Recession on the Horizon?

In a March 23, 2018 New York Times editorial, Robert Shiller was true to himself. Understating to overemphasize, he matter-of-factly observed: “When it comes to big shifts like a recession, economists aren’t very good at predicting them.” True to form, the behavioral economist and winner of the 2013 Nobel Prize in economics, unlike most pundits, had done his homework. Complementing his own research dating back to 1987, he referenced data produced by the Federal Reserve Bank of Philadelphia from 1968 to 2017. From studying the surveys he concluded: “While professional forecasters as a group have had some ability to assess the probability that GDP will decline in the next three months, they have exhibited no ability to do so a year in the future.”

Shiller finds this fallibility among professionals to produce accurate longer-term forecasts particularly troubling in the midst of the Trump economic boom. The President’s “unique— and polarizing effect— on mass psychology appears to be muddling the economic data more than usual.” Schiller worries this may be lulling forecasters into complacency about economic conditions. Optimism does not seem wholly unwarranted, however. The economy has been growing, fiscal policy is stimulative, interest rate are still low, and consumer confidence high – leading many to take the path of least resistance and extrapolate the present into the future.

The danger in expecting present trends to continue forever is that…they don’t. According to the National Bureau of Economic Research, the U. S. has had 33 recessions since 1954, averaging one every five years, although they have taken longer to develop since the Fed became more proactive in 1987. Even though it’s been almost nine years since the last recession ended, forecasters remind us that expansions don’t die of old age. In fact, the latest Philly Fed survey of 36 professional forecasters gives a 17% probability that GDP will decline a year from now – which, interestingly, is also the average forecasted probability for a decline in the next year for all surveys dating back to 1970. In other words, no storm clouds are appearing on the horizon. That conclusion might be comforting were it not for chronically inaccurate forecasts.

Schiller’s warnings of muddled data, despite such seemingly robust economic conditions, is a warning against the skewed dynamics of economic forecasting. In reading the Philly surveys leading up to the last two recessions (Q1 2001 – Q3 2001 and Q4 2007 – Q2 2009), forecasters were fastidiously loyal to the protocol of the surveys, sticking to the obvious variables: Rates of change in GDP, unemployment, productivity, inflation and the cost to borrow, factors that are important to everyone else. They were good at extrapolating (the essence of short-term forecasts) but rather bad at identifying inflection points (crucial for long-term ones). Why?

Economists Marcelle Chauvet and Jeremy Piger received rave reviews from peers on their quantitative recession probability index, which predicted recession dates that aligned well with the official NBER (National Bureau of Economic Research) results. There was one critical (to us) disclaimer. They admitted it is difficult to compute any forecast in a timely fashion: One has to wait for the appropriate data to be released, usually a delay of about three months. 🙂

Further, some factors that could aid the process are not included in the surveys. Because the surveys are designed to identify a consensus, there are no boxes to check for extraneous semi-hard factors like debt/GDP ratios or, in the soft extreme, all those forces that are examined in the comparatively new and, to most economists, antithetical art/science of “Behavioral Economics.” It is unlikely that outlier economists would be invited back for a second survey. The presumed strength in numbers – ranging from 36 to 54 economists – virtually guarantees the herd will never see a curveball coming.

Consumer confidence indices, like the Philly Fed surveys, ask respondents what they think, but cannot possibly delve into the underlying attitudes that might set the stage for an elongated boom or colossal bust. One pertinent example of such “soft” factors is Mr. Trump, who Shiller dubs a motivational speaker at his core and argues has had a direct effect on amping up consumer confidence. The Trump narrative presents him an unrivaled success, a billionaire, a bon vivant, and now President of the United States. As is widely evident, Trump’s prescription for great accomplishments is embracing stressful risk-taking, not quiet contemplation. Only a man who apparently disdains thinking things through and brags about going with his gut is likely to have no remorse if massive fiscal stimulus proves counterproductive, if spontaneous and unilateral tariffs lead to a trade war, and if, more insidiously, climate change is not the hoax he claims it to be.

Mr. Trump is the personification of these mostly recklessly unconventional ideas and, like most despots of the 20^th century, has appealed to many Americans on a visceral level. Whether malevolent or simply misguided, he is profoundly affecting the public psychology. It would seem he is attempting to tear the political and social fabric in which all the elements of our culture are held together and to what end? We’ll have to wait and see what his gut tells us. It is unlikely, it should be noted, that these tendencies, often conveyed at the subliminal level, can be captured by the consumer confidence indices. In fact, the indices routinely miss the subtle morphing of investment into speculation, as risk gets declassified and reckless return-seeking takes center stage.

Mr. Trump’s rash disregard for the potentially dangerous contagion effects of his actions is not without parallel in American history. Extreme volatility in markets has been a prologue for stunning economic reversals. In a year barely three months old, we’ve seen no fewer than 26 sessions with closing moves in the S&P 500 of 1% or more. Last year we had only eight.

In the financial and economic realm, the “Roaring 20s” were the inextricable forerunner to the depression era 1930s. A prequel? Doubtful because history never repeats itself precisely. No one knows what form the next economic contraction will take. But to deny one will come is an affront to history.