Note: As a Federal Reserve publication, this is in the public domain and not copyrighted.
https://www.federalreserve.gov/econres/notes/feds-notes/fina…
**June 21, 2022**
**Financial and Macroeconomic Indicators of Recession Risk**
**Michael T. Kiley, Federal Reserve**
**...**
**A range of approaches have been considered in calculating recession risk.**
**One strand of analysis uses financial market variables — often the slope of the yield curve — to assess recession risk.**
**A second strand augments the first approach by adding leading indicators (which summarize confidence and economic activity indicators) to recession prediction models.**
**A third approach considers the state of the macroeconomy — inflation and the business cycle, as measured by the unemployment rate — because historical analyses have emphasized how recessions were preceded by high inflation, an overheated economy, and a shift in monetary accommodation...**
**Approach**
**The risk of a recession is akin to the risk of a sizable increase in the unemployment rate. In light of this correspondence, our empirical approach focuses on the risk of a sizable increase in the unemployment rate....**
**A common approach to assessment of recession risk uses financial variables, such as the credit spread (here, the difference between the Baa corporate bond yield and the 10-yr Treasury yield) and the term spread (here, the difference between the 10-yr Treasury yield and the federal funds rate). These variables are used to predict economic activity or the probability of a recession ...**
**Recession Risk Using Leading Indicators**
**Another approach to assessing recession risk considers leading indicators identified by economists. As an example of this approach, I use the variables from the previous model (credit and term spreads) and add the change in the OECD's composite leading indicator for the United States. This leading indicator is a summary index of consumer confidence, business confidence, production and labor market indicators, and financial variables (including the term spread).**
**The probability of a recession over the next four quarters from this estimated model is reported in figure 2 and is quite low as of March 2022, at about 5 percent.**
**Recession Risk Using Inflation and the State of the Business Cycle (Unemployment Rate)**
**As of March 2022, inflation was at multidecade highs and the unemployment rate was near multidecade lows. ... A model with four variables is considered: CPI inflation (measured on a four-quarter change basis); the unemployment rate; the credit spread; and the term spread...**
**Figure 4 reports the probability of a recession over the next four quarters from this approach. This approach implies a sizable risk (above 50 percent) of a large increase in the unemployment rate over the next four quarters. Historically, elevated inflation and low unemployment have preceded recessions, consistent with the idea that such developments signal imbalances (overheated product and labor markets) that may unwind through an economic contraction...**
**The unemployment rate and inflation are stronger predictors of recession risk, relative to financial variables, over horizons longer than four quarters. The approach implies a more sizable risk of a large increase in the unemployment rate, of about 67 percent over the next two years....** [end quote]
This Federal Reserve economist is comparing the risk of recession using different models. Modeling the economy is his job. He is looking at past recessions and correlating factors.
As investors, we can use the model to plan ahead. Recessions cause higher unemployment, falling sales and lower profits for companies. This leads to lower stock prices during recessions.
The stock market has dropped considerably already, but that’s not because of a recession. The economy is not in a recession at this time. Unemployment is at a historic low. GDP is at a historic high. (The 1Q22 GDP drop was due to inventory adjustment, not a drop in sales.)
The cause of the 1 & 2 Q2022 stock market drop was the stated intention of the Fed to fight inflation by raising the fed funds rate to a “neutral” level from highly stimulative and to withdraw its purchase of long-term Treasury and mortgage bonds.
The “everything bubble” has been inflated by emergency high monetary stimulus (in addition to 20 years of continuous monetary stimulus). All assets rose together on this immense wave of money. All assets are falling together with the Fed’s announcement that the wave has passed.
The drops we have seen so far do not include the natural stock price drops during recessions. (Bond prices usually rise during recessions as interest rates fall.)
The high risk of recession was calculated without taking into account Fed Chairman Powell’s determination to wring inflation out of the system by cutting monetary stimulus. Monetary cuts aren’t able to solve the supply problems which are the root cause of inflation so they will be slow to act, guaranteeing that they will be in place for a long time.
https://www.wsj.com/articles/powell-says-fed-needs-compellin…
**Fed Chief Jerome Powell Concedes Possibility That Higher Rates Cause a Recession**
**‘It is essential that we bring inflation down,’ he tells Congress**
**Mr. Powell said the Fed plans to continue raising interest rates until it sees clear proof that inflation is slowing to the central bank’s 2% target.**
This is no time to be buying stocks even if the price seems reasonable by historic standards after recent drops. The excellent growth of the stock price in the past 10 years was driven by excess monetary stimulus which is being withdrawn.
This is no time to be buying long-term bonds since yields will be rising for the near-term future. It’s hard to say whether flight-to-safey buying of Treasuries will mute the rise in Treasury yields. Many corporate bonds that were bought with the Fed’s tsunami of monetary stimulus will fail. The companies will not be able to roll over the bonds when rates rise.
As your METAR weather reporter, I am advising everyone to take shelter and repair the roof since winter is coming. It won’t be like Hurricane Covid – fast to arrive, fast to depart. It will be slow and grinding.
Wendy
