Recession forecasts have been wrong for years. Here's why a 'perfect indicator' doesn't exist.
It hasn't been a great time for folks in the business of predicting recessions.
The Conference Board's Leading Economic Index signaled a recession in 2022. The highly regarded inverted yield curve recession indicator has been activated since November 2022. Even the commonly accepted layperson's definition of recession — two negative quarters of GDP — occurred in 2022. Most recently, the Sahm Rule, which measures short-term rises in unemployment, triggered its recession red flag in early August.
But as many economists will tell you, the US isn't and hasn't been in recession.
The creators of all these measures say this time may be different — their indicators could be, and have been, showing false positives. And the notable distortions to economic data from a global pandemic have unquestionably made the prediction business harder.
But the latest failures also reveal a harsh truth about the recession prediction game: Recession indicators aren't perfect, and they likely never will be.
Just ask one of the most prominent recession indicator creators.
"The economy is so complex that ... it's unlikely that we get the perfect indicator," Duke University professor and Canadian economist Campbell Harvey, who invented the inverted yield curve indicator, told Yahoo Finance.
Read more: How to recession-proof your savings
The National Bureau of Economic Research says a recession involves a "significant decline in economic activity that is spread across the economy and lasts more than a few months." The problem for investors and the like is that the NBER, which is the official arbiter of recessions, doesn't declare recessions until well after the fact. For example, the NBER didn't declare the recent pandemic-related recession in March 2020 an official recession until July 2021.
That may be why there's a rabid interest in projecting when the next recession will come.
The benefits of such a call vary. It can help, or hurt, political parties amid an election year. It can also provide a rationale for why consumers and the news media have struggled to explain the "vibecession" over the past several years.
For investors, there is an obvious reason. Making a call for an economic downturn that others don't see could produce a pretty sweet payoff. Just ask Michael Burry of "Big Short" fame, who made an estimated $100 million betting against the US housing market in 2007.
But most of us seem to be searching for something finite in the world of economics, which rarely is.
"It's really hard to read the economy right now," said Claudia Sahm, who worked as an economist for the Fed and now serves as the chief economist at New Century Advisors.
Sahm's rule is the perfect example of why there's rarely ever a clear read on economic data. It's a rather simple math equation: If the three-month average of the national unemployment rate has risen 0.5% or more from the previous 12-month low, the rule triggers.
This was triggered after the latest monthly jobs report on Aug. 2 (see chart below). Recession worries instantly arose. But Sahm, the rule's namesake who writes a newsletter for more than 18,000 subscribers and has become a popular financial television commentator, was quick to say "not so fast" on the recession call.
In other words, she acknowledged there was a flaw in her highly regarded formula.
The unemployment rate is increasing, in part, because of a large influx of immigrants coming into the labor force, something Sahm said she knew her rule couldn't fully account for at the time of its creation. "I knew that the Achilles' heel was the labor supply," Sahm said. "It's usually pretty much small. ... If there was a straightforward way to pull it out — the labor supply effects — you'd do it."
She added, "I actually don't know how much of this is the immigrants versus weakening demand. ... They're both in there."
This reveals one of the core things people get wrong or just plain overlook with some of these so-called indicators. They aren't really a black-and-white read on the economy — at least not to the people who made them.
"I don't base my entire thinking on where the economy is or is headed off the Sahm Rule," Sahm said. "That was never meant to be the purpose of it."
Even the legendary inverted yield curve indicator, which occurs when the yield on 3-month Treasury bills exceeds the yield on 10-year notes, has apparently stumbled. It's a perfect 8-for-8 in preceding every recession since 1968. But it's been flashing red since November 2022, and Harvey has admitted its undefeated streak may be over.
"[People] make the incorrect inference that this is like a perfect indicator," Harvey said. "And it's true that in the past, it's been perfect. ... But that doesn't mean that it will be perfect in the future. Indeed, it's extremely unlikely that it will not have a false signal."
In fact, part of the reason Harvey argues this time could be a false signal is because of how accurate his indicator has been. He believes that companies see the yield curve inverted and think, "We need to be careful in terms of what we're doing." For instance, around when his recession indicator first flashed in 2022, Wall Street's consensus swiftly moved to call for a recession. A broad swath of tech layoffs hit in the coming months.
And now, nearly two years later, no recession, and CEOs on conference calls are mentioning the word "recession" at the lowest level in nearly three years, per data from FactSet.
"Given that people see the yield curve invert, they take action upon it and growth slows," Harvey said. "We potentially dodge the recession. And it looks like a false signal, when actually it's just doing its job."
The dilemma both economists are having over whether their indicators are flashing false positives highlights the struggle industry experts have with claiming any one indicator can be perfect. Especially given the small sample size.
"We've got eight observations [since 1968]," Harvey said. "That's it. There's not a lot you can do with eight observations."
And often, just looking at the data might not reveal some of the alarming signs under the surface when heading into a recession. Steven Pearlstein won a Pulitzer prize for his extensive work predicting the financial crisis of 2007/2008 and for writing the US economy was on the cusp of recession. But Pearlstein told Yahoo Finance he didn't come to this conclusion by looking at traditional economic indicators.
"I was just looking at the financial markets and said this is f**ing nuts," Pearlstein told Yahoo Finance. "This is going to implode."
Pearlstein said that recession indicators that track economic data miss the larger fear most Americans have when they think about recessions. "Most of the recent recessions we've had were the result of a bursting of a financial bubble," Pearlstein said. "And none of these economic data really speak to that."
Harvard economist Jason Furman, who served as chairman of the Council of Economic Advisers under former President Barack Obama, joked, kind of, that "almost every recession indicator has not survived the next recession."
"It's just like a random thing that happens, you know, over and over again," Furman said. "I think we'd like to be able to predict, but I think we can't. And once you admit you can't, that itself is knowledge and wisdom."
He added that predicting recessions is like a roll of the dice. If you roll a one, maybe there's a recession, if you roll numbers two through six, maybe things will be OK. There are times when the die can have more possibilities to flash recession. In other words, the odds increase, but it's never certain.
"If you know how dice [work], that doesn't help tell you what number is going to come up on the dice, but it tells you how to gamble, and, more importantly, how not to gamble," Furman said.
This comes back to the truth about recession indicators: They can be right for a long time. But anyone who's ever been on a trip to Las Vegas knows that no one can guess correctly where the dice will fall forever.
Josh Schafer is a reporter for Yahoo Finance. Follow him on X @_joshschafer.
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