Recession chatter is on the rise… again. And for an obvious reason: there are fresh signs of weakness in several key indicators. But there's also ample evidence of strength, at least for the moment. How can we separate the signal from the noise? Carefully, methodically, and with a healthy dose of skepticism when we're told that a single number marks the tipping point. Let's dig slightly deeper into these guidelines via a summary of best practices for analyzing the mother of all known risk factors.
- Refrain from cherry-picking the data points. There's a habit of focusing on the latest update and drawing conclusions, for good or ill, about the broad macro trend. This is a great idea if you're trying to write a punchy headline or if you're a talking head with a particular agenda to promote. But it's a terrible idea if the goal is developing robust and relatively reliable real-time business-cycle analytics. In short, monitor the big picture based on a diversified set of indicators, or at least look to someone who crunches the numbers in a responsible manner.
- Don't rely on one methodology. There are as many ways to monitor and quantify recession risk as there are stars in the sky (or Republicans running for President). Much of what's labeled as recession risk analysis is worthless, but a handful of techniques are useful. But nothing's perfect. Business-cycle index A can stumble at times, which is why it's prudent to look for confirmation in Business-cycle indexes B and C. This would be a problem if you had to build and maintain benchmarks from scratch. Fortunately, there are several resources available, including regular updates from two regional Fed banks - the ADS Index and the National Activity Index. You can also find a transparent approach to recession-risk analysis here at The Capital Spectator, including last week's update.
- Recognize the tradeoff between reliability and timeliness. This is an iron law that no one can sidestep when estimating recession risk. Adjust your expectations accordingly. If you're looking for high-confidence estimates of the macro trend, the price tag is longer lag times. Alternatively, we can move closer to genuine real-time signals but at a cost of lower reliability. Finding the sweet spot that balances the two facets is the art of customizing the analysis to match your particular objectives when it comes to developing informed macro insight.
- Assume that every recession is different. This is an obvious point, or at least it should be, but it's easily overlooked. The danger here is that we may be led astray by analyzing previous downturns and assuming that the past is prologue. That's true, but only in part, with wide variation at any given point in time. History certainly offers valuable lessons, but it's never clear how the infinitely complex interactions of a national economy will unfold-especially one that's as big as the US economy. The 1973-74 recession in the US, to cite an extreme example, was largely triggered by a one-time event: an energy shock via the Opec-engineered oil embargo. The catalysts that lead to recessions aren't usually so stark, but every downturn unfolds for different reasons. Or to be precise: every recession is the byproduct of a series of events. The tell-tale signs are often similar, but not always. In short, don't assume that history is a crystal-clear roadmap for divining the next downturn.
- Favor econometric analytics. There's no substitute for relatively objective analytics that draws on a spectrum of data sets. But such efforts are in short supply. Meantime, there's always a sea of stories and narratives swirling about. That's a problem because we're all vulnerable to a variety of behavioral biases. The first line of defense: focus on broad measures of the trend. In addition, beware of seers dispensing advice about recession risk with little if any reliance on a transparent methodology that's grounded in a spectrum of indicators. Some folks are masters at spinning a good yarn as opposed to crunching the numbers and reporting on the trend. Keep that in mind when consuming the standard fare of news and commentary.