Recessions are economic downturns where the gross domestic product (GDP) of an economy contracts (declines) for a period of time. It is important to remember that a recession is not merely a slowdown or reduction of the GDP growth rate. A recession is negative growth, namely a reduction of the size of the GDP, which equates to a decline of demand for goods and services.

There is no official duration that defines a recession. A common rule suggests that a contraction lasting two consecutive quarters or more is a recession. However, a recession is defined a lot more by its severity than its duration. In the United States, the official arbiter for declaring a recession is the National Bureau of Economic Research (NBER), which defines a recession as “a significant decline in economic activity that is spread across the economy and that lasts more than a few months.”¹ Given the subjectivity involved with applying this definition, the NBER usually does not declare a recession until long after the fact.²

On July 28, 2022, the United States Department of Commerce reported that GDP declined at an annual rate of 0.9% during the second quarter of 2022, following a contraction of 1.6% in the first quarter.³ However, it should be noted that the second quarter GDP decline of 0.9% is an “advance estimate” subject to revision.⁴ The Department of Commerce will release an updated estimate at the end of August, and a final estimate at the end of September.

According to the Department of Commerce, the main reason for the second quarter decline was a reduction of inventories across industry sectors, which subtracted 2% from the GDP output.⁵ Accordingly, if inventories had been replenished, a growth of 1.1% would have been recorded for the second quarter instead of the 0.9% decline. It can be argued that a reduction of inventories does not legitimize calling a recession, especially since many companies were in fact stockpiling heavily at the end of 2021 in anticipation for an end to the pandemic. Besides inventory build-up or decline, the other main variables of GDP measurement are consumer spending, business investment, homebuilding, net exports and government spending.⁶

Given the variables and complexities of estimating GDP, it is not surprising that the NBER does not endorse the rule that two quarters of negative growth constitutes a recession. Most economists surveyed by The Wall Street Journal expect GDP growth in the third quarter, and positive growth for 2022 as a whole, although they have recently lowered their projections.⁷ Economists agree that a slowdown is taking place. They also agree that the risk of a “definitive” recession is increasing.

There is no magic formula for predicting when a recession will happen, and how severe it will turn out to be. Each recession has its own context and triggering events. Besides advance estimates of GDP growth (which are subject to interpretation and revision), many other leading indicators provide insights for anticipating recessions. It is also very important not to overlook contextual factors.

Indicators to Watch

Many indicators have proven to be fairly reliable in predicting recessions in the past. They are known as leading indicators because they help anticipate things to come. Although none of them are failsafe predictors on their own, taken together they provide a good sense of economic prospects. When most leading indicators point in the same direction, and if their trend lines are pronounced, the flashing signs cannot be ignored. Leading indicators of recessions are profiled below.

BOND YIELDS – A yield curve indicates the investment return of bonds across maturities, ranging from one year or less, to thirty years or more. In normal times, yields are higher for longer maturities. An upward yield curve indicates that the economy is expected to grow. A downward or inverted curve indicates that a recession is coming. The current United States government bonds yield curve (Figure 1) points to a recession, given the downward slope of maturities in the 1 to 10 year range. The downward slope of maturities in the 20 to 30 year range reflects a higher demand for longer term bonds, which is pushing yields a bit lower for 25 and 30 year maturities.

BUSINESS CONFIDENCE – The United States Conference Board monitors business confidence based on CEO perceptions of current and expected business conditions (Figure 2). The business confidence index ranges from 0 to 100. Levels above 50 indicate optimism, and levels below 50 indicate pessimism. The higher or lower the measure, the more there is optimism or pessimism as the case may be. In June 2022, business confidence dropped to 42, from an all-time high of 82. The very sharp decline of 40 points is the biggest drop ever recorded over a 12 month period. Levels below 40 have been an accurate predictor of recessions in the past. The current trend is cause for concern.

CONSUMER CONFIDENCE – The United States Conference Board also measures consumer confidence using a composite index that reflects consumer attitudes and expectations (Figure 3). Readings above 100 indicate that consumers are generally optimistic and willing to spend on major purchases. Readings below 100 indicate pessimism, resulting in less spending and a decline of demand for goods and services. The higher or lower the confidence level, the more there is optimism or pessimism. Consumer confidence reached 130 in June 2021, and declined to 96 since then. A drop of 34 points over 13 months is significant.

PRODUCTION ACTIVITY – S&P Global^TM measures production activity for the United States and other countries. One of its key indicators is the U.S. Composite PMI (Purchasing Manager’s Index), also known as the “Flash U.S. PMI Composite Output Index.” This leading indicator (Figure 4) is based on a survey of manufacturing and service companies located in the United States. It provides an indication of expected production activity. Levels above 50 indicate anticipated growth in the production of goods and services, while levels below 50 indicate anticipated decline. The level of production was measured at 47.5 at the end of July 2022, down from 68.5 recorded last year in June. A drop of 21 points over 13 months is significant.

