Outlook

Can we trust the LEI to signal the next U.S. recession?

LEI Perfect?LEI RefittedIn assessing recession risks for the U.S. economy, the natural starting point is the index of leading indicators, which has been calculated based on statistical analysis of past cycles. The index is unambiguously not signaling a recession now, as can be seen in the chart to the right. 

Based on that chart, one might be tempted to say with confidence that the next recession will be obvious in advance. That would be naive, however: “Forecasting” history is much easier than forecasting the future. The distinction is evident in our second chart, which focuses on the period ahead of the 2008-09 recession. The index reported at the time showed signs of peaking ahead of the recession, but there was no clear-cut downtrend—it had essentially stalled. Since then, history has been refitted, with the updated index now showing an unambiguous decline ahead of the recession.

In retrospect, the then-reported index did not capture the major strains in credit markets that were developing ahead of the 2008-09 recession.  It was also boosted by very misleading strength in money supply data, as the structure of the banking system changed over the years. When the index was re-estimated in 2012, money supply was dropped and a new Leading Credit Index was included.  That retroactively improved the LEI’s signal for the last recession.  But strains in the credit market may not be as important for the next recession as they were for the last one.

Taking a closer look at all of the current LEI components, are any signaling recession?  At the moment, none of the 10 components is currently pointing to recession, reinforcing the positive signal from the headline index, but there are several caveats:

  • Sometimes turning points are not obvious until well after the fact, with initial declines small enough to be volatility.
  • There are plenty of false signals along the way.
  • Lead times for each component vary dramatically.

So, what do we conclude? Never say never, but the risk of recession in 2018 looks quite low. The expansion appears to be gaining momentum, and none of the components or the overall index is hinting at recession. That said, we expect more mixed signals as the Fed keeps tightening. While our forecast only goes through the end of 2019, and we don’t show a recession by then, the cumulative probability of recession inevitably rises with time.

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