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Our Economic Model is Flashing a Warning. Here’s Why

Here at AIER, we predict recessions based on our time-tested, data-dependent Business-Cycle Conditions model. Our April report, which we are releasing today, shows a decline to 38 in our index of Leaders, its first drop below the neutral 50 level in 110 months.

We should take notice. But why did it drop? Persistent inconsistent economic performance, as economic weakness has spread over the past several months. And while this points to more brightly shining yellow caution lights, it is too early to call a recession for two reasons.

First, there have been previous instances (months in 2003 and 2005, for example) when the index dipped below 50 but bounced back the following month. Second, the underlying economic data are subject to revi­sion over the coming months. Revised data could significantly alter the signals from individual indicators.

The decline in our leading indicators reflects the tug-of-war between continuing long-term gains in the core domestic economy (including consumer spending, housing, and business investment) and declines in exports and commodity-related industries.

Over the final three quarters of 2015, real gross domestic product, or GDP adjusted for inflation, slowed from a 3.9 percent annualized rate in the second quarter to 2 percent in the third, to just 1.4 percent in the fourth. During that period, real personal consumption expenditures, or PCE, slowed each quarter, providing 2.4 percentage points to growth in the second quarter, 2 percentage points in the third and 1.7 percentage points in the fourth.

Nonresidential fixed investment, or business investment, performed even worse, contributing just 0.53 percentage points in the second quarter, 0.33 percentage points in the third, and subtracting 0.27 percentage points in the fourth. The slowing expansion and declining contribution to growth among these core components is significant, especially in light of the declines in our Leaders index. Continued weakening in these core areas would significantly increase the risk of a recession in the next six to 12 months.

In financial markets, two of our leading indicators are based on financial market data, namely inflation-adjusted stock prices and the Treasury yield curve. The signals from these two are mixed, with real stock prices trending lower – a negative signal – while the yield curve continues to give a positive signal. While our job is not to forecast the Leaders but rather to understand the context of the results, digging a little deeper into each suggests a slightly more positive interpretation on these two data points.

Meanwhile, the Federal Reserve kept interest rates unchanged in March. But the economic projections released following the March meeting of Fed policy makers suggest that rate increases may occur later this year. However, the projections come amidst uncertainty, and the actual path of Fed policy will depend on data from the months ahead.

On the fiscal policy side, the federal budget deficit has diminished steadily since the recession ended in 2009. In 2015 it fell below its long-term average. But in 2016 the deficit is expected to rise, according to the latest projections. And the deficit would be even greater if a recession does occur.

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