Beware of “foolproof” recession indicators. For years, people have been telling me that an inversion of the 2-year and 10-year yield spread on Treasury securities indicates that a recession will occur within 12 months. I’ve warned them that while the indicator has a good track record, it’s far from perfect.
This yield spread inverted on April 1st, 2022. In retrospect, this inversion seems to have been an April fool’s joke, as yesterday’s jobs figures were extremely strong, showing payroll employment rising by 339,000 in May 2023. You don’t see those sorts of big job gains when the economy is in a recession. It looks like the “infallible” yield curve indicator has failed us.
In fairness, the 3-month/10-year spread didn’t invert until October of 2022, so that one might yet prove accurate. This inversion may have contributed to Bloomberg’s panel of forecasters telling us last October that a recession was 100% certain to occur by October 2023.
But there’s another problem with forecasts of an imminent recession. Bloomberg reports that a labor market showing this sort of very widespread strength almost never occurs within 6 months of the next recession:
Meanwhile, the so-called diffusion index showed that 60.2% of industries added jobs, a proportion that’s historically inconsistent with a recession starting in the next six months. That means that the majority of economists projecting economic contractions in the third and forth quarters of this year may have to reconsider. The labor market is often considered a “lagging indicator,” but it’s rare — outside of the highly unusual Covid-19 experience — for it to abruptly stop with no forewarning.
I don’t know what will happen between now and October, but I do know one thing for certain: one of these reliable recession indicators will be wrong. Either the yield curve inversion will predict a recession that didn’t happen, or the diffusion index will fail to give its normal advanced warning.
This is one more example of why you should always maintain a healthy skepticism when someone shows you a supposedly sure fire indicator of future economic trends. As they say in the investment industry, past performance is no guarantee of future success.
P.S. It’s true that the yield spread accurately predicted a US recession in 2020. But in my view it just got lucky. Without COVID, I doubt whether a recession would have occurred during 2020.
READER COMMENTS
Thomas Hutcheson
Jun 3 2023 at 6:55pm
I don’t know either, but I take it the people who trade TIPS [5-year TIPS= 20 basis points below target] believe there will either be a recession or the most immaculate of immaculate disinflations imaginable.
Of course the main thing that is wrong with most recession predictions is that they do not spell out what changes (or none) in which policy instruments, especially Fed policy instruments, they are assuming.
spencer
Jun 4 2023 at 8:30am
Unlike what George Santayana said: “Those who fail to learn from history are doomed to repeat it”. In the area of economics, it is more accurate to say that those who believe economic history reveals eternal truths are doomed to error.
spencer
Jun 4 2023 at 9:48am
Nominal interest rates used to contain a significant “inflation premium”.
David S
Jun 5 2023 at 1:24am
What drives me crazy is when some prognosticator puts high odds on a recession occurring by a fairly specific date. Currently, that date happens to be the second half of 2023—which means that right now we might be in a recession and because of reporting lags we won’t know for sure until sometime in October. I’m still waiting for the recession of 2022. Maybe I slept through that one.
Ravi Batra wrote a book called the “Great Depression of 1990: Why it’s got to happen—How to protect yourself.” I bought this book in the bargain bin of a used bookstore for about 20 cents and read it….in 1995.(You can still buy this book on Amazon. I love having a market economy)
Michael Sandifer
Jun 5 2023 at 8:38am
Suffciently strong expectations of a recession of notable size in the very near future will bring the recession forward anyway. That really sums up how they’re ultimately unpredictable.
spencer
Jun 5 2023 at 9:54am
What’s shrinking is the “demand for money”.Shadow stats refers to this as: “The most-liquid “Basic M1” (currency plus Demand Deposits) held 118.1% above its Pre-Pandemic Level and is increasing year-to-year, versus the Aggregate M2 Money Supply holding up by 30.0%, but declining year-to-year, amidst no signs of an overheating economy.”Banks don’t lend deposits. An increase in bank CDs adds nothing to GDP. But money flowing to the MMMFs increases the supply of loan funds (activates monetary savings), but not the supply of money.
Monetary lags are mathematical constants, not “long and variable”. There are other disturbing factors that may temporarily alter this time series (means-of-payment money supply).
spencer
Jun 5 2023 at 10:24am
It’s exactly as Lawrence K. Roos said, Past President, Federal Reserve Bank of St. Louis and past member of the FOMC (the policy arm of the Fed) as cited in the WSJ April 10, 1986:
“…I do not believe that the control of money growth ever became the primary priority of the Fed. I think that there was always and still is, a preoccupation with stabilization of interest rates”.
bill
Jun 6 2023 at 1:15pm
One reason these things change is that the Fed also learns of these indicators and adjusts accordingly.
Andrew Wallen
Jun 10 2023 at 9:43pm
I don’t know if the recession prediction will come to fruition, but the addition to payroll appears to be people filling a small portion of the very high level of job openings that have been open for a while. Job openings averaged over 11 million during 2022 (reopening from pandemic closures). As of April 2023 job openings is around 10 million. It was high before the pandemic (around 7 million). The average from 2001 to 2019 was closer to 4.5 million. The labor participation rate has not come back up to pre-pandemic levels and has been in a broad secular decline since 2000. For men labor participation has been in decline for much longer. The addition of people going onto the payrolls is great, but the remaining high level of job openings is striking.
As usual, I am sure there are a variety of factors … changing labor/leisure preferences and an acceptance of lower household income (maybe boomers retiring out), people finding alternate sources of income/in-kind from the significant increase in government “mandatory” spending, etc.
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