Calling Recessions in Real Time

James D. Hamilton

Dept of Econ, UCSD

I. Overview of some of the issues

II. Track record of alternative approaches

Date of recession Announcement lag

peak trough peak trough

Jan 1980 Jul 1980 5 months 12 months

Jul 1981 Nov 1982 6 months 8 months

Jul 1990 Mar 1991 9 months 21 months

Mar 2001 Nov 2001 8 months 28 months

Is our objective to:• predict at t whether we will be in a

recession at t + j or• predict at t whether we were in a recession

at t - j

Theme: It’s very hard even to do (2) in real time.

Why should it be hard?

(1) recessions result in part from forecast errors

(a) Fed misjudges economy

(b) Firms misjudge markets

(2) economic relations change over time

June labor force participation rate (women aged 35-44)

30405060708090

1945 1955 1965 1975 1985 1995 2005

June labor force participation rate (men aged 45-54)

405060708090

100

1945 1955 1965 1975 1985 1995 2005

Why should it be hard?

(1) recessions result in part from forecast errors

(2) economic relations change over time

(3) data revisions

Source:Leamer (2008)

Nonfarm payroll employment as reported on different dates

What is the definition of a recession?Possible answers:

A. Ad-hoc qualitative summary of observable data (e.g., 2 quarters of falling real GDP)B. It’s a recession if and only if the NBER says soC. A recession is an objective but unobserved determinant of the data

I. Overview of some of the issues

II. Track record of alternative approaches

A. Predicting an ad-hoc event

Ray Fair (1993)

y1t GDP growth in quarter t

S t 1 if y1t 0 and y1,t 1 0

0 otherwise

yt c 1yt 1 pyt p tmodel implies

PrS t j 1|yt,yt 1, . . . .

Stock-Watson experimental

recession index (1988-1993)

yt L c t utDLut t L c t tS t 1 if c t s s 0

8 BtBt inferred to approximate NBER

In-sample: P(t|t)

In-sample: P(t+3|t)

In-sample: P(t+6|t)

Out-of-sample: P(t+6|t)

Out-of-sample: P(t+3|t)

Out-of-sample: P(t|t)

Recession began: July 1990P(t|t) > 0.5 by Nov 1990

I. Overview of some of the issues

II. Track record of alternative approaches

A. Predicting an ad-hoc event

B. Predicting what the NBER is going to say

PrS t j 1|yt Fyt; Choose F. and ytEstimate

Interest Rates• FF Federal Funds rate• 3M 3-month Treasury Bill rate• 5Y 5-year Treasury Bond rate• 10Y 10-year Treasury Bond rate• AAA Moody's corporate bond yield• AA Moody's corporate bond yield• A Moody's corporate bond yieldTerm Spreads• TS10YFF 10Y-FF Treasury term spread• TS10Y3M 10Y-3M Treasury term spread• TS10Y5Y 10Y-5Y Treasury term spreadCredit Spreads• CSAAA AAA - 10Y spread• CSAA AA - 10Y spread• CSA A - 10Y spreadEmployment Data• EMP Δ log non-agricultural employment• CEMP Δ log civilian employment• UICLAIM Δ log unemployment claims• UNEMP Unemployment rate• UNEMPD Change in unemployment rate• HOURS Δ log manufacturing hours

Stock Price Indices• DJ30 3-mo Δ log Dow Jones 30 average• SP500 3-mo Δ log S&P 500 stock price

indexMonetary Aggregates• M0 Monetary base (log-differenced)• M1 (log-differenced)• M2 (log-differenced)Other Macroeconomic Variables• CLI11 Δ log composite leading indicators• CPI, all urban, all items (log-differenced)• EXP Consumer expectation• EXPD Changes in consumer expectation• HOUSE Building permits (log-differenced)• VENDOR performance • INCOME Δ log personal income• IP Industrial production (log-differenced)• SALES Δ log Manufacturing & trade sales

Katayama (LSU, 2008)

Evaluated with 7 different choices for F(.) by post-sample and leave-2-years-out cross-validation

Conclusion:Improvements from F(.) with positive skew and

excess kurtosis

Best variables:• 10Y-3M treasury spread• S&P500 3-month growth• employment growth

Chauvet and Potter (2002, 2005)

Probit specification based on term spread allowing for serial correlation and structural breaks successfully predicted 2001 recession

Wright (2006)

• F(.) ~ Normal

• 10Y-30M treasury spread

• fed funds rate

• tries to predict an NBER recession any time within next 12 months

Leamer (2008):

Choose thresholds for 6-month changes so as to fit NBER dates

I. Overview of some of the issues

II. Track record of alternative approaches

A. Predicting an ad-hoc event

B. Predicting what the NBER is going to say

C. Recognizing a shift in the observed dynamics of economic variables

y t GDP growth for quarter t

S t 1 if recession at t

0 if not recession at t

y t s t t t N0, 2S t unobserved

PrS t j|S t 1 i p ij

Density of expansions

0

0.05

0.1

0.15

-15 -12 -9 -6 -3 0 3 6 9 12 15

GDP growth

Density of recessions

0

0.05

0.1

0.15

-15 -12 -9 -6 -3 0 3 6 9 12 15

GDP growth

= 4.7 = 3.5

= -1.2 = 3.5

Density of mixture

00.020.040.060.08

0.10.12

-15 -12 -9 -6 -3 0 3 6 9 12 15

expansion

recession

mixture

Density of mixture

00.020.040.060.08

0.10.12

-15 -12 -9 -6 -3 0 3 6 9 12 15

expansion

recession

mixture

)2|()2Pr(),2Pr(

),2Pr(),1Pr(

),2Pr(

)(

),2Pr()|2Pr(

ttttt

tttt

tt

t

tttt

SyfSyS

ySyS

yS

yf

ySyS

Density of mixture

00.020.040.060.08

0.10.12

-15 -12 -9 -6 -3 0 3 6 9 12 15

Probability of recession

00.20.40.60.8

1

-15 -12 -9 -6 -3 0 3 6 9 12 15

GDP growth in quarter t

Filter inference:

PrS t 1|y t,y t 1, . . . ,y1Smoothed inference:

PrS t 1|yT,yT 1, . . . ,y1

Contributions to percent change in real gross domestic product

-2

-1

0

1

2

3

4

5

6

2007:Q3 2007:Q4 2008:Q1 2008:Q2

GDP

Consumption

Nonresidential fixed investment

Residential fixed investment

Change in inventories

Exports

Imports

Government

Ft s t Ft 1 tyrt rFt vrtvrt rvr,t 1 rt

yt

ln sales

ln pers income

ln civ employ

ln ind prod

Chauvet and Hamilton (2006), Chauvet and Piger (2008)

Month Probability of Recession

February 2008 15.4%

March 2008 16.0%

April 2008 15.6%

May 2008 15.3%

June 2008 14.0%

July 2008 13.0%

Source: Jeremy Piger, Sept. 29, 2008

Source: Jeremy Nalewaik

Source: Jeremy Nalewaik

Hamilton (2005)

y t unemployment rate

y t cs t 1y t 1 2y t 2 t

S t

1 if expansion

2 if mild recession

3 if severe recession