Thomas M. Mertens, a Vice President in the Economic Research Department of the Federal Reserve Bank of San Francisco, argued in an Economic Letter issued at the end of 2022 that while the jobless unemployment rate is a reliable predictor of recessions, the data and its analysis does not signal that a recession is imminent. However, that conclusion could change as we continue into the new year.
According to Mertens, the smoothed jobless unemployment rate, tracked since early 1967, shows a predictable pattern throughout the business cycle, tending to rise sharply in recessions and gradually declining during expansions. The consistent unemployment patterns around recessions resemble the Treasury yield curve, an inversion of which has predicted every recession since the mid-1950s, causing commentators and market participants alike to warn of a recession risk in light of the yield curve’s current inversion.
Plotting the jobless unemployment rate differently than the typical line chart, Mertens has developed a “recession clock,” named after the circular nature of the graph, which plots the smoothed jobless unemployment rate on the horizontal axis and the change on the vertical axis. Charted in this manner, the time series serves as an advance predictor of recessions, a stark departure from models such as the “Sahm rule” that indicate a recession after it has already started.
This new model has led Mertens to conclude that the jobless unemployment rate is most successful in predicting future recessions at a horizon of eight months, serving as a shorter-term predictor relative to the slope of the yield curve, which has an optimal prediction horizon of 13 months, with similar forecast accuracies. The Economic Letter goes on to explore additional ways of leveraging the ‘recession clock’ to make predictions, comparing the yield curve slope against the historical trend recession clock angle and the real-time (three-month average) recession clock angle to conclude that recession probabilities are elevated, though not imminent.
While Mertens’ analysis has led him to conclude that none of the reviewed predictors indicate a coming recession over the next two quarters, he acknowledges that the underlying macroeconomic trend has started to turn and that predictions may change in the coming months. Businesses are also taking a conservative approach to prepare for a recession by cutting costs and reducing headcount to weather potential tough times ahead.
