E-sight Weekly August 2: When a two-quarter contraction is not a U.S. recession

If the US economy goes into recession, it will pull Canada into one as well. So, the current debate about whether the US economy fell into recession in the first half of this year is an important one. 

The Bureau of Economic Analysis reported that US real GDP contracted 0.9 per cent annualized in the second quarter of 2022 after a 1.6 per cent decline in the first quarter. This sparked media stories about how the US met the common definition of a recession being two quarterly contractions. 

However, no economist worth their salt would agree with that narrow definition. A proper definition of a recession is a broad and deep contraction in economic activity with a duration that lasts at least a couple of quarters. So, the two quarters of weakness is only one of three criteria. 

This got me wondering, where did the two-quarter rule of thumb come from? The National Bureau of Economic Research (NBER) is the official arbitrator of US recessions and their dates. To make its recession determination, the NBER uses six monthly economic indicators – and they do not support the view that the US is in recession. The indicators are:

  •  After-inflation Personal Income
  • Non-farm Payrolls
  • After-inflation Personal Expenditure
  • After-inflation Manufacturing, Retail and Wholesale Trade Sales
  • Household Employment
  • Industrial Production

If this is what the NBER monitors, where did the two quarters contraction in real GDP as the perceived benchmark come from? According to the font of all knowledge, the most cited answer on the internet is: Economist Julius Shiskin in an op-ed for The New York Times in December 1974 in which he attempted to articulate what the economic statistics would need to show for the National Bureau of Economic Research to say that a recession was taking place. He stated that in terms of duration, the NBER would need to see “declines in real GNP for 2 consecutive quarters” (since then we have shifted from looking at GNP to GDP but this is an aside). Since this article, the rule of thumb has been periodically referenced as the Shiskin definition of recession. Talk about a successful and influential op-ed.   

I went and got the 1974 op-ed and read it, and it was eye opening. Yes, he starts saying a recession has, “In terms of duration – declines in real GNP for consecutive quarters. But, he talks about all of the aspects of depth, breadth and duration. He says, “In terms of depth — A 1.5 per cent decline in real GNP; a 15 per cent decline nonagricultural employment; a two‐point rise in unemployment to a level of at least 6 per cent. In terms of diffusion — A decline in nonagricultural employment in more than 75 per cent of industries, as measured over six‐month spans, for 6 months or longer.” And, he stresses that these are illustrations. Indeed, he notes that, “these simple criteria do not take into account many of the economic processes involved in a cyclical change.” And, what is notable, is that he says that “many people use a much simpler definition – a two-quarter decline in real GNP.” In other words, Shiskin is claimed to the originator, but it appears the rule of thumb precedes him. I also found it fascinating that the op-ed was discussing the challenge of stagflation – the possibility of recession and high inflation – a risk that central banks are trying to avoid right now. 

The key point here is that even the economist that is attributed with coming up with the two-quarter contraction rule of thumb was not using it as a definition of recession. He was providing an illustration of the type of economic changes in a variety of indicators that would likely get the NBER to say that a recession had taken hold. He did remark that the two-quarter contraction was a simplistic rule that had worked quite well in the past, but he is also clear about the range of indicators needed for confirmation. Over time, his op-ed was simplified to a message of two quarters of contraction was a recession was mis-attributed to him and it was likely popular because it was guideline that markets and non-economists could understand and monitor. But, it doesn’t tell the full picture. 

So, what do the recent US non-GDP indicators tell us? None were showing material weakness in the first quarter of 2022, and in truth the GDP report was stronger than it looked – with the economy contracting 1.6 per cent annualized but final domestic sales grew by a solid 2.0 per cent. The story in the second quarter, however, was different with most of the non-GDP metrics starting to decline. In particular, manufacturing and trade sales as well as personal expenditure fell in the second quarter, while household employment growth and industrial production were softening. It is possible that the second quarter was the start of the recession, but I am skeptical because the impact of the rising interest rates are only just starting to be felt. 

The bottom line is that US aggregate economic growth faltered in the first half of the year, but the economy remained healthy while inflation accelerated to above 9 per cent. This is the context in which the Federal Reserve is raising interest rates and why they will not be deterred by the recent economic data from raising interest rates further. What the weakness in the first half of 2022 might do is limit how high the central bank raises rates. 

I expect the Fed to hike 50 basis points on September 21 and then it might remain on hold at the November 2nd announcement, which precedes the November 8 mid-term elections. Then I would expect another quarter or half point hike on December 14. That would mean short-term rates will have climbed roughly 3 percentage points over a very short timeline. This will dampen interest rate sensitive sectors of the economy, such as real estate and housing-related consumer purchases. Meanwhile, commodity prices are already falling as markets price in significantly weaker global demand. Together, this should lead to a steady falling trend in inflation. 

Will inflation fall all the way to around the 2 per cent objective? It might, but strong wage growth might prevent that outcome. The winter could bring another energy shock if Russia cuts natural gas supply to Europe. Further supply chain disruptions could occur if the health risks increase again, ad illustrated by the fact that China has announced a partial lockdown in Wuhan – this is a small event, but it highlights that the health risks persist. And, if any of these risks occur when economic growth in North America is slowing due to higher interest rates, the likelihood of an economic contraction will increase. There are a lot of factors that could make a soft-landing problematic, and the history of central banks engineering soft landings are exceptionally poor. 

Bottom line: I don’t believe the US was in recession in the first half of 2022. However, I do think the recession risks are high, with the timing being late this year and the first half of next year. Over the next six to twelve months, we will either see either soft or hard landing. Our models continue to predict that a soft-landing is achievable, but models are poor at capturing business and consumer psychology during economic turning points. If the US does experience a recession, it will feed into Canada through the nation’s deep trade and investment ties. Keep one eye on what the Bank of Canada is doing with domestic monetary policy, but equally keep the other on US developments because they are just as important. 

Categories: E-Sight, Economics, US Economy

Tags: , , , , , , , ,

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