Our Chief Economist Michael Knox wrote an interesting note last week regarding whether the recession in the US is in fact at an end, he noted that The Fed Chairman Ben Bernanke has commented that the US recession is “very likely” over. He said “very likely” because he meant “very likely”. In spite of this, the market interpreted his words as “certainly”. We think that the US GDP is definitely positive in the third quarter. We think it will come in at a surprisingly strong 3.7 per cent annualised. In spite of this, we agree with Bernanke that the recession is only “very likely” over.

We think the strong GDP number for the third quarter will result from three things. The first is improved production of automobiles. The second is improved production of communications equipment. The third is that housing production has actually bottomed out and started to rise slightly. However, we think the GDP number will overstate the health of the US economy.

At the beginning of last year, many observers of the US economy were misled by the strength of the US GDP. GDP was holding up. Broader indicators of the US economy, such as the Chicago Fed Index, suggested that the US was slipping into recession. GDP was wrong and the broader indicators were right.

The reason that the Chicago Fed Index was right was that it includes not just indicators of production and income but also employment; unemployment and hours; personal consumption and housing; and sales, orders and inventories. Indeed the Chicago Fed looks at a total of 85 indicators of national economic activity in these categories. The Chicago Fed then calculates the trend value for each of these indicators and assigns a level of standard deviation away from trend. A zero value for the Index indicates that the national economy is expanding at its historical trend rate of growth.

Negative values indicate below average growth and positive values indicate above average growth. For reference, trend growth rate in GDP since 1990 has been 2.56 per cent. In August, the three-month moving average of the Chicago Fed National Activity Index (CFNAI-MA3) improved for the seventh consecutive month. The August reading was - 1.09. This means that the US economy was -1.09 below trend. This was an improvement over the number for July of -1.61. Both of these numbers are a lot better than the low for this cycle of -3.63 in January. This meant that this US recession was the second worst since 1945. The worst was in January 1975 where the three-month moving average of the index stood at -3.72.

The improvement in the three-month moving average did not mean the figures were better for the month of August itself. All of the four categories were either flat or slightly down compared to the previous month. Of the 85 individual indicators, 31 made positive contributions while 54 made negative contributions. Still, the negative contributions were slight. Clearly, all of these numbers are much softer than suggested by what we think will be a very strong GDP number for the third quarter.

Last year we started using the Chicago Fed Indicator because we thought it was a more reliable measure than GDP. We still do. So how do we interpret what the Indicator is telling us in this circumstance? To help us do this, the Chicago Fed this month has issued a commentary on just that. It is called The Chicago Fed National Activity Index and Business Cycles. This is written by an economist with the rather presentable name of Scott Brave.

Brave tells us that the Chicago Fed National Activity Index is an example of a “Goldilocks Indicator”. Zero means that the economy is at exact trend growth rate. Zero means that the economy is “just right”. A number below zero means that the economy is “too cold”. A number above zero means that the economy is “too hot”. Brave says that the Chicago Fed National Activity Index can be very volatile. For this reason, the Chicago Fed focuses on the three-month moving average. He compares the levels of the three-month moving average to those which lead the National Bureau of Economic Research to declare a recession. He calls these “threshold values”. For example, a reading of -0.7 indicates that a recession has begun. He says that this threshold of -0.7 has correctly predicted a recession with 86 per cent accuracy on each occasion since 1967.

The problem, he says, is predicting the end of recessions. From 1967 to 1990, it seemed that the CFNAI-MA3 had to rise to 0.2 before we could say the recession was over. However, since 1990, recessions have been ending well before this threshold is reached. Brave suggests that since 1990, the lower threshold of -0.7 has become more reliable. He notes that in spite of the improvement in the CFNAI-MA3 this year, the reading of -1.09 in August is still well below the -0.7 threshold. This means the US economy is still in recession. We are looking for Goldilocks but Goldilocks is not yet in sight.

Conclusion

The Chicago Fed tells us that their National Activity Index is an example of a “Goldilocks Indicator”. Zero means that the economy is “just right”. A number below zero means that the economy is “too cold”. A number above zero means that the economy is “too hot”.

They note that in spite of the improvement in the CFNAI-MA3 this year, the reading of -1.09 in August is still well below the -0.7 threshold which suggests the end of a recession. This means the US economy is still in recession. We are looking for Goldilocks but Goldilocks is not yet in sight.

Reference:Chicago Fed Letter: The Chicago Fed National Activity Index and Business Cycles by Scott Brave, business economist; November 2009 Number 268.

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