Investing

Why economists have trouble predicting recessions

Twenty/20

Most economists predict another recession, but you may want to take their forecasts with a grain of salt. Accurately predicting a recession is no easy feat.

That dreaded R-word has been back in the lexicon on Wall Street lately because a dynamic in the bond market — what's known as an inverted yield curve — is flashing warning signals. An inverted yield curve has historically been an accurate predictor of recessions, and the current shape suggests a 38% probability of a recession by August 2020, according to the Federal Reserve Bank of New York.

As of August, 74% of economists predicted a recession will begin between this year and the end of 2021, down from 77% in February's survey, according to the National Association for Business Economics. Perhaps more telling: In each survey, more than 10% of economists said they don't know or have no opinion about the timing of the next recession.

Downturns are a normal part of the economic cycle, though the U.S. is now in its longest expansion ever — 10 years and counting. But recessions don't arrive at specified times, and predicting the next one is difficult, even for professionals.

Here's why recession predictions often have been, and can be, so faulty.

What it means to predict a recession

A recession is generally defined as two consecutive quarters of declines in gross domestic product (GDP), or the sum of the value of all goods and services produced in an economy.

The U.S. economy is massive — valued at more than $20 trillion in 2018 — and the four major categories of GDP are:

  1. Personal consumption expenditures (goods and services). This represents everything consumers spend money on, including cars, groceries, housing expenses, and health care.
  2. Gross private domestic investment. This category represents investments made by businesses, encompassing spending on things like buildings, equipment, and software.
  3. Government consumption expenditures and gross investment. As the name suggests, this captures all the spending at the federal, state, and local government levels.
  4. Net exports of goods and services. For many years, this has actually been a negative amount because the U.S. imports more goods than it exports.

Building blocks of the economy

How the four major categories contributed to GDP in 2018

$14.0T

Personal consumption

expenditures

$20.6T

Total GDP

$3.6T

Gross private domestic investment

$3.6T

Government expenditures

0

-

$0.6T

Net exports of goods and services

kiersten schmidt | grow Source: Bureau of economic analysis

Building blocks of the economy

How the four major categories contributed to GDP in 2018

$14.0T

Personal consumption

expenditures

$20.6T

Total GDP

$3.6T

Gross private domestic investment

$3.6T

Government expenditures

0

-

$0.6T

Net exports of goods and services

kiersten schmidt | grow Source: Bureau of economic analysis

Building blocks

of the economy

How the four major categories contributed to GDP in 2018

$14.0T

Personal consumption

expenditures

$20.6T

Total GDP

Gross private domestic investment

$3.6T

Government expenditures

$3.6T

0

Net exports of goods and services

-

$0.6T

Graphic: kiersten schmidt | grow

Source: Bureau of economic analysis

When trying to predict a recession, economists must nail both the timing and which categories have excesses — or possible bubbles — that could pop, leading to broader GDP declines. They also monitor other key indicators not included in GDP for signs of a possible recession. But just like any type of forecasting, people generally have more clarity about the immediate future rather than months or even years in the future.

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Surveys like the one from NABE cited above often ask economists to predict a recession years in advance. Five years ago, for example, about 40% of economists thought there was at least a 10% chance the economy would enter a recession within two years — and of course it never did.

Finally, complicating the prediction game is the fact that the Federal Reserve is tasked with maintaining a well-functioning economy. To do so, one of the tools the Fed uses is to set short-term interest rates — it raises rates to keep inflation in check when economic growth is strong and cuts rates to try to stimulate borrowing activity when growth slows.

Amid signs of slower economic growth this year, and concerns about another recession, the Fed cut rates in July for the first time since 2008 and Wall Street expects the central bank will do so again this month. That means that the Fed's potential actions could wind up thwarting economists' predictions.

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Turns out it's also hard to understand the past

Recessions aren't the only thing that economists have trouble getting right. Each month, Wall Street economists provide estimates for a slew of economic data from prior months or quarters — things like how many jobs were created, the number of homes sold, changes in manufacturing activity, and how much more (or less) consumers spent on retail goods.

Traders closely track the consensus, or average, of estimates that economists provide. But the group as a whole doesn't have a great track record.

In the past 12 months, for example, Wall Street economists have accurately predicted the number of new jobs created only one time — and the consensus estimate has been off by as much as 160,000 jobs, according to FactSet data analyzed by Grow.

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How to recession-proof your finances

Don't focus on predictions

People are Googling recession-related topics at rates not seen since the last recession ended in 2009, according to trend data from the search engine giant. But instead of jumping into the guessing game of when the next downturn will occur, it's more empowering to educate yourself about what to expect during a typical economic downturn.

There are steps you can take now to recession-proof your life, both financially and professionally, to ensure you're not caught by surprise.

Finally, it's important to keep perspective. Americans are likely to live through a handful of recessions during their lifetime, and these downturns can actually be a good opportunity to buy stocks or even homes at lower prices.

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