Why There Isn't A 100% Chance Of A Recession In The United States

by: Thomas L. Bruce

Okay, so that title has a couple of logical fallacies, but this is in response to a article titled USA Recession Odds: 100%? by Cullen Roche. In the article there is a chart that compares a "U.S. Recession Probabilities" indicator with actual recessions and it looks strikingly accurate. Roche writes:

What's interesting about this index is the current reading. At 20%, the index is at a level that has ALWAYS been followed by a recession.

I went to FRED and sure enough, here is the chart:

At first glance, this chart appears to be strikingly accurate and has gained quite a bit of attention in the past week, but after taking a closer look there are some pretty conspicuous reasons why we shouldn't race to the bank and withdraw all our savings just yet.

First off, among other points he makes, Jeff Miller's Seeking Alpha article Debunking The 100% Recession Chart shows that the 20% figure seems to have been picked arbitrarily. Miller points out the original research mentions 80% as the threshold:

The authors recommended waiting until a reading of 80% was reached for three consecutive months to avoid excessive false positives. (P. 9 of the paper).

Secondly, even if the 20% threshold were solid rule I still wouldn't have much reason to believe we're going into a recession. While I hesitate to say this time is different, it is. I applaud Dr. Piger for creating this model, but I feel like there is a missing component. FRED describes Piger's U.S. Recession Probability series as follows:

This recession probabilities series from University of Oregon economist Jeremy Piger is a monthly measure of the probability of recession in the United States obtained from a dynamic-factor Markov-switching model applied to 4 monthly coincident variables: non-farm payroll employment, the index of industrial production, real personal income excluding transfer payments, and real manufacturing and trade sales.

I'm in no position to dispute the accuracy of this model, but I must point out it doesn't directly take into account monetary policy... Please consider the following chart:

As you can see in the above chart, I've overlayed the U.S. Recession Probabilities Series with the Effective Federal Funds Rate. Since 1967, just prior to entering into a recession the fed funds rate has always been greater than 5%, but as of August 2012 (the time of the latest data point for U.S. Recession Probabilities) it was just .13%. On top of that, the fed has extended Operation Twist through year end and has embarked on QE∞ with the option to boost monthly asset purchases whenever it deems necessary. The fact of the matter is we have extremely accommodative monetary policy right now so clearly this time is different from the past.

Between Europe and the Fiscal Cliff there are some very real economic problems, and I'm not explicitly saying there won't be recession in the United States. I'm very concerned about several things in the global economy right now, but for the reasons I've mentioned above, I won't be losing any sleep over pragcap.com's article and neither should you.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.