GDP and Recession Risk

As we face the first increase in the targeted Federal Funds rate in nine years, I hear some analysts complain the Fed is behind the curve and others say the economy is likely to move into recession because it cannot handle the increase in interest rates. No matter which side you are on, there are already some indicators we can follow to see where the economy is headed and what the probability of recession is.

Two of these indicators we are already following. The first is the expected inflation rate for the next five years. This indicator is not based on actual data, but rather is a number tracked by the bond market. Thus it is an indicator of where market participants are betting the inflation rate will likely be. As of December 10th, that number is 1.20%. It was 1.30% at the end of October 2015. It was 1.27% on December 10, 2014. That is a narrow range and stable over the past year. It is also nowhere near the Fed’s stated target of a 2.00% long-term average for inflation. The conclusion we should come to is the Fed does not need to raise rates since the market is saying inflation, one of the key Fed guiding measures, will not be a problem for the next several years.

The next indicator to observe is the two-ten spread. This measure is the difference between the yield on the ten-year U.S. Treasury bond and the yield on the two-year U.S. Treasury bond. When this indicator turns negative, there is a high likelihood of a recession starting within two quarters. As of December 10th, the spread is 1.29%. As of October 31st, it was 1.41%. As of December 10, 2014, it was 1.59%. It has not been a straight line down over the past year, but a thirty basis point move over the past year is something to follow. For now, this indicator is well above zero. I do not expect to get concerned until it drops below 50 basis points. I think the financial media will get interested if it drops below 100 basis points.

The previous two indicators I have been following on the Analytical Road at blogspot. The next two I have just recently been reading about and both are hosted at the Federal Reserve of Atlanta. One uses historical GDP to predict the likelihood the U.S. is currently in a recession. This is useful since the NBER is the official body which can declare a recession but can sometimes have multi-year delays in their decision. The second uses current data and estimates for an in-period forecast of quarterly GDP. We will start with a look at that indicator.

GDPNow is updated at least once per week. On December 4th, the forecast for the fourth quarter was 1.5%. On December 11th, it moved up to 1.9%. The change over the week comes from the increase in real retail sales and the decrease in wholesale trade and retail inventories. At 1.9%, it won’t raise any concern even though that is a low number. A 1.5% number for the fourth quarter would raise concern. Using the current estimate of 1.9%, it appears the economy is not outgrowing its long-term average. There aren’t too many more financial numbers before the end of the quarter and I suspect the estimate will start to decrease volatility and the focus will turn to the first quarter of 2016. For now, this indicator seems to suggest no change is needed.

The other indicator from the Atlanta Fed is called the GDP-Based Recession Index. This indicator uses historical GDP and a large number of probability estimators to estimate the likelihood the U.S. economy entered a recession in the previous quarter. This indicator was last updated on August 10, 2015 and reads 13.3%. This is significantly below the level of 67% which is the trigger to indicate a recession has begun.

Of these four indicators, the forward five-year inflation rate and the two-ten spread are collected daily. GDPNow is updated weekly. The GDP-Based Recession Index is updated quarterly. I have thought about putting these together into a single page, but there is another indicator we need to watch because we have an extraordinary market with the Fed’s zero interest rate policy. This measure also comes from the Federal Reserve of Atlanta and is called the Wu-Xia Shadow Federal Funds Rate. When the Fed moved rates to zero, there was academic talk about the lower bound of zero. While some European economies and the ECB have moved their rates below zero, the Fed has held rates at the zero bound. Researchers Cynthia Wu and Fan Dora Xia used some clever data to calculate what the Federal Funds rate should have been. The shadow rate reached a low in May 2014 at -2.99%. As a saver, I am very pleased the Fed did not lower rates to that level. The rate as of November 2015 is -0.004%. Since that May 2014 low, this shadow rate has been moving very quickly higher. It seems reasonable the Fed would want to stay near this rate as this is what the market and economy indicate is necessary. In that case, a 25 basis point move this week would not be unreasonable.

The result of this walk through our data is to conclude that a rate increase is needed by one measure and not necessary by others. Our two daily indicators are subject to the emotional volatility of the market and based more on what market participants expect rather than what has occurred. The next week will be interesting to see how these indicators react. I am assuming the Fed does increase rates but will also say future increases are data dependent. I am not expecting another date to be explicitly mentioned. I would expect that to be the unwelcome market moving event. Once we move off the zero based policy, the shadow rate will go away. What we will be left with is two market based indicators and two GDP based indicators as a set to indicate what the Fed is likely to do. I will work on making a cohesive case for these over the next few months.

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Author: dmcnic

Educated as an economist, I now work as an Analytical Professional for a manufacturing firm. I have have a second job as a part-time lecturer at the University of Washington in Bothell. While all baseball interests me, the Mariners are my home town team. Married with one dog.

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