Recession indicators: 6 key signals to watch
Editorial staff, J.P. Morgan Wealth Management
- The National Bureau of Economic Research (NBER) considers various indicators to determine when a recession occurs but doesn’t have a fixed formula.
- Six key economic indicators the NBER considers are employment, industrial production, income, consumer spending, business sales and overall economic output.
- The nonprofit research organization The Conference Board provides indexes that aim to forecast future economic downturns and track current economic activity.
- There may be signs of contraction in the U.S. economy at different points in the business cycle, but experts generally look for widespread declines across multiple measures before determining that the economy is in recession territory.
Economies ebb and flow, and recessions are an inevitable part of the cycle. While often brief, these downturns can have far-reaching effects that can set economies back for years.
During periods of market volatility, many investors wonder if the U.S. economy is in a recession or entering one soon. To better understand the risk, here’s a closer look at recessions and the key economic indicators that determine them.
What is a recession?
A recession is a period of significant decline in economic activity that occurs across an economy and lasts longer than a few months, according to the National Bureau of Economic Research (NBER), the organization that declares U.S. recessions.
While you may have heard that a recession occurs after two consecutive quarters of negative gross domestic product (GDP) growth, that’s not technically true. The NBER doesn’t rely solely on any one indicator or provide specific time requirements for indicators.
Instead, it considers the “depth, diffusion and duration” of an economic contraction by analyzing various economic factors over an extended period. That process takes time, which is why many recessions are often declared several months after they begin – and sometimes not even until after they end.
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What causes recessions?
The economy fluctuates between periods of expansion and contraction. However, recessions occur when events shock the aggregate supply or aggregate demand, causing economic activity to decline far beyond a typical contraction. According to the NBER, some of the most common causes of U.S. recessions have been mistimed fiscal policy changes, financial crises and housing market crashes.
The most recent recession, for example, hit at the start of 2020 when the COVID-19 pandemic caused economic shutdowns, a surge in unemployment, supply chain disruptions, decreased demand and a sharp stock market sell-off – though it lasted for just a few months. The recession before that, which lasted from approximately 2007 to 2009, followed the bursting of the housing bubble and coincided with the subprime mortgage crisis. Unexpected events like these can throw off the normal economic balance enough to trigger recessions.
6 key recession indicators the NBER considers
The NBER doesn’t have a set formula to determine if the U.S. is in a recession, but it does use six key economic indicators to help identify recessions.
Employment levels
Employment trends are a core signal of economic health. To gauge them, the NBER looks at the total nonfarm payroll employment and overall employment levels reported by the U.S. Bureau of Labor Statistics (BLS). Rising employment typically indicates growth, while falling levels suggest a contraction.
Industrial production
Industrial production refers to the real output of U.S. factories, utilities and mining operations. For this, the NBER looks to the Industrial Production Index (IPI) reported by the Federal Reserve. When IPI is declining, it suggests that factories are producing less, which can mean reduced demand, an economic contraction or other economic challenges.
Income data
Income data provides insight into the earnings of individuals and businesses. The NBER reviews inflation-adjusted figures on personal income – excluding government transfers – and gross domestic income, both of which are reported by the U.S. Bureau of Economic Analysis (BEA). Declining income in either report is a red flag because it suggests a drop in earnings, which often leads to a slowdown in overall economic activity.
Consumer spending
With consumer spending driving the bulk of the U.S. economy, the NBER looks at the BEA’s report on real personal consumption expenditures. If spending is declining, it can indicate falling consumer demand and slowing economic growth.
Business sales
Sales data from manufacturing and trade industries help gauge real demand in the economy. The NBER uses this data from the BEA to distinguish between falling prices and true reductions in buying activity. When sales are declining, it suggests that consumers and businesses are cutting back on purchases.
Overall economic output
GDP measures the total value of goods and services produced in the U.S. The NBER reviews BEA data on real GDP to assess overall economic performance. A decline indicates that the economy is shrinking.
Key reports tracking recession indicators
While not an exhaustive list, the NBER mentions a few key reports when discussing its assessment of economic turning points. There are no fixed rules about which reports are considered to be the most important, but in recent downturns, personal income and nonfarm payroll employment have been most heavily weighted by the NBER.
