Stall speed

Posted by Neil Hume on Jun 24 09:40.

FT blogger (and Markets Live contributor) Gavyn Davies recently raised the question of whether the growth rate of the US economy had dropped below stall-speed and was heading back to recession.

He concluded it wasn’t, but there wasn’t much room for error:

It seems clear that the US economy has slowed down enough this year to be flirting with its stall speed, without actually breaching it so far. Since the reasons for the slowdown include temporary factors like the Japanese earthquake and severe weather conditions, the most likely out-turn is that the economic growth will remain above the stall speed in the remainder of 2011, as expected by the Fed and the forecasting consensus. But there is not that much room for error.

Goldman Sachs has also been looking at the concept.

Like Davies the bank thinks the US is right around the stall speed — that’s real GDP growth of less than 2 per cent for a couple of quarters. However, the recent data disappointments aren’t enough to tilt the balance of risks towards a recession says Goldman economist Andrew Tilton.

He thinks two important drags on economic activity — high petrol prices and disruptions from the Japanese earthquake and tsunami — have already begun to lift and the US economy isn’t about to plummet back into recession and require more policy stimulus to restart the engine.

Each of these is worth at least half a point on second quarter growth, he says and with vehicle production rebounding Tilton reckons growth could be back above 3 per cent in the third quarter.

Fingers crossed, then.

Periods of low growth are more likely to be followed by recessions than by a return to “normal” growth. A recent paper by Jeremy Nalewaik of the Federal Reserve Board (“Forecasting Recessions Using Stall Speeds”, April 14, 2011) shows that growth is typically weaker in the prelude to recessions. For example, Nalewaik finds that since 1947, when two-quarter annualized real GDP growth falls below 2%, recession follows within a year 48% of the time. This is more than twice as high as the unconditional probability that an economy in expansion enters a recession within a year (about 19%). When year-over-year real GDP growth falls below 2%, recession follows within a year 70% of the time. The exhibit below, based on calculations along the lines of Nalewaik’s, illustrates how recessions are much more frequent after a period of slow growth.

In the past, all but the smallest increases in the unemployment rate have quickly led to recessions. We have noted repeatedly in the past our “three-tenths rule”: since World War II, an increase in the three-month moving average of the US unemployment rate by more than 0.3 of a percentage point has always led to a much bigger increase in the unemployment rate, i.e. a recession (see Ed McKelvey, “The 0.3-Point Rule for Unemployment–Why We Think it Won’t Hold in 2011,” US Daily, October 20, 2010). While this is a very low threshold, it’s worth noting that the recent increase is still well below it. On a three-month average basis, the unemployment rate bottomed at 8.90% in April and was 8.95% in May, only a five basis point increase. (In last year’s growth scare, the three-month moving average increased by 11 basis points.) It would take a sustained increase in the unemployment rate to at least 9.3% in coming months to breach the three-tenths threshold, and we think this is unlikely.

How close is the economy to stall speed now? First-half GDP growth is likely to be about 2%, suggesting we are right around the “stall speed”. (In other work, Nalewaik found that gross domestic income (GDI) may provide a more accurate real-time measure of activity than GDP; real GDI grew 1.4% annualized in Q1 and looks likely to remain fairly soft in Q2 as well.) The historical record cited in point 1 above, and illustrated in the chart, suggests that even after one or two quarters of sub-2% GDP growth, the economy is still more likely to return to continued expansion than fall into recession. After a year below 2%, however, recession becomes more likely than not. (Note that in our forecast, the year-over-year real GDP growth rate has already bottomed out at 2.3%.)

Related link:
FOMC statement – 22 June 2011 – FT Alphaville

This entry was posted by Neil Hume on Friday, June 24th, 2011 at 9:40 and is filed under People. Tagged with , , , , .

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