By Rom Badilla, CFA
The Economic Cycle Research Institute recently released its Weekly Leading Index numbers. The ECRI Weekly Leading Index level has been steadily declining since the end of April. Furthermore, the ECRI Weekly Leading Growth Index had a negative weekly reading of 3.46 for the first time since mid-2009, which marked the beginning of the end of U.S. economic woes.
Are we to see a double dip in the coming months as forecasted by the negative reading in this leading indicator? ECRI Managing Director Lakshman Achuthan stated a need for a “persistent” decline in the index in order to determine the possibility of a double dip in the U.S. economy. Here, we will attempt to determine what is deemed as “persistent” by examining prior recessions.
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The ECRI data goes back to as early as 1968 and is released weekly. During that time, the U.S. economy experienced seven recessions as determined by the National Bureau of Economic Research. If we look at the ECRI Growth Rate Index in the weeks prior to the beginning of each of the seven recessions, it is fairly clear that the Index hits negative territory signaling its forecasting effectiveness.
Out of the seven recessions during this time period, six experienced consistent and mostly consecutive negative growth rates in the weeks leading up to the official start of the recession.
The ECRI Growth Rate Index stayed in negative territory for about 19 weeks on average before the onset of the seven recessions (16 weeks if we count only consecutive negative readings). In the 2001 recession, the lead-time of negative growth rates was at 26 consecutive weeks with 44 negative weekly readings out of the preceding 46 weeks. The longest consecutive weekly lead-time occurred before the 1970 recession where the ECRI Growth Rate Index posted a negative reading for 28 straight weeks. The shortest lead-time happened before the 1990-1991 recession. The lead-time was 6 weeks of consecutive negative rates. Despite the short lead-time, there were 12 negative readings out of a total of 14 weeks prior to the recession.
Interestingly, the ECRI Growth Rate Index did not post negative numbers prior to the 1981-1982 recession. However, the index had extremely low readings in the weeks prior to the onset. There were 7 weeks of below average readings with 5 growth rate prints below 1.0 (the average growth rate of the 2211 total weekly observations is at 1.84). So clearly, the index signaled to a degree, economic weakness.
Of course, the leading indicator is not perfect as there have been many strings of negative weekly readings that did not lead to a recession. This is why Achuthan suggests that we need to see persistent evidence before making the determination. I will refer to these episodes as “head-fakes”. In total there were 20 episodes of negative growth rates that were head-fakes, dating back to the beginning of the ECRI Growth Index. There are many head-fakes that lasted only one week while others persisted a lot longer. If we establish that the “typical” lead-time of negative readings in order to indicate the beginning of a recession, is the aforementioned average of 19 weeks, we can rule out most of the head-fakes.
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There were four head-fakes that lasted longer than 19 weeks. The longest lasted 34 weeks as evident from October 1987 to June 1988, which is the period after the “Black Monday” stock market crash. Pundits of today’s negative growth rate will probably point to the recent “Flash Crash”, which drew similar comparisons to “Black Monday” as the reason for the weak growth reading. Furthermore, another notable head-fake occurred from August 1998 to January 1999, which lasted for 23 weeks and marks the crisis spurred by the Long Term Capital Management debacle. As we all know, LTCM was triggered by the Russian debt default that sent waves across the globe. That crisis resulted in extreme market volatility and frozen credit markets, which resembles today’s market fueled by the Greece and the European debt crisis. Again, critics could easily point that out as to the reasons for today’s negative reading from the ECRI Growth Index. The other two head-fakes occurred in 1984 that lasted 21 weeks and in 2002-2003, which persisted for 24 weeks.
I can point out that during the four lengthy head-fakes, the Federal Reserve cut interest rates. So we can surmise that these head-fakes did not lead to a recession simply because the Federal Reserve swiftly responded and successfully averted an economic growth slowdown. In the 1987 head-fakes after “Black Monday”, the Federal Reserve responded with a cut in short term rates within a week of the first negative growth rate reading. The Federal Funds rate stood at 7.25 percent and reached a low of 6.50 percent in 15 weeks. For the 1998 head-fakes after the LTCM meltdown, the Federal Reserve pumped liquidity into the system by cutting rates, 5 weeks after the first negative reading from the ECRI Growth rate index. In the 1984 and the 2002-2003 head-fakes, the Fed responded within 15 and 13 weeks, respectively with short-term rate cuts.
So where does that leave us exactly? The latest ECRI Growth Rate stands at -3.46, which again, is the first print after posting stellar positive growth rates since mid-2009. Furthermore, the ECRI Weekly Leading Index is currently at 123.24. The Index has declined 6.21 percent in the past 12 weeks, which is the largest decline in the weeks prior to all of the episodes of negative growth rates, head-fake or not. Comparatively, the average decline for the ECRI Index stands at 1.59 percent for episodes that led to a recession (excluding the 1981-82 recession where the ECRI Growth Rate failed to predict a recession). The average drop for head-fake episodes is at 1.04 percent.
It remains to be seen if negative growth rates will persist long enough, which could signal another recession. At the very least, we established some idea as to the number of weeks needed to signal the beginning of a recession. We also established that when prompted by the negative readings in the ECRI Growth rate, a possible slowdown could sometimes be avoided if followed by policy stimulus.
However, in the event that today’s readings persist in negative territory, the U.S. economy may not be able to avert a recession in the same manner of the four previously mentioned head-fakes. A response in Monetary Policy may be limited today given that the Fed Funds Rate cannot go below zero. While the U.S. government has other tools to stimulate the economy, we may not have the political will to enact them as well as perform them in a timely manner. Given these restrictions coupled with the significant decline in the ECRI Index, the risks of an economic slowdown followed by double dip are certainly present.