The Daily Interview: Economic Cycle Research Institute's Anirvan Banerji

When economists try to figure out whether a recession's coming, they look to gauges like the Index of Leading Economic Indicators. This statistical grab bag, released monthly, distills information from all corners of the economy. So what better place to go to learn about the odds of recession than the home of the index itself?

Anirvan Banerji Director of Research Economic Cycle Research Institute

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Both the original index and the subsequent Weekly Leading Index, or WLI, hail from the Economic Cycle Research Institute, founded by the late Geoffrey Moore (who also had a stint as Alan Greenspan's college stats teacher). After Moore died last year, his mantle was taken up by the institute's director of research, Anirvan Banerji.

Writing in TSC last fall, Banerji saw cause for economic worry well before the fourth-quarter debacle, warning at the time that a massive jump in oil-price inflation could well trigger a recession. Since then, the economic picture has mostly gotten worse. In today's Daily Interview, we talk with Banerji about what's happened, and whether recession can still be avoided.

TSC: You've dated the beginning of the current economic downturn as June 2000. Now, you say, we're at a tipping point in terms of whether we go into a recession or not. Why don't we know yet?

Banerji: What is interesting is that leading indicators are designed to predict recessions. But whether we're headed into a slowdown or a full-scale business-cycle recession, in either case for the first six months or so [from the beginning of a downturn], the pattern is virtually the same. A slowdown and a recession look indistinguishable.

But then the patterns diverge. If a recession is ahead, the WLI growth rate keeps going down, whereas if it's a slowdown, it starts recovering. So there's a tipping point right around six months after the beginning of a slowdown, where the economy can be either tipped into recession or tipped away from recession. We are right now at that very interesting point.

This is very important to understand: You've heard a lot of people, a lot of major investment houses, come out with declarations saying we are in a recession or we are not in recession. It's not that some people are right and some are wrong. The reality is, it is not possible to tell. It is not determined yet.

TSC: When will we know whether we'll go into a recession?

Banerji: In the next couple of months we should get a better idea.

Five months ago, there was a significant recession probability already. Where did it come from? Well, the Fed had been tightening for a year, since the middle of '99.

But on top of that, you had the growth that had been driven by the technology sector, which a year ago everybody would have told you was immune to cycles. That hubris is precisely what contributed to the viciousness of the downturn in technology. They were completely blindsided by the effects of a slowdown.

Because technology is such an important part of manufacturing, the manufacturing sector today is already in a recession, and it's headed for the worst recession since 18 years ago.

This was bad enough, but on top of that, we got the oil spike last summer and fall, which was of a size that had never not been followed by recession. So now you had a double whammy already.

The final straw was record cold temperatures in November and December -- the coldest average temperatures in the U.S. in 106 years of recorded history. When you got that on top of these factors that were already planning to plunge the U.S. economy into recession, you got extreme weakness. That was the situation at the end of December-beginning of January, when the Weekly Leading Index growth rate plunged to a 10-year low.

At that point, we were veering very close to a recessionary track. But what's happened in January in the past four weeks is that there's been a steady bounce-back in the WLI growth rate, four straight weeks of back-to-back improvement. That is somewhat encouraging. But the difficulty is to tell whether it's just a dead cat bounce because of warmer weather, or a more fundamental turn away from recession. And right now, the jury's still out. It's not something that is knowable.

TSC: You've written before about something called the Katona effect [named after the late George Katona of the University of Michigan]. Can you explain how this would relate to the energy price shock you've talked about?

Banerji: The Katona effect shows there's an inverted relationship between price level volatility and growth in consumer spending. When there's a jump in price volatility, people take precautionary steps and pull back on expenditures. But it's particularly potent when driven by food and energy prices, because those are nondiscretionary. This kind of effect was particularly potent because of the energy price hikes that hit us on top of the slowdown we were getting into anyway, and that exacerbated the technology slowdown as well.

TSC: In terms of confidence levels, how much help should we expect to get from the interest rate cuts that have already happened, and that are on the way?

Banerji: We are in the unique situation where half of all Americans own stocks, and because of that consumer confidence is now very sensitive to investor confidence. And investor confidence, of course, can be very quickly influenced by Fed policy.

It's not just the fact of rate cuts, but the whole context in which it's done, which decisively influences investor perceptions. To the extent that investors interpret actions and words to imply the Fed is on top of the situation and will do whatever it takes, that gives investors quite a bit of confidence. If they're not that secure in their belief, especially in the face of declining earnings and negative earnings surprises, it's easy to lose confidence.

TSC: So it seems like investors are watching Greenspan , and he's watching them, although he might not put it that way.

Banerji: This whole back-and-forth, this whole dynamic, will be decisive in determining where the economy is headed.

The Fed has a lot of freedom in action in terms of interest rates right now. Underlying inflationary pressures are going down very decisively. If you looked at the Future Inflation Gauge, after hitting an 11-year high last April, it's gone down steadily and rather sharply for the next nine months. It's telling us, and was telling us months ago, that there is no inflation risk, which simplifies the situation for policymakers.

TSC: Looking ahead, where will you look for clues about the likelihood of a recession?

Banerji: Essentially at this point, with manufacturing in deep trouble, the key is the service sector, which is very sensitive to consumer and investor confidence.

If you see the WLI growth rate keep recovering through the rest of February and March, then you could definitely get more confidence in the idea that the economy is veering away from recession.