Summary
Typically, a recession occurs after six to eight consecutive declines (shaded areas above). The number of declines is now at 30 (top panel below) and the economy is nowhere near a recession, as shown by quarterly GDP growth in the bottom panel below.
“All models are wrong, but some are useful” – UK statistician George Box
The LEI is a model. Its construction and indicators mimic the thinking of many economists and market types. Many have a similar conclusion to the LEI that the U.S. economy is a disaster. This is why so many of them pined for a 50 basis point cut. But as the chart above shows, the economy is stronger than this model suggests.
Even though this model is wrong, it is useful. It helps explain why so many are so pessimistic about the U.S. economy.
Change
We have argued that recessions and financial crises change an economy for years. We had both in 2020. This changed the economy. Change does not mean worse or dystopian; it means different. This economy is different from the 2019 (pre-Covid) version.
Remote work, mass immigration, deglobalization, changing spending attitudes, and the psychological impact of 40-year high inflation have all contributed to this change.
How long will these changes to the economy last? Until the next recession and/or financial crisis? Most likely, that change, like 2020, will not be good or bad; it will just be different.
Data Dependent
Who does not think the economy has changed? Jay Powell, as he noted in his July press conference:
And, as I said, we’re prepared to respond if we see that it’s—that it’s not what we wanted to see, which was, you know, a gradual normalization of conditions … I think you’re back to conditions that are close to 2019 conditions, and that was not an inflationary economy—broadly similar labor markets then.
We are not going back to 2019. That was the “pre-Covid” cycle. We are now in the “post-Covid” cycle.
This is why data dependence does not work. You have to assume a set of relationships between the economy and measures of it, like payrolls, inflation, retail sales, etc. However, if the economy is shocked by a change, like in 2020, these relationships will not work in the new cycle.
So, let LEI’s failure to predict the post-Covid economy be a constant reminder that Powell, many economists, and market pundits spend their days describing how things worked in 2019 and not how they work now (post-Covid). This is how mistakes are made.
Inflation
As we have argued in previous posts, a new inflation cycle started roughly four years ago. We are not returning to pre-2020 inflation (red) but to a new post-Covid inflation cycle (blue).
Cutting rates under the assumption that this is still the 2019 economy risks a big policy mistake.
The Index of Leading Economic Indicators’ failure to predict the post-Covid economy should be a reminder that this is no longer the pre-Covid economy. Assuming the economy “normalizes” to the pre-Covid economy risks policy mistakes.
Comment
The Index of Leading Economic Indicators (LEI) is a model of ten indicators that predict the economy.
The ten indicators are combined into an index. As the chart below shows, it is at its lowest level since 2016.
This index has now seen 30 consecutive months without a positive monthly reading, the longest stretch in the 64 years of data shown.