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Using Econometric Models to Predict Recessions

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Using Econometric Models to Predict Recessions Using econometric models to predict recessions Mark W. Watson On April 25, 1991, the Busi- growth in economic activity in Eastern Europe ness Cycle Dating Committee over the next five years, since the statistical of the National Bureau of record contains few transformations of com- Economic Research (NBER) mand to market economies. determined that the U.S. Since the focus of this article is on how, 1111econ¬omy had reached a business and how well, econometric models forecast cycle peak in July 1990 and had fallen into a recessions, I begin by defining a recession. A recession. Could this recession have been pre- statistical model requires a precise definition, dicted by econometric models? In this article I and, as we will see, different definitions lead to discuss how econometric models can be used to different econometric approaches. After I de- forecast recessions and provide a partial answer scribe these econometric methods, I evaluate to this question by documenting the forecasting the recent forecasting performance of one performance of one model, the NBER's Experi- econometric method: the NBER's Experimental mental Recession Index. Recession Index, which I developed jointly Econometric models describe statistical with James Stock of Harvard University. It relationships between economic variables. By turns out that this index did not perform well extrapolating these relationships into the future, over the current recession. Unraveling the econometric models can be used for prediction. reasons for its poor performance says much Carefully constructed econometric forecasts about the causes of the current recession. can predict recurring patterns in the economy, What is a recession? but even the best econometric model can not anticipate unique events that have not left a Contrary to popular wisdom, the official statistical footprint in past data. (NBER) definition of a recession is not "two or Recognizing these strengths and weakness- more quarters of consecutive decline in real es, most economists base their forecasts on a GNP." The official definition is far less pre- combination of econometric analysis and judg- cise. Indeed, it so imprecise that it is worth ment (or economic instinct). The relative providing in detail. Burns and Mitchell (1946) weight given to judgment and econometric give the official definition of a recession as one analysis depends on how unique the forecasting period is expected to be. For example, econo- Mark W. Watson is senior consultant at the Federal Reserve Bank of Chicago, research associ- metric models can be expected to work well for ate at the National Bureau of Economic Research, predicting the response of the economy to mon- and professor of economics at Northwestern etary expansions and contractions, since the University. Much of the work discussed in this article was carried out in collaboration with James statistical record contains many similar epi- H. Stock and was supported by grants from the sodes. On the other hand, econometric models National Bureau of Economic Research and the probably will perform poorly for predicting National Science Foundation. The author thanks Steven Strongin for comments on an earlier draft. 14 NLOWOVRL PN[\PNL]R`N\ phase of a business cycle. A business cycle is construction of the index are given in the Ap- defined as follows: pendix. The shaded areas in the graph are the "Business cycles are a type of fluctuation postwar recessions, as determined by the found in the aggregate economic activity of NBER. As is evident from the graph, reces- nations that organize their work mainly in busi- sions are periods of sustained and significant ness enterprises: a cycle consists of expansions declines in the index. occurring at about the same time in many eco- It is interesting to compare the NBER nomic activities, followed by similarly general official peak and trough dates to those that recessions, contractions, and revivals which would be determined using the rule of two merge into the expansion phase of the next consecutive quarters of declining GNP. I do cycle; this sequence of changes is recurrent but this in Table 1. The two sets of dates are more not periodic; in duration business cycles vary different than one might imagine. Recessions from more than one year to ten or twelve years; are often interrupted temporarily by one quarter they are not divisible into shorter cycles of of positive GNP growth; this causes the GNP similar character with amplitude approximating rule to miss the peak or trough. This occurred their own." during the recessions of 1949, 1973-1975, and Using this definition, the NBER Business 1981-1982. Moreover, two of the postwar Cycle Dating Committee somehow determined recessions determined by the NBER-1960-61 that the U.S. economy reached a cyclical peak and 1980—did not coincide with