There Are (Still) No Shortcuts For Estimating Recession Risk

The St. Louis Fed last week pondered the question: “Is the U.S. Due for a Recession?” In a blog post the bank advised that after a long expansion “there is a concern that, even though the economy looks good right now, the next recession may be lurking just around the corner.” On the short list for possible smoking guns, the post continued, is the low unemployment rate, which is currently at 4.1%, which is near a two-decade low.

Looking for a recession when the unemployment rate is low appears to be a classic case of counterfactual thinking, but Hyman Minsky famously pointed out in his financial instability hypothesis that stability is destabilizing and in a capitalist system every expansion creates the seeds of its own destruction. By that logic, the low jobless rate may be a warning sign after all.

The St. Louis Fed entertains the notion, explaining:

In U.S. economic history, it seems the longer an economic expansion continues, the lower the unemployment rate becomes. Thus, if a long economic expansion increases the likelihood of a recession, as the idea of positive duration dependence suggests, then a low unemployment rate may indeed suggest the increased likelihood of recession.

To be fair, the bank recognizes that estimating recession risk is best pursued in a multi-factor framework. And for good reason: no one indicator is flawless in the art/science of looking for reliable and timely recession signals.

It may appear otherwise if you’re in a Minsky state of mind and looking at the jobless rate these days. After all, every recession in the postwar era has started with a low unemployment rate, and so one can argue, naively, that a low jobless rate alone equates with a high recession risk. But this is misleading because low unemployment usually signals continued growth. Looking to those few times when low unemployment marks the start of a new recession is only valuable with hindsight.

As an example, consider the jobless rate as it appeared in the summer of 2016. The rate had dipped under 5% for the first time since the previous recession ended. One could have argued that the decline, after a relatively long run, had finally hit bottom and a new downturn was near.