Can Economists Predict Recessions?

When individuals inquire about the economy, their inquiries often revolve around predictions. They wonder if a recession is looming when inflation might abate, why economists failed to foresee the 2008 crisis, and most importantly, whether economists possess any insight into the economy's future.

These questions have gained heightened significance recently. Over the past four quarters, economic forecasters have, on average, anticipated a 42% chance of a U.S. economic contraction in the upcoming quarter, as per the Survey of Professional Forecasters (SPF) conducted by the Federal Reserve Bank of Philadelphia. Thus far, no recession has materialized, though the projected risk of a downturn in the fourth quarter remains relatively high at 34.4%.

Simultaneously, policymakers, including those at the Federal Reserve, depend on economic forecasts—both external (like the SPF) and internal (such as the Fed Board of Governors' Tealbook forecasts)—to guide their decisions on adjusting interest rates. If the economy is expected to remain robust, characterized by elevated inflation and low unemployment, this typically warrants higher interest rates compared to when the economy is anticipated to cool, marked by declining inflation and weaker economic growth.

A Recession: What Is It?

A recession, broadly speaking, is a significant economic slump that lasts for more than a few months. A stretch of at least two consecutive quarters of negative economic growth is the formal definition. Gross domestic product (GDP) is used in these situations to measure economic growth, as was mentioned above. However, more frequently than not, the term “recession” is employed in a broader sense.Top of Form

A recession typically lasts between six and eighteen months. The length of time might vary depending on the severity of the downturn and the steps taken to address it by the government and central bank (in the US, the Federal Reserve). Economic downturns can be brought on by a singular occurrence (like the financial crisis of 2008), but they are a normal component of the business cycle and have a variety of underlying causes.

What Happens During a Recession

It is typical for stock values to decline and the unemployment rate to increase during a recession. Because investors have less money to invest and less confidence in the market to grow their investments, stock prices decrease. As a result of the decreased demand for equities, stock prices (and hence portfolio values) would inevitably decline.

During a recession, business revenues also drop, which prompts many to stop employing new employees or reduce the size of their existing workforce. There will be a large number of company closures, which will result in more job losses. The unemployment rate rises as a result of this. More people are conserving money rather than spending it, which is a result of both an increase in the unemployment rate and general economic uneasiness. This drop in expenditure may lead to a further decline in corporate revenues, restarting the cycle.

The fact that inflation normally declines during a recession is one potential benefit. When inflation spirals out of hand, it can completely destroy an economy by causing a currency to lose value. Periodic slowdowns in economic growth can prevent inflation from becoming out of control.

What Kinds of Recessions Exist?

The recession caused by the coronavirus is the most notable recent example. The COVID-19 pandemic's spread had a significant financial impact on the American economy, particularly as closure orders started to be issued across the country. Due to this, market predictions became incredibly unstable, which had a ripple effect on the stock market. As the pandemic devastated far more than just the United States, this recession eventually spread to the entire world.

Before it, the United States went through the “Great Recession,” which lasted from the end of 2007 to 2009. The majority of economists believe that the U.S. housing bubble's fall was the direct cause of this recession. As a result, unemployment rates have increased.

Difficulties in Predict Recession?

There is a margin of error for any economic projection. This is due to:

The economy is impacted by a wide range of factors. For instance, the impact of failed sub-prime mortgage loans on the whole economy was far greater than ever before despite the fact that the significance of shadow banking was completely neglected in 2007 estimates.

There is a lot of uncertainty all the time, such as how customers will respond to particular events or what will happen to oil prices.

Even the current situation of the economy is difficult to determine (data collection issues, insufficient statistics).

Economic Forecasting: Accuracy vs. Precision

How accurate are economic forecasts? We must distinguish between the qualities of accuracy and precision in order to respond to this query. A forecast is considered accurate if it is generally accurate. Therefore, if, on average, it rains 30% of the time on the following day, we would argue that the weather forecast is accurate when it indicates there is a 30% probability of rain tomorrow.

The future's events are less unclear following a detailed forecast. A forecast with a 50% probability of rain on Monday and a 50% chance of rain on Tuesday is less accurate than one with a 99% likelihood of rain on Monday and a 1% chance of rain on Tuesday.

Even without being exact, a forecast can be correct. The Weather Channel is now forecasting a high of 63 degrees on Halloween in St. Louis, but this is only a statistical average for that time of year. This is an illustration of how unreliable weather forecasts for the next month are. Forecasts with more accuracy provide less room for ambiguity.

Even without being exact, a forecast can be correct. The Weather Channel is now forecasting a high of 63 degrees on Halloween in St. Louis, but this is only a statistical average for that time of year. This is an illustration of how unreliable weather forecasts for the next month are. Forecasts with more accuracy provide less room for ambiguity.

Are Economic Predictions Reliable?

Let's first investigate the accuracy of economic forecasts. We'll concentrate on the SPF's quarterly predict recession probability. These predictions are made by commercial economic forecasters and indicate the likelihood that real gross domestic product (GDP) growth will be negative in a specific quarter. If real GDP growth was truly negative that quarter, we can compare the recession probability offered by the forecasters (averaged across respondents) to what actually transpired.

If projections are accurate, then there will, in fact, be a recession 15% of the time when forecasters estimate a 15% risk of one for the upcoming quarter. A linear regression can be used to condense the performance of the recession forecasts:

Recessiont = α + β*Recession_Probabilityt + εt

Here, we perform a regress analysis on the average recession probability provided by the forecasters When forecasters state there is no risk of a recession, the constant term, represents the likelihood that one actually occurs. should be 0 if the forecasts are correct. The slope term, shows how the actual likelihood of a recession shifts as the expected likelihood of one shift. should be 1 if the forecasts are correct. (The error term is tepsilon subscript t.)

In the illustration provided below, we examine the real probability of predict recession, represented on the vertical axis, alongside the one-quarter-ahead average forecasted probability of a recession obtained from the SPF. The data covers the period from the fourth quarter of 1968 to the third quarter of 2023.

Exploring the Connection Between Predicted and Actual Recession Probabilities