Recent financial market turmoil raises the spectre of credit crunch and recessions. But economists ...
Recent financial market turmoil raises the spectre of credit crunch and recessions.
But economists are bad at forecasting recessions, and economies tend to spend more time in expansion than in recession.
Macroeconomic models built with historical data tend to reflect conditions of an economy during expansion, and are known to produce large forecasting errors during recessions, which is a technical way of saying they are not helpful.
So there are advantages of using methods specifically aimed at forecasting recessions. One such method for the US economy is a rule of thumb using the official leading economic indicator (LEI). The LEI is currently published by the Conference Board in the US.
It is a composite of 10 economic indicators that have proved reliable and consistent in showing the direction the economy is going. It has been periodically revised and updated to maintain this property.
The rule of thumb says that three consecutive monthly declines of the LEI signal an impending recession.Using the officially declared cycle peaks and troughs from the National Bureau of Economic Research, it is relatively straightforward to check the performance of this method of forecasting recessions.
And the performance of this indicator has been impressive. Since January 1959, when the LEI was first available, it has given a signal for all seven recessions.
On average, the indicator has given a warning five months before the start of the recessions. However, the signal for the 1990 recession was given one month after the start. The magnitude of the decline in the indicator over the three months was an average of 2.2%.
It has also given four false signals: in 1962, 1966, 1984 and 1995. With the exception of 1966, the indicator declined under 1.5% over the relevant three months.
This indicator is now available up to September 2007, and is not currently giving a signal of a recession. It declined in one out of the last three months (August), and has increased by 0.2% over the past three.
John Ip is senior economist at Morley