Traditional recession indicators have misfired — are we in for a sneaky recession?

The old joke is that “an economist is an expert who will know tomorrow why the things he predicted yesterday didn’t happen today.” It is particularly fitting today.

A steady string of positive economic surprises during the first half of 2023 has led forecasters to reconsider their prior calls for a U.S. recession this year.

Resilient consumers, stubbornly tight labor markets and sustained corporate pricing power have forced the Federal Reserve to push policy rates to a 22-year high.

Shifting narratives surrounding the state of the U.S. economy, and the apparent failure of traditional recession indicators to accurately predict an economic downturn, have complicated the task of forecasters.

Last year, initial expectations for a soft landing were quickly abandoned as the war in Ukraine, the summer surge in food and energy prices, the rapid pace of Fed rate hikes and crashing asset markets led to the year-end consensus view that the U.S. economy was headed for a hard landing in 2023.

At the start of 2023, equity markets rallied and a case was made for a “no landing” scenario, characterized by resilient economic growth and a higher-for-longer interest rate regime. This narrative was suddenly abandoned and replaced by fears of a crash landing as banking sector turmoil raised concerns about financial stability. Recently, a slew of positive economic data has raised hopes that a soft landing may still be feasible.

In short, the predictions keep falling flat and the indicators keep failing to indicate. In fact, the surprising resilience of the U.S. economy has led economists to reconsider their prior forecasts and reevaluate the relevance of traditional recession indicators.

An inverted yield curve, for example, has been widely touted as an accurate predictor of economic downturns. The spread between the 10-year and 2-year T-notes has been negative since July 2022, and the spread between the 10-year T-note and the 3-month T-bill has remained negative since October 2022. Yet a recession does not appear imminent. This has led some to wonder whether the inverted yield curve has lost its potency as a forecasting tool.

Some economists have noted that the term premium (extra compensation typically offered to investors for holding long-duration assets) is currently quite low, and as such it takes only a few expected rate cuts to invert the yield curve. They also note that sustained disinflation will allow the Fed to initiate multiple rate cuts in 2024-25, even in the absence of a full-blown recession.

Another factor potentially distorting the yield curve signal is the fact that major banks have so far not been hurt by the inversion. The conventional view is that banks, which borrow short and lend long, would be hurt by an inverted yield curve, since it theoretically squeezes their lending margins. Historically, reduced credit availability and a recession have followed. Currently, however, large banks have been able to maintain their net interest margins as they have been slow to raise rates paid to depositors and quicker to push up borrowing costs.

Furthermore, the rise of private credit has partially offset pullback by traditional lenders. In fact, despite significant monetary tightening, financial conditions have not materially tightened so far.

The Sahm Rule, another widely-followed recession indicator, is based on the empirical regularity that a recession usually occurs when the three-month moving average of the unemployment rate rises half a point above its 12-month low. But in recent quarters, despite signs of economic softening, firms have tended to hoard labor, potentially distorting labor market signals.

U.S. manufacturing PMI, typically a leading indicator, has been contracting for the last eight months. Yet, this might just reflect ongoing pandemic stimulus-induced distortions in consumer behavior. In 2020 and 2021, consumers gorged on goods as they were stuck at home, leading to a sharp recovery in goods demand. Durable goods purchases were thus brought forward. Since 2022, consumer spending on goods has eased, even as spending on services has surged. 

Additionally, accumulation of excess savings and a lengthy pause in student loan repayments have altered traditional consumption patterns. Furthermore, unlike past recoveries, those at the lower end of the income spectrum (who tend to have a higher marginal propensity to consume) saw some of the fastest wage gains in the pandemic aftermath.

A key business-cycle driver, the housing market, has also experienced significant distortions. Low inventories of existing homes for sale (homeowners who have locked-in low mortgage rates are staying put) and sustained demand for single-family homes have caused new construction to remain strong despite a doubling of mortgage rates.

Given the unusual nature of the pandemic shock and associated policy interventions, it would have been hard for economists to fully factor in the resultant distortions in traditional recession indicators. However, as the distortionary effects continue to wane, tried and true relationships may reassert their significance.

Consequently, despite the recent bout of optimism, a recession may still be in the cards. 

In fact, while Gross Domestic Product data suggest ongoing economic resilience, Gross Domestic Income figures paint a less flattering portrait of the U.S. economy. GDP and GDI data should be indistinguishable in theory, but given the differences in measurement focus, the two series do not always align.

Recently, there has been growing discrepancy between the measures.

A simple average of GDP and GDI and a more sophisticated combination measurement (the GDPplus) both indicate that U.S. economic performance was actually quite weak for much of the past year. As such, recent triumphalist rhetoric surrounding an economic rebound and equity market optimism may turn out to be premature.

Vivekanand Jayakumar is an associate professor of economics at the University of Tampa.