SF FED: EXPECT A “SLUGGISH RECOVERY”

The San Francisco Fed is out with a relatively honest and realistic outlook for the economy.  Using two indicators that I have highlighted in the past the SF Fed comes to the conclusion that the next few years are likely to be below trend growth:

Two indicators of economic activity

The Federal Reserve Banks of Chicago and Philadelphia both produce business cycle indicators designed to gauge current and future economic activity. Known respectively as the Chicago Fed National Activity Index (CFNAI) and the Aruoba-Diebold-Scotti (ADS) index, they are plotted in Figures 1 and 2. Both indicators are constructed by condensing a wide range of economic data into a single index that summarizes business cycle conditions.

The monthly CFNAI has proved useful as an early indicator of recessions (see Evans, Liu, and Pham Kanter 2002 and Brave 2009). It is distilled from 85 monthly series drawn from four broad data categories: consumption and housing; employment, unemployment, and hours worked; sales, orders, and inventories; and production and income. The index is constructed to have an average value of zero, with a positive reading indicating growth above trend and a negative reading indicating growth below trend.

Chicago Fed National Activity Index

Philadelphia Fed’s ADS Business Conditions Index

Figure 1 shows that the CFNAI recorded extreme negative readings during the recent recession, but bounced back sharply during the second half of 2009. However, in recent months the index’s rebound has stalled. The index recorded three consecutive negative readings for June, July, and August.

The ADS index is distilled from six different data series, including the weekly series on initial claims for unemployment insurance; the monthly series for payroll employment, manufacturing and trade sales, industrial production, and personal income less transfer payments; and the quarterly series on real GDP growth. The index is updated each time a new piece of data is released. Its average value is zero, with positive readings indicating better-than-average conditions and negative readings indicating worse-than-average conditions. Like the CFNAI, the ADS index’s monthly average value can be used as a real-time recession indicator (see Jorda 2010).

Figure 2 shows that the ADS index has exhibited a pattern similar to the CFNAI in recent months. The average reading for June turned negative followed by average readings closer to zero, but still negative, in July and August.

Empirical forecasting models for real GDP growth

Historically, both the CFNAI and the ADS index started declining prior to the onset of past recessions. Both indicators may be useful not just in forecasting recessions, but also in projecting the magnitude of real GDP growth in future quarters. To assess the power of these indicators to predict growth, we construct simple empirical models that use data from the first quarter of 1972 through the second quarter of 2010. We perform a regression, a statistical exercise in which we look at the relationship between the two-quarter moving average of real GDP growth and four explanatory variables dated at least two quarters earlier. For example, average growth in the third and fourth quarters of 2010 would be predicted using variables that pertain to the second quarter of 2010 or earlier. The explanatory variables are the end-of-quarter monthly value of the CFNAI or ADS index; the change in the same index from the previous quarter; the quarterly change in the end-of-quarter monthly average of the Standard & Poor’s 500 stock index; and the quarterly change in the end-of-quarter monthly average yield of the 10-year Treasury bond. A similar exercise is performed using the four-quarter moving average of real GDP growth and the same set of explanatory variables dated at least four quarters earlier.

Two-quarter GDP growth, actual and forecasted values

The monthly value of the CFNAI or ADS index at the end of the quarter provides a gauge of recent economic data, whereas the change from the previous quarter indicates whether the data are improving or deteriorating. Given that financial markets are forward looking, the quarterly changes in stock prices and long-term Treasury yields measure the degree to which recent data may have shifted investor expectations about the future. All these variables are statistically significant in helping explain real GDP growth two to four quarters ahead. The two-quarter-ahead forecasting models explain about 50% of the variance of real GDP growth since 1972, while the four-quarter-ahead models explain about 30% of the variance.

Figure 3 plots forecasts from the two-quarter-ahead models versus the two-quarter moving average of real GDP growth from 2007 to 2010. Both forecasts track the actual data fairly well through the first half of 2010, but with a lag, which is typical when current and past data are used to make predictions about the future. For the second half of 2010, the CFNAI model predicts an average growth rate of 1.0%, while the ADS model predicts an average growth rate of 1.9%. The four-quarter-ahead CFNAI model predicts average growth rates through the first half of 2011 of 1.6% and the four-quarter-ahead ADS model predicts 2.2%. By contrast, the most-recent Blue Chip consensus forecast is for 2% growth in the second half of 2010 and 2.3% through the first half of 2011.

The conclusions here?  Sluggish growth and a persistently high unemployment rate.  Read the full paper here.