The list includes:
- Declining employment levels: All Employees, Total Nonfarm (BLS), Employment Level (BLS)
- Declining industrial production: Industrial Production, Total Index (Federal Reserve)
- Declining income: Real Personal Income, Excluding Current Transfer Receipts (BEA), Real Gross Domestic Income (BEA)
- Declining consumer spending: Real Personal Consumption Expenditures (BEA)
- Declining business sales activity: Real Manufacturing and Trade Industries Sales (BEA)
- Declining overall economic output: Real Gross Domestic Product (BEA)
Can we predict recessions?
Recessions can sometimes be predicted. The Conference Board, a global nonprofit organization, publishes indexes designed to identify the peaks and troughs of business cycles for the world’s major economies.
In the U.S., it provides the Leading Economic Index (LEI), which has been a well-known predictor of turning points in economic activity since it was established in 1938.
Over the past roughly six decades, a sustained decline in the LEI has preceded all but two U.S. recessions, according to an analysis. For reference, an LEI decline is considered to have entered recessionary territory when it falls more than 4% over a six-month period. However, it’s important to note that while the LEI has historically been used as a predictor of recession, it is not foolproof. Like any indicator, it can miss recessions or produce false positives.
LEI components and their significance
Today, the LEI is based on 10 components. Here’s what those components are and when they can signal a contracting economy that could lead to a recession.
- Stock market performance: When the S&P 500 stock index decreases, it may suggest falling investor confidence.
- Interest rate spread (10-year Treasury bonds minus federal funds rate): Short-term interest rates become higher than long-term rates, and the yield curve inverts.
- Unemployment insurance claims (average per week): The number of unemployment insurance claims increases, signaling more layoffs.
- Manufacturing output (average hours per week): Production workers are scheduled for fewer hours, often one of the first signs of slowing demand.
- Manufacturers’ new orders for consumer goods and materials: New orders for consumer goods and materials decrease in anticipation of consumers cutting back on spending.
- Institute for Supply Management (ISM) new order index: The index falls to 50 or less, indicating declining orders over the past month.
- Manufacturers’ new orders for capital goods: Orders for capital goods decrease, suggesting reduced investment in future growth.
- Building permits for new housing units: The number of residential building permits issued decreases, showing homebuilders expect weaker demand or tougher conditions.
- Leading Credit Index: Lending conditions tighten, making it harder for consumers and businesses to borrow.
- Average consumer expectations: Consumer sentiment drops, suggesting Americans are worried about the economy and may pull back on spending.
The Coincident Economic Index (CEI)
The Conference Board also publishes the Coincident Economic Index (CEI), which is based on four factors the NBER uses to determine recessions: payroll employment, personal income, industrial production, and manufacturing and trade sales. Rather than identifying early signs of contractions, the CEI tracks signs that we’re in a recession. As a result, it can help determine if the current period may later be deemed a recession.
Recession probability estimates
Various leading authorities in the financial space release periodic recession probability estimates. Following these can provide insight into whether a recession may be on the horizon.
Interpreting recession indicators
Reports tracking the NBER’s top economic indicators can point to growth at some times, with signs of slowing or plateauing at others.
For example, the CEI could signal growth while the LEI points to a potential contraction. While some declines may be notable, they may not reflect the broad-based, sustained weakness typically associated with recessionary territory.
Overall, there may be signs of a contraction, but not necessarily the widespread declines across multiple measures that the NBER looks for when dating a recession.
Keep in mind that recession probability estimates can change over time.
The bottom line
Identifying if the U.S. is in a recession is tricky because the NBER doesn’t provide a specific formula or threshold. Furthermore, recessions aren’t typically identified until several months after they’ve begun or ended. However, past recessions and the above indicators can help you better understand when one may be coming or if one is occurring.
Frequently asked questions about recession indicators
The Sahm Rule recession indicator is used to warn against the potential onset of a recession. It’s triggered when the three-month moving average of the national unemployment rate increases at least 0.5 percentage points above its low during the previous 12 months.
The lipstick index is an economic theory suggesting that sales for “affordable luxury” items, such as lipstick, increase when a recession is looming. The rationale behind it is that while larger purchases may become too expensive, there’s a period where consumers can still spring for small luxuries that make them look and feel better.
While not tracked by NBER, some of the unusual recession indicators rumored to have been used over the years are increases in the sales of lipstick, men’s underwear, champagne, workplace refrigerator fullness, rising divorce rates and the hemline index. The hemline index theory suggests that shorter skirt hemlines reflect a more optimistic and carefree mood, while longer ones mirror a more cautious and somber atmosphere.
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Editorial staff, J.P. Morgan Wealth Management
