Recessions: How Are They Determined?

With everyone running around and screaming, arguing about whether or not we are in a recession, I think some have forgot to focus on how it is determined that we are in a recession. Many are waiting for 2 quarters of negative GDP growth, but in my opinion you will be waiting around for a while losing money if you wait for GDP to turn negative. GDP of late has also been propped up by one of the largest stimulus in history and a boom in exports fueled by a weak dollar, which has strengthened as of late.

Looking at the time period of the last recession, one can see that there was not 2 consecutive quarters of negative GDP growth. In fact if you look at how the National Bureau of Economic Research determines a recession (this is the official board that comes out and declares recessions), you will see that 3/4 factors do not even directly factor into GDP. NBER does not weigh GDP as heavily as the following factors because GDP is released quarterly and the NBER likes to use monthly data because they feel it is more accurate.

The NBER defines a recession as the following: a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real income, employment, industrial production, and wholesale-retail sales.

Employment

The condition of the employment is one of the factors that goes into determining whether or not we are in a recession. If you have not kept up lately, the unemployment rate currently stands at 5.7%. There has never been such a rapid increase in unemployment, without the economy being in a recession.

That being said, there has also never been a recession where the unemployment rate peaked below 6%, which means if we really are in a recession, there is probably room for further deterioration of the labor market. Also, average number of hours worked per week is at its lowest level in over 10 years, which means a lower paycheck for the consumers. But in the end, unemployment is not directly factored into GDP although it is correlated. It does however help indicate a significant decline in economic activity.

Real Personal Income Minus Government Transfers

Real personal income excluding government transfers is the next factor that the NBER looks at when trying to determine if we are in a recession. This measure just went negative in July to a mark of -0.7% , down from a positive 1.8% mark in May. Disposable personal income was also down 1.9% month over month. This measure does not go into GDP either because income is not a part of GDP, which is focused primarily on consumer spending.

Industrial Production

Industrial production has come to a standstill of late. Year over year growth in industrial production has come down from a peak of 2.5% growth in January 08 to a mere 0.2% growth rate in July 08. Total manufacturing production is also reaching levels last seen during the 2001 recession. The following industrial production indexes are currently deteriorating: total industrial production, total manufacturing production and total non durable manufacturing. By the way, industrial production numbers are not factored into GDP either.

Real Sales Activity

Real sales activity is the last factor that the NBER uses to determine if we are in a recession. This is the one figure that actually does figure into GDP. That being said, I feel as though this number has been bolstered by the government stimulus. Retail sales grew at a meager 0.1% in June, compared with a 0.9% growth rate in May, which represents the time period when all the stimulus checks were distributed and Americans had to cope with the fact that they would not have any additional income from Uncle Sam. With the bad labor market, I would not expect to see this data improve in the near future. The American consumer will continue to be strained until the housing market and credit crunch problems are resolved.

All that being said, I think people make too big a deal of waiting for GDP to turn negative, when three out of the four factors that the NBER uses to determine recessions does not directly factor into GDP. Are we in a recession? I think so, especially after looking at all the data. So why hasn’t the NBER come out and said we are in a recession? Normally, they announce we are in a recession towards the end of the economic downturn, not at the beginning. From an investing point of view, stay defensive; buy into healthcare and staples and stay away from the firms that rely heavily on consumer spending to make money.

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