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What a difference two years can make!

Two years ago, we were coming off strong GDP growth in the first half of 2000, and the markets worried more about inflation than recession. But the Economic Cycle Research Institute's U.S. Long Leading Index, or USLLI, was plunging, warning of recession danger. Under those circumstances, that summer's sharp spike in oil prices was dangerous, and I warned of an oil recession ahead.

Fast forward to now. We're coming off weak GDP growth, and markets are worried about another recession this year, but the USLLI is not flashing recession signals the way it has before every past recession. In fact, it actually rose in July 2002, its latest reading. Under those circumstances, an oil price hike may slow growth this year, but it isn't recessionary.

The Long Leader's Message

What's clear from the chart of USLLI growth and an inflation-adjusted measure of the size of spikes in oil price inflation is this: Before every past recession, USLLI growth plunged well below zero (see the arrows on the chart). In five of the last six recessions, a sharp oil price spike then helped tip the economy over into recession. But now, USLLI growth is holding well above zero, and even if it were to plunge, oil prices must spike much higher (high $30s to low $40s) and stay there for a few months if they are to match the size of past pre-recession oil spikes.

Source: Economic Cycle Research Institute (ECRI)

What does the USLLI tell us that we don't know already from the daily deluge of economic numbers? The USLLI is essentially the ultimate forward-looking leading indicator, designed to cut through the noise of daily data releases and give us the earliest warning of recessions and recoveries.

The USLLI monitors the key drivers of the business cycle, which show up as precursors to every recession. It tells us when the economy is in a window of vulnerability, when any shock could tip the economy over into recession. It also tells us when the economy is not very susceptible to shocks.

Because of the USLLI and other robust leading indices, the Economic Cycle Research Institute was able to predict not just the last recession in September 2000, six months before the recession began, but also the 1990-91 recession, five months before it started. (That was documented in The Wall Street Journal.) We didn't know in February 1990 that Saddam Hussein would invade Kuwait in August. But we did know that the economy had entered a window of vulnerability, in which any serious shock would trigger a recession.

Today, the USLLI is telling us that all this talk of a double dip this year is another false alarm. Sure, this is only a subpar recovery, and that's just what we predicted . But just as two years ago most economists were looking backward at strong GDP numbers and ruling out a recession by projecting them forward, today they are looking back at weak GDP numbers and warning of a double dip ahead. The way to predict turning points is not to extrapolate backward-looking indicators into the future; it's to look at the most durable, reliable forward-looking indicators of recession and recovery.

How Durable an Indicator?

One concern about the current period is that this is the aftermath of a popped asset-price bubble, like the period after the 1929 U.S. crash and the "lost decade" of the 1990s in Japan, both of which saw deflationary spirals. Under such unusual circumstances, how likely is it that a long leading index would keep working properly?

Well, it turns out that such post-bubble periods are not really uncharted territory for the long leading index. We've charted the performance of the USLLI from 1928 to 1940, when it faithfully anticipated every recession and recovery, including the Great Depression.

Source: Economic Cycle Research Institute (ECRI)

ECRI's Japanese Long Leading Index, or JLLI, constructed the same way as the USLLI, has correctly called each recession since the Japanese asset-price bubble popped.

Source: Economic Cycle Research Institute (ECRI)

In these two charts, the growth rates of the USLLI and JLLI are shown along with the growth rates of ECRI's U.S. Coincident Index and Japanese Coincident Index, respectively. These coincident indices, designed to move in step with the economy, tell you what the economy actually did during those periods. The shaded areas show the periods of recession. Even in deflationary post-bubble periods, the long leading indices accurately called every turning point in the economy.

That's not to suggest that deflation is in sight for the U.S. economy. As I showed a year ago, in both the U.S. and Japan, deflationary periods have historically been those in which the economy spent more time in recession than in expansion. That's unlikely in the U.S. unless the 2001 recession were to be the first of a succession of long recessions punctuated by shorter expansions.

An Objective View

Unlike analysts who essentially highlight indicators that support their gut feelings, the long leading indices are objective, time-tested tools for predicting recessions and recoveries. I'm not trying to make a bullish or bearish "case" here; making a case is what an advocate does, and I'm not advocating a bullish or a bearish view.

When you read about someone's forecasts, you might ask what his or her vested interest might be. ECRI's mission is to preserve and enhance business cycle research, so my vested interest lies in accurately forecasting turning points to further the credibility of that approach. As the indicators turn, so will my views, because my key concern is accuracy.

Because the long leading indices are so durable and have been stress-tested under a wide variety of conditions, I don't have to switch indicators just because it's a different time and place. It's not different this time -- the long leading index is based on fundamental drivers of cycles in market economies, and those don't change.

Nothing, even these indicators, is infallible. But on the basis of its history, its grounding in theory and its objectivity, the USLLI is less likely to be wrong than indicators whose choice was driven by other agendas.

When the USLLI turns down in a recessionary fashion, I'll let you know. But until then, its message is unambiguous: Despite the threat of an oil shock, a double dip back into recession remains unlikely this year.
Anirvan Banerji is the director of research for the Economic Cycle Research Institute, which was founded by Dr. Geoffrey H. Moore, creator of the original index of leading economic indicators (LEI) for the U.S. Department of Commerce. Banerji is on the economic advisory panel for New York City, and is also a member of the OECD Expert Group on Leading Indicators. At time of publication, neither Banerji nor his firm held positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Banerji cannot provide investment advice or recommendations, he welcomes your feedback at Anirvan Banerji.