Many recession forecasting indicators seem to have been wrong! Is this time really different?

People predicting a US economic recession have not had a good time recently.

The Leading Economic Index of the World's Largest Corporations issued a signal of an economic recession in 2022, and the highly regarded recession indicator, the inverted yield curve, has been issuing warnings since November 2022. Even the commonly accepted definition of a recession by the general public, which is two consecutive quarters of GDP decline, occurred in 2022. Recently, the Sam Rule, a rule used to measure short-term unemployment rate increases, also issued a warning of an economic recession in early August.

However, as many economists have pointed out, the US has neither entered nor ever been in a recession.

Is This Time Different?

The creators of all these indicators have stated that this time may be different. Their indicators may be giving false alarms. Undoubtedly, the significant distortion of economic data caused by the COVID-19 pandemic has made forecasting more challenging.

But recent errors have also revealed a harsh truth in the game of predicting economic recessions: economic recession indicators are not perfect, and likely never will be.

Campbell Harvey, a Duke University professor and Canadian economist who was the first to consider the inverted yield curve as a recession indicator, said, "The economy is so complex... we are unlikely to find a perfect indicator."

The US National Bureau of Economic Research states that an economic recession involves "a significant decline in economic activity that is spread across the economy and lasts for several months."

The problem for investors is that the US National Bureau of Economic Research is the official arbiter of economic recessions, and it only declares an economic recession long after the fact. For example, the US National Bureau of Economic Research did not announce the pandemic-related economic recession of March 2020 as an official economic recession until July 2021. This may be why people are so eager to predict when the next economic recession will arrive.

The benefits of such predictions vary. It can help or harm relevant political parties in election years, and it can provide reasons for consumers and the news media to explain the "atmosphere of recession" that has been difficult to explain in recent years.

For investors, the reasons are clear. If an economic recession really comes, early bets can bring substantial returns. For example, Michael Burry in "The Big Short" shorted the US real estate market in 2007 and estimated to have made $100 million.

Claudia Sahm, former Federal Reserve economist, inventor of the Sam Rule, and current Chief Economist at New Century Advisors, said, "It's really hard to read the economy right now."

The Sam Rule perfectly illustrates why few people can clearly interpret economic data. It is a rather simple mathematical equation: if the three-month average of the national unemployment rate rises by 0.5% or more compared to the lowest value of the previous 12 months, the rule is triggered.

After the latest non-farm payroll report released on August 2nd, the rule was triggered. Concerns about an economic recession immediately arose. But Sahm quickly dismissed the notion of an economic recession happening "so soon." In other words, she acknowledges the flaws in her revered rule.

The rise in unemployment, partly due to a large influx of immigrants into the labor market, Sahm said she knew when formulating the rule that it could not fully explain this. "I know that the 'Achilles' heel' is labor supply," she added, "I actually don't know how much of it is immigrants, how much is weak demand, both are having an impact."

This reveals a core issue that people make mistakes or completely ignore when using these indicators - they are not truly black-and-white economic interpretations, at least not for their creators.

"I don't base all my thoughts on the Sahm rule to judge where the economy is or where it is going," Sahm said. "That has never been its purpose."

Even the "legendary" recession indicator - the inverted yield curve, seems to have encountered setbacks. Since 1968, it has correctly issued warnings before economic recessions 8 times in a row. But now, it has been issuing red alerts since November 2022, and Harvey also acknowledges that its invincible winning streak may have come to an end.

"People mistakenly assume that this is like a perfect indicator," Harvey said. "Indeed, in the past, it has been perfect. But that doesn't mean it will be perfect in the future. In fact, it is impossible not to send out false signals."

In fact, Harvey believes that one reason the inverted yield curve this time may be a false signal is that his indicator has been too accurate in the past. He believes that companies seeing the inverted yield curve will think, "We need to be cautious when taking action."

For example, when his recession indicator first lit up in 2022, Wall Street's consensus quickly shifted to predicting an economic recession. In the following months, there was a widespread wave of layoffs in the tech industry.

Now, nearly two years have passed, there has been no economic recession, and according to FactSet data, the frequency of CEOs mentioning the word "recession" on earnings calls is at its lowest in nearly three years.

"Given that people see the inverted yield curve, they will take action, leading to a slowdown in economic growth," Harvey said. "We may have dodged an economic recession. It looks like a false signal, but in fact, it is just doing its job."

There is never a "Holy Grail"

These two economists are debating whether their indicators are sending out false positive signals, highlighting that no indicator is likely to be perfect. Especially with a very small sample size.

"Since 1968, we have only had 8 observations," Harvey said. "You can't do much with 8 observations."

Moreover, merely looking at the data may not reveal some underlying worrisome signs when entering an economic recession. Steven Pearlstein won the Pulitzer Prize for his extensive work predicting the 2007/2008 financial crisis and the impending recession in the U.S However, Pearlstein told Yahoo Finance that he did not come to this conclusion by looking at traditional economic indicators.

Pearlstein said, "I was just observing the financial markets, which were going crazy at the time, on the verge of collapse."

Pearlstein said that tracking economic recession indicators based on economic data ignores the bigger fears that most Americans have when it comes to economic downturns. "Most of the economic recessions we have experienced recently have been caused by the bursting of financial bubbles, and these economic data do not really reflect that."

Jason Furman, a Harvard economist who served as chairman of the Council of Economic Advisers under President Obama, jokingly said, "Almost all economic recession indicators have not survived the next economic downturn. It's like a random event, you know, happening over and over again, and we really want to be able to predict it, but I don't think we can. Once you admit you can't, that itself is knowledge and wisdom."

He added that predicting economic recessions is like rolling dice, sometimes the dice are more likely to land on a certain number, but it's never certain. He said:

"Knowing how the dice work doesn't help you predict what number the dice will land on, but it can tell you how to gamble, and more importantly, how not to gamble."

This brings us back to the truth about economic recession indicators: they may be correct for a long time, but no one can always guess whether this indicator will work again next time