Recession: Straight Up, With a Twist

There is a significant debate going on in economic and financial circles about the odds for a recession in the United States in 2008. In fact we heard on Bloomberg Television a savant saying that it is unthinkable that the economy could decline to negative so quickly from its current positive growth.

Definition of a recession

The textbook definition of a recession is two consecutive quarters of negative growth in real GDP. This definition has been problematic in this decade however, because of the tinkering that our government has done with the measures of inflation. As you know, real GDP is GDP deflated by the inflation rate. The official deflator used for GDP is called the GDP chain deflator.

The National Bureau of Economic Research (NBER) recognized this and determined that there was a recession in the US in 2001 from March through November, even though the quarter to quarter real GDP annualized growth rates for the four quarters of 2001 were -0.5%, 1.2%, -1.4% and 1.6%. As you can see, we did not have two consecutive quarters of real GDP declines. How does the NBER explain this?

"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 [as of October 2003], 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 [including personal income, employment, industrial production and manufacturing/trade sales]. 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."

The point of this diversion is to define what a recession is, although it cannot be so neatly compartmentalized to such a simple formula, especially in these times of government revision of economic data.

A quick look at the chart at John Williams' excellent site, Shadow Government Statistics will give you the idea of how the notion of Consumer Price Inflation has been distorted by the Clinton and Bush administrations. Inflation has a direct effect on real GDP, and therefore on the formal definition of recessions. Of course, it has a real impact on lots of other things including consumer and voter sentiment, and Social Security and other cost of living increases, which is a strong incentive for the government to down play inflation.


Advance Indicators of Recession

We tend to favor the US Treasury yield curve as a significantly reliable indicator of approaching recessions. Here is a description of the classic definition from Paul Kasriel of Northern Trust:

"...each of the past six recessions (shaded areas) was preceded by an inversion in the spread between the Treasury 10-year yield and the fed funds rate. But there were two other instances of inversion - 1966:Q2 through 1967:1 and 1998:Q3 through 1998:Q4 - immediately after which no recession occurred. It would appear, then, that an inverted yield curve is more of a necessary condition for a recession to occur, but not a sufficient condition. That is, if the spread goes from +25 basis points and to -25 basis points, a recession is not automatically triggered. Rather, whether an inversion results in a recession would seem to depend on the magnitude of the inversion and, to a lesser extent, the duration of it. Recession-signaling aside, the yield curve remains a reliable leading indicatorof economic activity. Although the spread going from +25 basis points to -25 basis points might not result in a recession, it does indicate that monetary policy has become more restrictive." That's the current theory, but has it? Has the growth of US money supply been restrictive?

Has Monetary Policy Been Restrictive?

The most alarming thing to us is that despite the inverted yield curve and the Fed funds tightening we just witnessed over the last few years, from historic lows to the 5+% level, monetary policy has not only NOT been restrictive, it has been what many would define as loose. When one looks at real interest rates we had been in a prolonged period of negative interest rates, and only recently had been back in the positive area. It appears that we might be slipping back down into the negative again as the Fed tries to forestall the impending recession and the collapse of the stock - housing bubbles.

It appears to us that even while the Fed feigned monetary conservatism with the right hand, with the left hand they were doing all that was in their power to encourage the reckless growth of credit and the lowering of regulatory oversight and market discipline. To use an analogy, they were preaching energy conservation while running every light on in the house, the backyard, the neighbors house, and slipping pennies into the fuse box to keep it all going. Well, here we are.

What we are seeing is true moral hazard, the unintended consequence of the financial engineering being practiced by the wizard's apprentices at the Fed helping to nuture market distortions, asset bubbles, and imbalances that have become too big to correct naturally without systemic risk. Even though one can mask one's actions with words, and use information selectively and slyly to dampen the alarms and misdirect the public awareness, the chickens will come home to roost, and in this case they are more like the nemesis of retribution for our many economic trespasses. Let us hope that it is not as bad this time as the last time the Fed tried short circuit market discipline and engineer the economy centrally. We believe that the next twenty years or so will provide a rich opportunity for study, and probably the rise another new theory, a new school of economics, that tries to account for exactly what happened and why.

We are old enough to remember that stagflation, now seemingly so familiar, was once considered an improbability, a black swan. In the 1970's stagflation was triggered by an exogenous supply shock in the disruption in the market pricing of crude oil, impacting a slowing economy in monetary inflation from the post-Nixon era and the abandonment of the vestiges of the gold standard. The tonic that time was the tough monetary love of Paul Volcker.

What will they call it when a slowing economy with monetary inflatin is hit with a currency shock, as the dollar is displaced as the reserve currency of the world? We're not sure what they will call what we are about to experience, except on the bigger scale of thing, it will be just another episode in the hubris of arrogant men who consider themselves to be above principle, above the rules.

