Tuesday, November 6, 2012

Recession Probability - 100%

During my usual morning reading process I came across a posting on PragCap by Cullen Roche regarding a chart of U.S. recession probabilities.  The chart can be found at the St. Louis Federal Reserve website and is derived from a study by J. Piger and M. Chauvet, from the University of Oregon, which was published in the Journal of Business and Economic Statistics in 2008.  (For other economic geeks the full paper is attached)
Cullen points out that "What’s interesting about this index is the current reading.  At 20%, the index is at a level that has ALWAYS been followed by a recession. As you can see below, the index has never approached 20% without a subsequent recession. All 6 recessions since 1967 have coincided with 20%+ readings in the US Recession Probabilities index."  Currently, that index, as shown in the chart below, is approaching that 20% level as of August which is the latest reported data.
The recession probabilities, as stated in the research article, are obtained from a "dynamic-factor markov-switching model applied to four monthly coincident variables: non-farm payroll employment, the index of industrial production, real personal income excluding transfer payments, and real manufacturing and trade sales."  Without getting to far into financial econometrics a Markov switching model involves multiple equations that can characterize the time series behaviors between different data sets.  By permitting the switching between equations the model is able to capture more complex dynamic patterns.  The question that we want to answer is whether the indicator is currently correct in its prediction of a U.S. recession or "is this time different."

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