Evaluating the Potential for a Recession in 2008

Evaluating the Potential for a Recession in 2008
May 13, 2008
Marc Labonte
Specialist in Macroeconomic Policy
Government and Finance Division

Evaluating the Potential for a Recession in 2008
The U.S. economy has faced some bad news lately. The housing boom has
come to an abrupt halt, and housing sales and house building have been falling at
double digit rates. Problems in housing markets have spread to financial markets,
causing a “liquidity crunch” in August 2007, and calm has not been restored since.
Financial institutions have written off large losses because of falling asset values,
particularly for mortgage-backed securities. Commodity prices have been rising, and
the price of crude oil has recently topped $120 per barrel. While each of these factors
might not be enough to cause a recession in isolation, their cumulative effect could
be great enough to push the economy into recession. In light of this news, it is
perhaps unsurprising that consumer confidence is at a five-year low.
In response to these events, Congress has enacted an economic stimulus package
(P.L. 110-185) and the Federal Reserve has aggressively cut interest rates and lent
directly to the financial system to spur economic growth. Despite these actions, a
recent survey of private sector forecasters put the chance of a recession in 2008 at


A look at the available data suggests that economic growth has slowed
considerably, but it is too soon to tell if the economy has entered a recession.
Typically, the NBER does not announce that the economy has entered a recession
until the recession is well under way, for good reason. Recessions are defined as
prolonged and sustained declines in economic activity, so by definition, a persistent
downturn cannot be identified until it has persisted. Any decline in economic activity
at this point is only nascent. Growth was slow in the last two quarters for which data
are available, but remained positive. During the onset of the liquidity crunch,
economic growth was an unusually high 4.9% in the third quarter of 2007.
Employment declined slightly in the first four months of 2008. The same forecasters
who believe there is a one in two chance of recession also predict that growth will
average 1.4% in 2008.
Given the lags between policy changes and their effects on the economy, the
economy has not yet felt the full impact of the stimulus package and the Federal
Reserve’s actions.

In troduction ......................................................1
How Recessions Are Defined........................................2
What Causes Recessions?...........................................4
Employment and the Business Cycle...............................5
What Causes the Business Cycle?.................................5
Current Recessionary Pressures.......................................6
Housing Bust.................................................7
Liquidity Crunch..............................................8
Energy Shock.................................................9
Popular Leading Indicators of Recessions..............................11
Yield Curve Inversion.........................................12
Credit Spreads...............................................14
Stock Prices.................................................15
Index of Leading Indicators.....................................15
Policy Responses.................................................16
Fiscal Stimulus...............................................17
Monetary Policy..............................................18
Are Recessions Unavoidable?...................................19
List of Figures
Figure 1. Real Personal Income......................................3
Figure 2. Non-farm Employment.....................................4

Evaluating the Potential for a
Recession in 2008
The U.S. economy has faced some bad news lately. The housing boom has
come to an abrupt halt, and housing sales and house building have been falling at
double digit rates. Problems in housing markets have spread to financial markets,
causing a “liquidity crunch” in August 2007, and calm has not been restored since.
Commodity prices have been rising, and the price of crude oil has recently topped
$120 per barrel. In light of this news, it is perhaps unsurprising that consumer1
confidence is at a five-year low.
In response to these events, Congress has enacted an economic stimulus package
(P.L. 110-185) and the Federal Reserve has aggressively cut interest rates and lent
directly to the financial system to spur economic growth. Despite these actions, a
recent survey of private sector forecasters put the chance of a recession in 2008 at2


A look at the available data suggests economic growth has slowed considerably,
but it is too soon to tell if the economy has entered a recession. Recessions are
defined as prolonged and sustained declines in economic activity, and any decline in
economic activity at this point is only nascent. Growth was slow in the last two3
quarters for which data is available, but remained positive. During the onset of the
liquidity crunch, economic growth was an unusually high 4.9% in the third quarter
of 2007. Employment declined slightly in the first four months of 2008. The same
forecasters who believe there is a one in two chance of recession also predict that
growth will average 1.4% in 2008.
Given the lags between policy changes and their effects on the economy, the full
impact of the economic stimulus package and the Federal Reserve’s actions has not
yet been felt. This report summarizes the available evidence pointing for and against
a recession in the near term.

