Economic Indicators of a US Recession
The National Bureau of Economic Research (NBER) Business Cycle Dating Committee (BCDC) — the committee responsible for identifying the dates of peaks and troughs that frame economic recessions and expansions — defines a recession as “a significant decline in economic activity spread across the economy, lasting more than a few months.”
The slowdown in economic activity is typically seen across numerous economic indicators.
Economists rely on indicators to reveal the economy’s current, past, and future state, including their speculation over the probability of a recession.
What are Economic Indicators?
Economic indicators are data sets that help analysts, economists and investors understand what has happened or what may happen in segments of the U.S. economy. There are two major types of indicators: lagging and leading.
- Lagging economic indicators record trends that have already happened, these are backward-looking metrics. Examples include the unemployment rate and corporate profits reports. By the time we receive the data, the jobs and profits have already been gained or lost.
- Leading economic indicators are forward-looking, meaning they have the potential to forecast where the economy is headed. Economists use these indicators to predict what the economy might do in the future. Business inventory levels, for example, can shed light on whether demand for certain products is high or low enough to cause the economy to expand or contract.
What is a Recession?
A recession is a period of time when economic activity declines significantly across the board for more than a few months. The National Bureau of Economic Research (NBER) officially declares recessions once they are over.
In a recession, unemployment rises, wages decline, and credit becomes harder to come by. These economic downturns often have effects in both the short and long term.
Common Economic Indicators to Predict Recessions
Economists rely on many economic indicators to predict recessions. The following are some of the most important.
Treasury Yield Curve
US Treasures with longer maturities usually pay higher yields, but short-term bonds will occasionally pay higher yields than long-term bonds.
When this occurs, it indicates that the market is pessimistic about the economy’s long-term prospects. When it does, it’s called an inverted yield curve because the graphs that illustrate changing interest rates slope downward instead of upward.
While there is no foolproof formula to predict a recession, the yield curve has a better historic track record than any other common indicator, according to Forbes. It has predicted all of the last eight U.S. recessions: 1970, 1973, 1980, 1990, 2001, and 2008. The yield curve also inverted before the 2020 recession.
The Treasury yield curve shows the return on short-term Treasury bills compared to long-term Treasury notes and bonds. In a normal yield curve, returns on short-term notes will be lower than long-term bonds because investors need a higher yield to invest their money for longer.
When the yield curve inverts, it often foreshadows a recession, but the timing of the ensuing pullback is highly unpredictable.
Although there have been false positives where the yield curve inverts without a recession, and recessions have occurred without an inverted yield curve signaling a warning beforehand, an inverted curve tends to mean a recession may not be far behind.
Rising unemployment is a classic indicator of a recession because recessions perpetuate unemployment, and unemployment perpetuates a recession.
When a recession sets in, unemployment rises as demand and output decrease. With fewer businesses hiring, more and more unemployed people have to compete for fewer and fewer jobs, and the labor market becomes much more competitive.
This keeps them out of work longer and with less money to spend. As individuals spend less, demand for products and services falls further, forcing businesses to lay off even more workers, and the cycle continues.
According to the Federal Reserve Bank of St. Louis, the Sahm Rule Recession Indicator signals the start of a recession when the three-month moving average of the national unemployment rate rises by 0.50 percentage points or more relative to its low during the previous 12 months.
Gross Domestic Product (GDP)
Two consecutive quarters of negative GDP growth has long been the common definition for the start of a recession. A healthy economy steadily expands, and while one bad quarter can be a fluke, two straight quarters of declining productivity tend to indicate a serious underlying issue.
In fact, businesses tend to adjust their expenditures on inventory, payroll and other investments based on GDP output. However, this doesn’t mean it’s a perfect indicator. GDP can be misleading because of Federal Reserve changes to monetary policy or changes to government spending.
For example, the government has increased GDP by 4% as a result of stimulus spending and the central bank has pumped around $2 trillion into the economy. Both of these attempts to correct recession fallout are at least partially responsible for GDP growth.
Additionally, GDP is a lagging indicator, meaning it only tells us what has already happened, not what is going to happen. Still, GDP is used as a key determinant as to whether the US is entering a recession or not.