JOBLESS CLAIMS – Weekly jobless claims are reported by the United States Department of Labor. The data includes the number of people filing for unemployment insurance benefits for the first time (initial claims), and those already receiving benefits. The data is adjusted for seasonal fluctuations. When jobless claims rise, the demand for goods and services is expected to drop, because unemployed individuals normally reduce their spending. On July 30, 2022 initial jobless claims totaled 260,000, reflecting a 29% increase from three month ago. Because initial claims can be volatile on a weekly basis, most economists track the four week moving average. The four week moving average of initial jobless claims has been increasing rapidly since March (Figure 5), despite the fact that many jobs are available. Many jobs are unfilled due to labor skill shortages.

STOCK MARKET VOLATILITY – When there is aggressive monetary stimulus such as ultra-low interest rates and quantitative easing, it is less clear whether stock market indexes are a reliable indicator of anticipated economic expansion or contraction. Since the financial crisis, there have been many instances where stock markets rallied following bad economic news, in the anticipation that aggressive monetary stimulus would continue. Over time, the remedy became the lifeline and “the only game in town” according to some analysts. Despite recent hikes, interest rates continue to be very low by historical standards. The aggressive monetary stimulus has inflated stock market levels and real estate values in the past 10 to 12 years. For these reasons, it can be argued that stock market volatility is perhaps a better leading indicator of challenging economic conditions.

Stock market volatility is an indicator of investor sentiment associated with risk. It represents the degree of fear among stock market participants. The greater the fear about future economic conditions, the more that stock market values fluctuate widely and rapidly. The Chicago Board Options Exchange (CBOE) Volatility Index (commonly known as the VIX) measures the anticipated stock market volatility based on the prices of stock market options. Values below 20 indicate relatively low volatility, while values above 20 indicate relatively high volatility. Extreme volatility occurred early 2008 (start of the financial crisis) and early 2020 (start of the pandemic). In both cases, volatility reached levels above 80 for brief periods. Stock market volatility (Figure 6) remains low, mostly because investors concerned with current economic conditions have been gradually shifting their investment portfolios away from stocks in an orderly fashion.⁸

Factors to Consider

For the most part, the above indicators point in the same direction. Economic growth is slowing, confidence is weakening, and the risk of a recession is increasing. But measuring risk is never a perfect science, especially when conditions are very different from the past. The Covid-19 pandemic affected supply chains, and the war in Ukraine compounds the problem. These events, together with tight labor markets and aggressive fiscal and monetary stimulus have proven to be a perfect storm for high inflation. These conditions are very different from the recession of 2008-09, which had nothing to do with supply chain issues, tight labor markets, a pandemic, a war and high inflation.

In the United States, the annual rate of inflation accelerated to a new high of 9.1% in June. Inflation is even worse in the United Kingdom at 9.4%, and not much better in continental Europe at 8.6%, and in Canada at 8.1%. These inflation rates are alarming and completely outside traditional targets of 1 to 3%. In response, central banks are raising interest rates aggressively (albeit starting from all time lows). The United States Federal Reserve is worried that high inflation may persist and become entrenched. It has recently committed to keep raising interest rates until inflation is “under control.” The Federal Reserve is willing to accept a higher risk of recession while doing so.⁹

It is not clear whether higher interest rates will be as effective to curb inflation at a time of limited supply and tight labor markets, as they have previously been in times of excessive demand and abundant labor. The supply-driven inflation that we are seeing now may be a much bigger challenge. Central banks have no experience dealing with this kind of inflation. There is uncertainty regarding the effectiveness of monetary policies in the current the context. Interest rates may have to climb higher than currently anticipated in order to meet inflation targets. The consequences of high interest rates on deeply indebted individuals, businesses and governments could be devastating.

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¹ National Bureau of Economic Research, “Business Cycle Dating Procedure: Frequently Asked Questions” (NBER, www.nber.org/business-cycle-dating-procedure-frequently-asked-questions, Accessed July 29, 2022.)
² Harriet Torry, “U.S. GDP Fell at 0.9% Annual Rate in Second Quarter; Recession Fears Loom Over Economy” (The Wall Street Journal, July 28, 2022, Article accessible through www.wsj.com).
³ Harriet Torry, “U.S. GDP Fell at 0.9% Annual Rate in Second Quarter; Recession Fears Loom Over Economy” (…).
⁴ Bureau of Economic Analysis, “Gross Domestic Product, Second Quarter 2022 (Advance Estimate)” (NBER, www.bea.gov/news/2022/gross-domestic-product-second-quarter-2022-advance-estimate, Accessed July 29, 2022).
⁵ Jon Hilsenrath, “Inventory Swing Is a Key Culprit Behind U.S. Recession Talk” (The Wall Street Journal, July 28, 2022, Article accessible through www.wsj.com).
⁶ Jon Hilsenrath, “Inventory Swing Is a Key Culprit Behind U.S. Recession Talk” (…).
⁷ Harriet Torry, “U.S. GDP Fell at 0.9% Annual Rate in Second Quarter; Recession Fears Loom Over Economy” (…).
⁸ Eric Wallerstein, “Volatility Measure Hits Three-Year Low Despite Market Tumult” (The Wall Street Journal, August 3, 2022, Article accessible through www.wsj.com).
⁹ Nick Timiraos and Tom Fairless, “Powell Says Fed Must Accept Higher Recession Risk to Combat Inflation” (The Wall Street Journal, June 29, 2022, Article accessible through www.wsj.com).