. So, people who point out that the NBER hasn’t declared an economic turning point yet shouldn’t pounce too aggressively on the crowd following that “naïve” 2-quarter negative GDP criterion. That criterion might turn out to be correct again, we just don’t know it yet!