Is The Labor Market Conditions Index Forecasting A Recession?

Inferring recession probabilities from one indicator is a dodgy way to monitor business-cycle risk, but it’s forever popular. Last week I criticized an effort to estimate recession risk by using the ISM Manufacturing Index in isolation; today we focus on a similar attempt to use the Labor Market Conditions Index (LMCI) as the basis for deciding if the US economy has slipped over to the dark side.

Earlier this week, Bloomberg reported that “recession risk is rising,” based on analysis of LMCI.

After falling just three times from 2012 to 2015, the index has fallen every month of 2016 except for one, July. And in July the annual change in the LMCI, from July 2015, turned negative.

That’s only the eighth time in nearly 40 years the index was down on a year-over-year basis, Deutsche Bank Chief U.S. Economist Joseph LaVorgna wrote in a note to clients today. Of the seven previous occasions, LaVorgna wrote, “four were soon followed by recession.”

LMCI is published monthly by the Federal Reserve. This multi-factor benchmark is a valuable tool for analyzing the labor market and the economy, but like any data set it suffers limits for capturing the breadth and depth of the US macro trend. Granted, no serious business-cycle model can ignore job creation and related metrics, and by that logic LMCI is a worthy time series. But it’s not flawless, and so the possibility of false signals is forever lurking in real-time analysis. That’s hardly a surprise—every indicator falls short of dispensing reliable and timely warnings of recession warnings.

The solution is to build a business cycle benchmark based on a range of indicators and monitor the results regularly. There’s always a degree of uncertainty, but combining indicators is a solid foundation for robust analytics. Modeling the data from different perspectives further enhances the dependability of the signals. As an example, the US Business Cycle Risk Report combines analysis of two broadly defined indexes published by Federal Reserve banks with a pair of proprietary benchmarks designed by The Capital Spectator. But I digress.