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Friday, October 05, 2007

Does a Recession matter?

by Calculated Risk on 10/05/2007 08:15:00 PM

First, what is normal economic growth? To answer that question, look at this graph of the distribution of four quarter real GDP growth since 1956 (the last 50 years).

Note: this graph uses each moving four quarter period as a data point. Each quarter will eventually be in four different events (they are not all independent).

Four Quarter GDP Distribution for 50 YearsClick on graph for larger image.

The bars represent the number of times the four quarter real GDP growth was within a certain range. As an example, the ">1%" range is for a four quarter growth rate of 1% to 2% real GDP.

In general, the probability of real GDP growth is a bell curve distribution centered around 3% to 4% real GDP growth.

Most forecasts start with trend GDP growth and then try to decide why growth in the next period will be higher or lower than trend. Instead of trying to forecast a specific number for GDP growth, I usually try to forecast in one of the four circles market on the graph. These are arbitrary definitions that I use: Booming Growth, Trend Growth, Sluggish Growth / mild Recession, and Severe Recession.

For 2007 my forecast was for Sluggish Growth / mild Recession, and I've tried to break it down a little further by saying it is pretty much a coin flip between a mild recession and sluggish growth, but I lean towards a recession. Although there is a bright line between a recession and no recession, the economic difference between sluggish growth and a mild recession is pretty minor.

What is a Recession?

In the U.S., recessions are identified by the National Bureau of Economic Research (NBER), a private, nonprofit, nonpartisan research organization. Here is the NBER’s Recession Dating Procedure. Here are some excerpts:

A recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales. A recession begins just after the economy reaches a peak of activity and ends as the economy reaches its trough. Between trough and peak, the economy is in an expansion. Expansion is the normal state of the economy; most recessions are brief and they have been rare in recent decades.
Q: The financial press often states the definition of a recession as two consecutive quarters of decline in real GDP. How does that relate to the NBER's recession dating procedure?

A: Most of the recessions identified by our procedures do consist of two or more quarters of declining real GDP, but not all of them. According to current data for 2001, the present recession falls into the general pattern, with three consecutive quarters of decline. Our procedure differs from the two-quarter rule in a number of ways. First, we consider the depth as well as the duration of the decline in economic activity. Recall that our definition includes the phrase, "a significant decline in economic activity." Second, we use a broader array of indicators than just real GDP. One reason for this is that the GDP data are subject to considerable revision. Third, we use monthly indicators to arrive at a monthly chronology.
For the four quarter period ending in Q2 2007, real GDP growth was 1.9% (for the Q1 ending period, four quarter GDP growth was 1.5%). So the U.S. economy is currently in the Sluggish Growth / mild Recession category.

If we go back to the graph, 5 out of the 19 events with 1% to 2% growth happened during a NBER defined recession. For the 0% to 1% category, 9 out of 11 events happened during a recession. This suggests that the U.S. economy is skating just above a recession, and if the four quarter real growth rate falls below 1%, there is a good chance the NBER will declare a recession.

So do Recessions matter?

What matters is what happens when the economy slows. With a slow economy, the unemployment rate will rise as is currently happening in the U.S. If the economy slides into a recession, then employment will actually decline month after month.

Another key impact is profit growth slows - or profits even decline - as the economy slows. We are already seeing declining profits in housing related sectors, and we will probably see declining profits for the financials too. Note: many analysts are arguing S&P earnings will still be strong, even if the U.S. economy slows, because so many earnings are from strong overseas economies. This is part of the "decoupling" debate.

Also, during an economic slowdown, many problems that were hidden during the previous expansion will be exposed. As an example, sales growth will slow at many companies exposing various structural problems - especially in highly leveraged companies. Some of these companies will go bankrupt making investors more cautious, increasing the spread between high and low quality debt. The recent bank failures are an example of a slowing economy exposing problems.

So recessions do matter in that economic activity slows down, but the key point here is that there is very little difference between sluggish growth and a mild recession (my current forecast). There is a significant difference between the current economic environment and either booming growth or a severe recession; however I think both of those scenarios are unlikely in the near future. Even trend growth seems unlikely over the next year.