1 Conference Board, “The Conference Board Consumer Confidence Index Declines Almost

12 Points,” press release, March 25, 2008.

2 Blue Chip, Economic Indicators, vol. 33, no. 5, May 2008.
3 It is noteworthy that final sales declined in the first quarter of 2008. In other words, GDP
growth was positive only because firms added to inventories.

How Recessions Are Defined
Recessions are officially designated by the National Bureau of Economic4
Research (NBER), a non-profit research organization. According to popular belief,
recessions are periods of two or more consecutive quarters of negative economic
growth. While historical recessions have often followed this pattern, it is not the
official definition. In fact, the 2001 recession did not follow this pattern — economic
growth contracted in the first and third quarters of 2001, but not the second. Rather,
the NBER defines a recession as
a significant decline in economic activity spread across the economy, lasting
more than a few months, normally visible in real GDP, real income, employment,5
industrial production, and wholesale-retail sales.
Gross domestic product (GDP) data is released quarterly and the latter four measures
are available monthly. Since recessions are dated on a monthly basis, GDP data does
not offer enough precision for the NBER’s purposes. Of the four monthly factors,
the NBER
places particular emphasis on real personal income excluding transfers and on
employment, since both measures reflect activity across the entire economy. The
committee places less emphasis on the industrial production and real sales series,
which mainly cover the manufacturing and goods-producing sectors of the6
Typically, the NBER does not announce that the economy has entered a recession
until the recession is well under way — for good reason. By definition, a persistent
downturn cannot be identified until it has persisted. For example, the recession
which began in March 2001 was not announced by the NBER until November 2001.
As it turns out, the NBER later identified November as marking the end of the 2001
recession. Thus, it is possible that at some future date, the NBER could identify the
economy as currently experiencing a recession.
Figures 1 and 2 show real personal income (less government transfers) and
employment, respectively, before, during, and since the 2001 recession. While both
figures show a clear and sustained downturn in 2001, neither shows a similar
downturn to date. Real personal income has flattened since mid-2007, but has not
shown any persistent decline. (It fell, but only modestly, during the 2001 recession.)
Employment has declined in the first four months of 2008, but only modestly
compared to past recessions.7 Industrial production has been flat but shown no

4 For more information, see CRS Report RS22793, What is a Recession, Who Decides When
It Starts, and When Do They Decide?, by Brian W. Cashell.
5 National Bureau of Economic Research, “The NBER’s Business Cycle Dating Procedure,”
Oct 21, 2003, p. 2.
6 Ibid.
7 There are two major official employment series kept by the Bureau of Labor Statistics, the
Current Employment Series (known as the “payroll” series) and the Current Population

downward trend since mid-2007. Retail sales fell in February, but rose in January
and March 2008. On balance, a recession may have already started, but it is too soon
to be sure since data do not exhibit a smooth trend.
Figure 1. Real Personal Income

8 800
8 600
8 400
8 200
8000 2000 $
7800 of
7 600ns
7 400
7 200illio
7 000B
6 800
6 600
n ul an ul an ul n ul an ul an ul n ul an
Jan 00-Jul1-Ja01-J-J2-J3-J03-J4-Ja04-J-J05-J6-J06-J7-Ja07-J-J
00- 20200 202002 200200 20200 202005 20200 20200 202008
Source: CRS calculations based on data from the Bureau of Economic Activity
Note: Series constructed by subtracting government transfers from personal income and adjusting for
inflation by the personal consumption expenditures deflator, as used by the NBER. Monthly data are
a nnua l i z e d .
7 (...continued)
Series (known as the “household” series). The NBER, and most economists, favor the
payroll series because it has a larger and more robust sample. For that reason, the payroll
series is discussed in the main text and shown in Figure 2. In 2008, the two series have
moved together. The unemployment rate is calculated from the household series, and has
also shown a slight deterioration in the second half of 2007.

