U.S.: It's Time to Nail Down What the R-Word Really Means
When your neighbor is out of work, that's a recession; if you're out of work, it's a depression. As definitions of recession go, that old saying captures the right tone of despair. A more sophisticated rule of thumb says a recession is two consecutive quarters of declining real gross domestic product. Actually, neither definition is very accurate.
The popular press, executives, and politicians are quick to bandy about the R-word, probably because recession is a more dramatic--and more easily hyped--notion than sluggish growth. But to follow what the economy is truly doing, and to get a clear idea of how policymakers at the Fed are thinking, it is important to understand how economists define recession.
For that, go to the source: the Business Cycle Dating Committee of the National Bureau of Economic Research (www.nber.org). It's a group of academic economists who for decades have determined the months in which recessions have begun and ended. According to the NBER, "A recession is a significant decline in activity spread across the economy, lasting more than a few months, visible in industrial production, employment, real income, and trade" (table).
A recession is more than a slowdown that lifts the jobless rate, or a drop in demand that affects a single sector, such as manufacturing. The entire economy actually shrinks. The growth process goes into reverse as economic weakness spreads from one sector to another and begins to feed on itself. It's like a coiled spring that suddenly snaps and begins to unwind.
So far, growth has only turned weak, but the economy is not unraveling in the classic recession way. And stimulus from the Fed's lower rates and the expected tax cuts will soon provide a lift. Those two policy actions are why growth in the second half should be stronger than in the first.
EVEN SO, amid all the uncertainty--and hype--about the state of the economy, the NBER decided to issue a communique on May 15 that explains why its committee has not yet met to discuss the onset of a recession. Basically, the Bureau says that data through April are inconclusive. Of course, keep in mind that the NBER moves slowly. It did not set the July, 1990, start of the last recession until April, 1991, a month after the downturn was later determined to have ended.
Right now, the economy's path looks more flat than down (chart), based on the Conference Board's index of coincident indicators. This index is important because it is made up of the same four data series that the NBER examines when its economists sit down to date the start of recessions and expansions. The index was unchanged in April, after rising 0.1% in both February and March, and it has been going sideways since last September. By comparison, the index fell sharply from July through November of 1990. Even the unrevised data made it evident that the recession had begun by the end of 1990.
OF THE FOUR COMPONENTS of the coincident index, the two that weigh most heavily in the NBER's determinations are industrial production from the Federal Reserve and payroll employment from the Labor Dept. But despite the recent weakness in each of these indicators, the declines do not yet add up to a recession.
For example, the NBER notes that industrial production peaked in September, 2000, and has since declined 2.8%. In the 1990-91 recession, the peak-to-trough drop was 4.5%. To match that, output would have to drop substantially in the next several months, making industrial activity a key indicator to watch.
However, the Bureau points out that industrial production is a small and declining part of the economy. That's why the broader payroll employment data will also be a crucial benchmark in coming months. But here again, payroll employment, while having fallen 276,000 since February, is far from matching its declines in the 1990-'91 recession, which totaled 1.8 million.
Sharply weaker demand is also a key element of recessions, since it is the interaction between demand, output, and employment that creates a downturn's vicious cycle. For this, the NBER looks at personal income and business sales, adjusted for inflation.
On that score, sales by manufacturers, wholesalers, and retailers are now down 0.9% from their August, 2000 high, while their peak-to-trough drop in the last recession was 5.1%. Personal income, which fell 2.6% in the last downturn, has been growing since last autumn. This pattern emphasizes the importance of consumers in the outlook, and it shows why their unflagging demand has kept the index of coincident indicators from falling, despite the declines in output and jobs.
Demand is also where the Fed's efforts to stimulate growth will come into play in the coming months. The Fed's unprecedented aggressiveness is the chief reason for optimism that the current economic weakness will not devolve into a recession--and a likely key reason why the NBER has not yet scheduled a meeting about the business cycle. Clearly, the Bureau wants to see how this policy plays out. The Fed's May 15 rate cut brings the Fed's benchmark federal funds rate to 4% from 6.5% at the beginning of the year, and another cut still seems likely when the Fed next meets on June 26-27.
THE FED HAS TAKEN POLICY from restrictive to accommodative in less than five months, providing stimulus that will begin to hit the economy this fall, not to mention the coming impact from tax cuts. The real federal funds rate, which is the rate adjusted for expected inflation, has fallen well below its average level of the past 15 years.
Plus, the yield curve, illustrated by the difference between short- and long-term interest rates, has gone from inverted to positively sloped. That is, long rates are now greater than short rates. Indeed, in the past two months the fed funds rate dropped by 100 basis points, but the yield on 10-year Treasury bonds rose 60 basis points. That means the credit markets are betting that Fed stimulus will lift the economy (chart).
Bondholders are demanding a bigger payoff for their investments because strongly stimulative policies could lift inflation next year, forcing the Fed to take back some of this year's rate cuts. But for now, the Fed seems unmoved by the bond market's behavior. In its May 15 policy announcement, it went out of its way to downplay price pressures, saying inflation "is expected to remain contained."
But inflation is a question for 2002. Right now, the topic is recession. Some of the key data are pointed in the wrong direction, and second-quarter real GDP may even decline. So far, however, it's a good bet that the Fed's rate cuts will keep the economy's weakness from becoming so significantly deep, widespread, or lasting as to cause the NBER to declare a recession.
By James C. Cooper & Kathleen Madigan