Three Sequential Signals of Recession
Timing and predicting recessions is an important task, not only for traders looking to make a profit but also for policymakers looking to correctly time stimulus measures.
Not many people are against government stimulus measures during difficult times, but the problem is that recessions are difficult to spot in real-time, and policymakers often provide help too late and then offer support for too long.
In 1980, Victor Zarnowitz and Geoffrey Moore, two pioneers of business cycle research, proposed a signaling system that could help alert policymakers to recessions.
The concept was that policymakers could be alerted to recessionary periods in a series of stages, helping to conduct timely stimulus measures because the effectiveness of any stimulus effort is only as good as the timing.
Most, if not all, government stimulus today is highly reactionary, which has amplified the boom-bust cycle. The government helps boom the booms and bust the busts.
The signaling system outlined by Zarnowitz and Moore, which I have slightly modified, involves tracking leading and coincident indicators of economic growth.
Leading indicators provide advanced warning of where the economy will go in the future.
This chart shows the popular and well-studied Conference Board Leading Index. It’s clear that the growth rate turns negative before the economy enters a recession. A few false flags exist, but the proposed three-step signaling process will account for that.
The Aggregate Coincident Index, which is comprised of employment, personal income, personal consumption, and industrial production, defines the economic cycle and recessionary periods.
When the Aggregate Coincident Index turns negative, a recession is underway with no exceptions.
The Aggregate Coincident Index is for the entire economy, but we can also track a Cyclical Coincident Index, which specifically tracks the construction and manufacturing sectors.
With virtually no exceptions, all recessions start in the construction and manufacturing sectors, so these two sectors deserve special attention.
Over the long run, the economy has grown at about 2% on average. So in our signaling system, the 2% level will mark the “trend” level of growth.
Signal #1: Warning of Below Trend Growth
The concept of the first signal, which we will call Signal #1, is to define a period where the economy is expected to grow below trend or to spot a potential pocket of weakness.
The first warning signal is triggered when the Leading Index falls below 2% growth and the Coincident Indexes, both the Aggregate and the Cyclical, are above 2%.
This signal tells us that in the future, the economy will transition from growing above trend to growing below trend, the first thing that happens on the way to a recession.
This chart shows the periods when at least a Signal #1 was triggered.
Since 1970, Signal #1 was triggered an average of 13 months before the recession. A few signals occurred without a recession.
When the Leading Index falls below trend, the economy will soon run into a soft patch. This is the first signal that policymakers should start preparing for a potential downturn, likely pausing any restrictive policy.
Signal #1 was triggered in June 2006. The Fed paused monetary tightening around this time, which was appropriate.
Signal #1 was triggered in May 2022. The last time Signal #1 was triggered, in 2006, the Fed paused monetary tightening. This time, the Fed got more aggressive and hiked interest rates even faster after Signal #1 was triggered.
After the Leading Index warns you of below-trend growth, the next signal defines actually arriving at that below-trend growth.
Signal #2: Transition to Below Trend Growth (Pre-Recession)
Signal #2 is triggered when the Leading Index falls below -1%, signaling that a recession is coming, while the Coincident Indexes are both below 2%. This signal tells you that the economy is growing below trend already, a pre-recessionary state, with leading indicators saying the next step is a recession.
Since 1970, Signal #2 was triggered an average
of six months before the recession started.
The concept was that when you received a Signal #2, a recession was completely unavoidable, and policy should switch to easing.
Monetary policy has long and variable lags, so easing policy six months before the recession would massively help achieve more desired results.
Signal #2 was triggered in July 2007. The Federal Reserve was just starting to ease policy around this time, waiting until the end of 2007 to ease more forcefully. So the Fed was slightly late.
Today the Leading Index is below -1%, and the Coincident Indexes are below 2%, so we have a Signal #2. Historically speaking, a recession became a certainty on this signal.
Sitting here today, we received our Signal #2 five months ago, in December of 2022, and the average lead time before a recession starts is six months.
Policy should have switched to easing, but still, the Federal Reserve continues to tighten monetary policy.
Signal #3: The Recession
Signal #3 confirms a recession, but at this point, significant problems have hit the economy. Signal #3 is triggered when the Leading Index is negative, and the Coincident Indexes are negative. This is an undeniable recession.
On average, this signal occurs two months after the recession start date, which is why investors and policymakers must key off Signal #2.
Signal #2 has a 100% track record of spotting recessions. Waiting for Signal #3 will leave policy lagging.
The official recession dates aren’t known for well over a year, and the Federal Reserve, average economist, and average investor don’t realize the recession until it’s well underway.
The Most Dangerous 8-Month Period
On average, there is an eight-month lag between a Signal #2 reading, which is a reliable recession flag, and Signal #3, the undeniable confirmation of a recession.
This eight-month gap is the most dangerous period for the Federal Reserve and for investors. The recession is virtually assured, but most investors and the Fed still can’t see it or refuse to believe it.
Only when Signal #3 comes does the Fed panic and investors give up as the waves of job losses create defaults and deflationary pressure.
With the Leading Index deeply negative and the Coincident Indexes below 2%, we have a sustained Signal #2.
This signal was triggered five months ago, and the average recession starts six months after getting a Signal #2.
Policy should be easing already as a result of this, but the Federal Reserve is still raising interest rates targeting lagging economic indicators.
Monetary policy has never been this opposed to the business cycle signals in the last 50 years.