The Non-Farm Payrolls November Boogie Woogie

It has become popular of late to pay attention to the Birth Death Model from the Bureau of Labor Statistics. Also known as the imaginary jobs number, it is the plug which BLS uses to account for jobs created by new businesses that are not captured by the normal reporting system. There is a method to this madness, but we'll leave that for another day. The good news is that the number has become fairly predictable, as shown by our first chart, which tracks the numbers over the past four years. This month the number willl be a manageable 20,000 jobs added, or so. This is a smallish number, and since it falls in a month where a huge number of jobs are added and seasonally adjusted lower, and since the number is added BEFORE the seasonal adjustment, we can safely ignore it.

(By the way you can click on the charts if you wish to read them, or just for fun if you don't care about details as you are on a managerial or government career path.)

The second chart is a comparison of the actual net jobs in red, and the seasonally-adjusted or headline number in blue. Please note that there may be a HUGE difference between the two. This itself is not surprising because employment is subject to significant seasonal variations, especially in some employment positions. The BLS statisticians use seasonal adjustment formulas to take the raw number as reported to them by industry, and develop the adjusted, headline number to which Wall Street overreacts. These numbers are further adjusted and revised, sometimes signficantly, a year or more after the original headline, although the first three months see the largest adjustments. The latest BLS trick seems to be to come in with an outlier number in the current month, but adjust the prior months higher or lower. Its a statistics thing. Statisticians can make accountants look intractable when it comes to pleasing the boss, especially with this kind of revisionist latitude.

Yes, you say, but what's your CALL there partner? Because we all don't care what's happening, we just want the over under, the hook, the net-net, y'know what we mean?

Having had some experience with trending large, seasonally variable data in private industry, and often having to look behind the forecasts in order to do the hairy knuckle work of providing capacity, we would like to stress that the punchline from the above is that acting on a single month's data is pretty much reckless and irresponsible, and only encouraged by marketing types, including those that work for government and Wall Street. The headline November Jobs number can easily be justified at 200,000 jobs added, with no help whatsoever from the Birth Death model, simply because the huge latitude in the seasonal adjustment, and the sloppiness of the current month data. On the other hand, (economic codeword for shit happens) that's bush league data massaging. A much more elegant approach would be to come in with the current number of about 90,000, but to adjust the prior month number higher. This is called planning ahead for the next time around. No one cares after two months anyway. Stock speculators have the memory span of a goldfish, which is why they never seems to be bored as they swirl around the bowl.

As all practical people understand, the real story is in the trend. Its the averaged trend that provides the most realistic picture, and helps you decide whether to spend your time polishing that provisioning plan, or to start polishing that resume and making calls to executive search firms. In this case, this chart of the Twelve Month Moving Average is the money chart, and the message is clear as crystal. The economy is in a slump, not a recovery, and the jobs trend is not only not good, technically its pretty damn scary (time to polish up the resume and get 'er done in private industry, which seems to be a trend in the Bush Administration). We won't bother with a forecast for the unemployment statistic, the percent of motivated workers actively seeking jobs, because its a slightly different set of useless data in which the unemployed workers get ghosted after they become inconvenient for reporting purposes.

A good analogy here is when tech companies write down inventories, or take reserves from current sales. You just know the respective realities are going to get resurrected on some future income statement and beat-by-a-penny earnings release. At some point the US is going to have hell to pay for how we have run this business called our country, but the goal is to set that day well into the future, at least until after the next election.

P.S. Kudos to Hank and his crew for the finely executed rally-for-no-reason today. It made our confidence swell like Bill Clinton's willy at a Girl Scout convention. The spokesmodels on the Orwell Channel got the message that Wall Street Likes the Hope Now Pay Later Mortgage Plan. On a happier note, there is a consensus among those that have actually examined the plan that it does less than a presidential visit to New Orleans during the Hurricane Katrina aftermath, thanking the Lord for small favours received.

Professor Marvel Never Guesses. He Knows!

Is it likely that a fresh look at the economic data had Ben Bernanke and Don Kohn doing a sharp about face on the balance of risks to the economy? Given the speed with which their change in policy was communicated, catching a fellow Fed head flatfooted in spouting the party line the day before, it seems more probable that something on the order of one or more major players started to spew smoke from the cracks in their mark to moonbeams calculations, and Hank made that call to the Professor.

We obviously don't know, but suspect this revelation was connected with a subprime contagion affecting the derivatives markets. If derivatives are Weapons of Mass Destruction, then the Credit Default Swaps market is the H Bomb. Credit Default Swaps, if they start unwinding, can develop a chain reaction that will take out a fair chunk of the real economy, in addition to two or three big name corporations.

Subprime had the Fed a little concerned; CDS has them staring into the abyss and shitting their pants. Aren't you glad we have men so familiar with the mistakes the Fed made in 1929 to 1932 with regard to Fed Policy? We wish they had at least audited the courses covering the Fed's mistakes form 1921 to 1929. Sure, they are the experts; we're just concerned that they may be preparing to fight the last war.