two quarterly in July 1990. Actually, this is not as difficult as declines in GNP. The NBER approach to dat- it appears. As lawmakers have claimed about ing recessions yields more reasonable results obscenity, recessions may be difficult to define, than the GNP method because it relies on a but you know one when you see it. large number of monthly indicators rather than Figure 1 presents an index of aggregate a single quarterly indicator. activity constructed using four monthly coinci- The NBER's experimental indicators dent indicators; the index of industrial produc- tion total nonagricultural ewzvyywex¬ manu- There are two distinct econometric meth- facturing and trade sales, and real personal ods used for predicting recessions. The first is income. The precise details underlying the based on traditional macroeconometric models like the Wharton, DRI, or Michigan models. FIGURE 1 NBER Experimental Coincident Index sxnex2 1B=?F166 866 186 1=6 1:6 186 bLR 100 86 =6 :6 1B:8 -;1 -;: -;? -=6 -=9 -== -=B -?8 -?; -?8 -81 -8: -8? -B6 YOTE:"_tmpqp"mrqms"mrq"rqcqssu{zs"ms"pqtqryuzqp"ny"ttq"YBER"Busuzqss"Cycxq"Dmtuzs"C{yyuttqq5 FEDERAL RESERVE RANK OF CHICAGO 15 TABLE 1 approach, as implemented in my work with Stock, predicts recessions WKN[ l—}sxe}} mymve |epe|exme nk¬e} kxn ze|syn} yp PWP nemvsxe using the official NBER definition. The remainder of this article will focus on this approach. Readers Peku ]|y—qr PWP nemvsxe ze|syn} interested in a discussion of tradi- tional econometric models or a 11/:8 16/:B :BC13:BC11 more technical description of the ?/;9 ;/;: ;9C113;:C11 indicators approach should read the 8/;? :/;8 ;?C1`3;8C1 discussion in the Box. :/=6 8/=1 Wyxe At the request of the Secretary 18/=B 11/?6 =BC1`3?6C11 of the Treasury in 1937, a research 11/?9 9/?; ?:C1113?;C1 team at the NBER led by Burns and 1/86 ?/86 Wyxe Mitchell identified a set of leading, ?/81 11/88 81C1`388C1 coincident, and lagging indicators ?/B6 B6CR`3B1C1 of economic activity for the U.S. NOTE: The GNP decline periods indicate periods during which economy. These indicators were GNP was declining for two or more consecutive quarters. chosen to ¬evv policymakers where the economy was going, where it was, and where it had been. In the The second is based on economic indicators early 1B=6}2 the WKN[ ceded re- like those originally developed by Burns and sponsibility for the system of economic indica- Mitchell at the NBER in the 1930s, the Com- tors to the Commerce Department. Since then, merce Department's Composite Index of Lead- the Department of Commerce has maintained ing Indicators, or the NBER experimental indi- the indicators, periodically updating the set of cators that Stock and I developed. Traditional variables to reflect changes in the economy and macroeconometric models were not developed data availability. The Department of Com- to predict recessions, but they were developed merce publishes the indicators monthly, and the to predict variables like real GNP. These mod- composite index of leading indicators is regu- els can be used to construct approximate reces- larly reported in the financial and popular press. sion predictions by using their forecasts to In 1987, James Stock and I started an calculate the likelihood of two consecutive WKN[ sponsored project to rethink the system declines in real GNP. In contrast, the indicators of economic indicators.' We developed three Nmyxywe¬|sm we¬ryn} py| z|ensm¬sxq |eme}}syx} Predicting recessions using traditional Symbolically, the model is represented as macroeconometric models Traditional macroeconometric models describe (1) Yt = Q/ft483 Yt-2 , Yt-p2 et0 + the relationship between a set of "endogenous" variables, say Y,, "exogenous" variables, et3"and which shows the relationship between the endoge- nous variables and their past values, the exogenous errors, s¬ . The endogenous variables are the vari- ables that the model is attempting to explain; in a variables, and the errors. Forecasts of the endoge- typical model they include real GNP, investment, nous variables w"periods into the future constructed the rate of inflation, interest rates, and other vari- using information through time t"are denoted as ables. The exogenous variables are variables that Of"that is, the conditional expectation of Yt+j the model takes as given and are important for given information available at time t5"This forecast explaining changes in the endogenous variables; in is the best guess of the endogenous variables at time a typical model they include government purchases, t2w"given information available to the forecaster at tax rates, and the monetary base. The error terms time t5"(The forecast is best in the sense that it capture changes in the endogenous variables not minimizes the average squared forecast error.) explained by the exogenous variables. They are The forecast, Ot"ft2w"is just one summary of the modeled as random. information at time t"relevant for predicting the 16 OJJ/ f 111111 v-Nv¬\`NRCv-RW future.
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