Figure 2. Non-farm Employment

2001 2002 2003 2004 2005 2006 2007 2008
Source: Bureau of Labor Statistics
Note: The figure plots the payroll” employment series from the Current Employment Statistics, as
used by the NBER.
What Causes Recessions?
In the long run, economic growth is determined solely by the growth rate of
productivity and capital and labor inputs that determine the overall production of
goods and services — what is sometimes referred to as the “supply side” of the
economy. But in the short run, growth can be influenced by the rate of overall
spending, also known as the “demand side” of the economy. The pattern caused by
these short-term fluctuations in spending is known as the business cycle. Overall
spending includes consumer spending, business spending on capital goods,
government spending, and net exports (exports less imports).
Spending and production are equalized by prices. Because prices adjust
gradually, spending can temporarily grow faster or slower than the potential growth
rate of the supply side of the economy. Recessions are characterized by a situation
where spending is not growing fast enough to employ all of the economy’s labor and
capital resources. Recessions can come to an end because government has used
fiscal or monetary policy to boost spending or because spending recovers on its own
when prices have gradually adjusted. Then the economy begins a period of
expansion. Economic booms eventually give way to “overheating,” which is
characterized by a situation where spending is growing too fast, and labor, capital,
and productivity cannot grow fast enough to keep up. In this scenario, faster
economic growth can become “too much of a good thing” because it is unsustainable.
Overheating is typified by a rise in inflation — because there is a greater demand for
goods than supply of goods, prices begin to rise. Overheating then gives way to
recession. While the pattern is predictable, the timing of the pattern is not — some
expansions are longer than others.

Although there is no foolproof way to differentiate between changes in growth
being caused by cyclical forces and structural forces, movements in the inflation rate
offer a good indication. When inflation is rising, growth is probably above its
sustainable rate because overall spending is growing too fast, and when inflation is
falling, growth is probably below its sustainable rate because overall spending is too
sluggish. Inflation is not a perfect indicator of cyclical activity, however, because
sudden spikes in the price of specific goods sometimes cause overall inflation to
temporarily change. Volatile energy prices are the prime example of when a change
in inflation may not be indicative of the stage of the business cycle.
Employment and the Business Cycle
Just as rapid economic growth can be too much of a good thing, so too can rapid
increases in employment and decreases in the unemployment rate. As explained
above, the economy’s potential growth rate is determined by the growth rate of inputs
to the production process, such as labor. When employment rises faster (slower) than
the labor force grows, the unemployment rate will fall (rise). With enough
employment growth, at some point all available labor will be utilized in the
production process, and this will happen before the unemployment rate reaches zero.
Unemployment never reaches zero because some workers will always be in the
process of leaving an old job and finding a new one, and some workers will always
be in the wrong place at the wrong time for the skills they have compared to the skills
needed for local employment opportunities. The rate of unemployment consistent
with employment for all workers who do not fall into these two categories is known
as the “natural rate of unemployment” or “full employment” or the “non-accelerating
inflation rate of unemployment (NAIRU).”8
If overall spending is growing rapidly enough, unemployment can be
temporarily pushed below the natural rate. When unemployment is pushed below the
natural rate, too many jobs will be chasing too few workers, causing wages to rise
faster than productivity. But wages cannot persistently rise faster than productivity
because, again, overall spending cannot grow faster than production (assuming
labor’s share of income remains constant). Wages can temporarily rise faster than
productivity, but the result would be rising inflation. In recessions, the process
works in reverse. Because spending is insufficient to match potential production,
businesses lay off workers. This causes the unemployment rate to rise above the
natural rate. As unemployment rises, workers moderate their wage demands in order
to find scarce jobs or keep existing jobs. As a result, inflation falls.
What Causes the Business Cycle?
Expectations play an important role in the business cycle, and people’s
expectations are not always rational. John Maynard Keynes described the cause of
the business cycle as “animal spirits,” or people’s tendency to let emotions,
particularly swings from excessive optimism to excessive pessimism, influence their
economic actions. For example, businesses make investment decisions based on