Another indicator of a recession is declining industrial production. Manufacturing activity and industrial production influence the GDP strongly. Since workers are required to manufacture new goods, increases in industrial production and manufacturing activity can also boost employment and possibly wages as well. In turn, the opposite can also lower employment and wages.
Increases in production can be misleading at times. Sometimes the goods produced do not make it to the end consumer. They may sit in wholesale or retailer inventory for a while, which increases the cost of holding the assets.
Therefore, when looking at production data, it is also important to look at retail sales data and inventory data to fully understand the state of the supply chain. If both are on the rise, it indicates there is a heightened demand for consumer goods.
Supply chain issues have recently played a large role in economic slowdowns after the COVID-19 pandemic forced lockdowns for many manufacturers and transporters.
Durable Goods Orders
The durable goods orders report is a broad-based monthly survey conducted by the US Census Bureau that measures current industrial activity. Durable goods refer to big-ticket, more rarely purchased goods such as machinery, cars and commercial jets.
This report is different from consumer purchases of durable goods such as washing machines or refrigerators. While consumer durable goods are important, business orders are a better indicator of future business cycle changes.
For example, if the economy is contracting, companies will delay purchases of new expensive equipment. They tend to continue using old machines to save money. When the economy is growing, the first thing firms do is buy new equipment to gear up for higher anticipated demand.
The Stock Market
The stock market can be a good predictive indicator. A company’s stock price represents expectations of the firm’s future earnings. A rise in stock prices means investors are confident about future economic growth. A fall in stock prices means investors are pessimistic about the future of the economy, likely preferring inflation hedges to volatile assets such as stocks.
Consumer spending is a key indicator of economic health because it impacts virtually every element of a recession, including many indicators listed above: Real GDP, employment, durable goods, income and consumer confidence. In fact, consumer spending makes up two-thirds of American GDP measurements.
An estimated total of personal consumption expenditures (PCEs) is compiled by the US government monthly to measure and track changes in the prices of consumer goods over time. PCEs are a measure of consumer spending, detailing how much is spent on durable and non-durable goods, as well as services.
Other measures of income and wages, including the real personal income levels, as well as other metrics of consumer spending, such as wholesale-retail sales, are useful metrics to understand consumer sentiment.
- Read More: How Do Recessions Impact Fashion Trends?
The Housing Market
Home sales are another indicator of recession because if sales start declining, it can mean that people can’t afford to make home purchases. That can result in new construction slowing, meaning fewer jobs in that sector.
The housing market is especially susceptible to the Fed raising interest rates because doing so translates into higher mortgage rates. The Fed has been on its most ambitious rate-hike cycle in decades this year, so the housing market and home sales have naturally begun to take a hit.
Recession Indicators in 2022
Looking at the above metrics in late 2022, it’s apparent that the risk and probability of recession have increased. The US has already seen negative GDP growth for the past two quarters, which many consider the definition of a recession. However, the labor market has remained strong and consumers have maintained high spending levels, even amid high levels of inflation.
Ultimately, we will not know if we’re currently experiencing a recession until NBER declares it after the fact. Recessions and economic downturns differ depending on a variety of factors that historically have encompassed a wide range of market and economic outcomes. There are many variables that can impact how the economy responds to slowing GDP and rising inflation, the outcomes have yet to be seen.
If Economic Indicators Point to a Recession… Then What?
There are many things investors can do to prepare for a recession, and many of them are strategies you can implement no matter the state of the economy.
Investors may pay down debt, focus investments and retirement accounts on long-term growth, diversify their portfolios, and find places to cut back on spending.
As investors face elevated market volatility due to uncertainty over persistent inflation and the impact of the Federal Reserve’s tightening policy on US economic growth, it is helpful to remember that long-term fundamentals ultimately drive asset prices.
None of the economic indicators mentioned can alone forecast a recession, there are many variables that play into each metric as well as into recessions. Making investment decisions based on indicators can be risky because of these additional variables. Instead, these indicators are useful to get a big picture of how businesses, laborers, investors, and consumers feel about the state of the economy.
This material is provided for informational and educational purposes only. It is not intended to be investment advice and should not be relied on to form the basis of an investment decision.