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Updating How We Predict Recessions

Money 2This institute has long been known for its work in identifying turning points in the economy, including predicting recessions. And we have a pretty good track record in that regard since we started studying business cycles in 1953.

But such work requires vigilance, and changing with the times as necessary. Part of that vigilance includes periodically reviewing how well our model is working, and updating it when necessary. Last year we began such a review.

Here’s what we’re changing in our model, starting with our upcoming January edition of Business Conditions Monthly.

Here at AIER, we use three kinds of indicators: leaders, which are those that peak and trough ahead of a turning point in the broader economy, such as new orders for consumer goods; coinciders, which are those that peak and trough at roughly the same time as the broader economy, such as industrial production; and laggers, which are indicators that peak and trough after a turning point in the broader economy, such as inventories.

We use 24 indicators in all: 12 leaders, six coinciders, and six laggers. As part of our review, we statistically tested the individual indicators for how well they reflected the actual performance of the economy. We determined that five leaders, one coincider, and two laggers were no longer effective. And so, we replaced eight indicators, or one-third of the 24 indicators in the model. For example, we dropped the Vendor Performance Index and added Retail Sales to our Leaders indicators.

We also removed the subjectivity within the model. Up to this point, AIER researchers reviewed each indicator, and their qualitative assessments were taken into account in the final index. We have removed this step in the new process. From this point forward, we will use only data to create our business cycle evaluation. Our economists will then interpret what the numbers mean. We believe this will make the process, and the results, more scientific.

One other change we’ve made is that we used to exclude indicators that tended to be more stable, neither trending upward or downward. Now, those are included in our model.

You can read our research brief about the changes here. From the brief: “AIER remains committed to the scientific approach to analysis and to the long history of business-cycle research at the institute. This update to our Business-Cycle Conditions model remains true to both. We are confident these enhancements will live up to the high standards and record of success of the former model.”

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