8 For more information, see CRS Report RL30391, Inflation and Unemployment: What Is
the Connection?, by Brian Cashell.

their projections of future rates of return, which will depend on future sales and so
on. These inherently uncertain projections change as current conditions change. If
businesses believe economic conditions will be unfavorable in the future, they will
not make investments today, reducing the growth rate of GDP from what it otherwise
would have been. Likewise, households may postpone purchases of durable goods
or housing if economic conditions look unfavorable. People’s projections of the
future may be overly influenced by the present or recent past.
Even when expectations are rational, expectations can change as unexpected
events occur. “Economic shocks” also play a dominant role in the business cycle.
A shock refers to any sharp and sudden change in economic circumstances on the
demand or supply side of the economy that disrupts the steady flow of economic
activity. A well known example is an energy shock: when the price of energy
suddenly rises, it disrupts both production, because energy is an important input to
the production process, and consumer demand, because energy products account for
a sizeable portion of consumer purchases.9 Other prominent shocks include natural
disasters, global events that influence foreign trade, financial market unrest, and so
on. A sudden change in expectations that affects consumer or investment spending
can also be thought of as a shock to aggregate demand. Since these shocks are
typically unpredictable, the business cycle remains unavoidable.
Policy can also play an important role in the timing and shape of the business
cycle. The speed at which a recession ends can depend on the amount of monetary
and fiscal stimulus. Although overheating may not be directly caused by stimulative
policy, sometimes policymakers do not realize the economy is beginning to overheat
until it is too late. Expansions often end when, in order to offset the rise in inflation,
monetary policy is tightened to reduce overall spending to the point where it is
growing at the same pace as overall supply again. In the process of policy-induced
deceleration, the economy can easily overshoot and begin to contract. In essence,
policymakers trade off a lower rate of economic growth in the short run to achieve
a more stable and higher average growth rate over time.
Current Recessionary Pressures
As discussed in the last section, recessions are started by negative economic
shocks or the normal boom and bust pattern inherent in the business cycle. Both of
these factors may be present currently. The economy has undergone an energy shock
in the form of a sudden spike in energy prices. While a boom and bust pattern is only
modestly visible in price inflation data, it is starkly present in the housing market.
Furthermore, the housing downturn has spilled over into financial markets, and the
resulting pullback in credit offers another potential recessionary channel.
Although any one of these factors in isolation might not be powerful enough to
cause a recession (depending on their severity), in concert they could. An economy-
wide recession would result if spillover effects from the downturn in these three areas

9 For more information, see CRS Report RL31608, The Effects of Oil Shocks on the
Economy: A Review of the Empirical Evidence, by Marc Labonte.

caused activity in the rest of the economy to decline as well. In the fourth quarter of

2007, declines in residential investment and inventories dragged down GDP growth,

but the other sectors of the economy grew at relatively healthy rates. In the first
quarter of 2008, weakness in the economy was more widespread.10 The following
sections will discuss the channels through which these shocks could lead to an
economy-wide slowdown for each factor.
Housing Bust
After years of rapid appreciation, national house prices flattened in 2006 and
have fallen slightly since.11 Larger price declines have occurred in several regional
markets. There have already been large drops in house sales and residential
investment (house building). Since the rise in prices during the preceding housing
boom was unusually large, it is difficult to say how deep and long-lasting the housing
downturn will be. Given the central role that the housing boom has played in the
current economic expansion, many observers fear that a crash in the housing market
will lead to an economy-wide recession.12 They are concerned that the fall in house
prices could spill over into a decline in aggregate spending through four channels.
First, builders could respond to lower prices by reducing residential investment,
an important component of gross domestic product (GDP). This effect has already
been felt, with the rate of residential investment falling by double digits since mid-

2006 and reducing overall GDP growth by about one percentage point on average,

all else equal. While this drag on growth may persist in coming quarters, most
observers agree that it is unlikely to get much larger. This suggests that the drag from
the slowdown in house building is too small to cause a recession by itself.
Second, the fall in housing prices could lead to a decline in consumer spending
through a negative “wealth effect.” Some economists have argued that when house
prices were rising, households responded to their greater housing wealth by
increasing their consumption spending; were prices to fall, presumably the effect
would be reversed. This effect is difficult to measure and faces some theoretical
objections. For example, every housing transaction is composed of a buyer and
seller. When house prices fall, sellers are made poorer but buyers are made
wealthier, in the sense that they are provided an opportunity to devote less of their
income to mortgage payments and more to other consumption.

10 Output data by industry are released with a considerable lag. The most recent industry
data available show that 80% of the slowdown in growth in 2007 was caused by a decline
in output in the financial sector and construction, and a slowdown in growth in real
estate/rental housing and mining. While growth slowed somewhat across many industries,
these data suggest that problems in housing and the financial sector were still mostly
contained in those industries in 2007. Source: Bureau of Economic Analysis, “Advance
GDP-by-Industry Statistics,” press release BEA 08-17, April 29, 2008.
11 Based on government data from the Office of Federal Housing Oversight for resales of
owner-occupied homes with conforming mortgages. Private sector data sources show a
sharper decline in house prices.
12 For in-depth analysis, see CRS Report RL34244, Would a Housing Crash Cause a
Recession?, by Marc Labonte.

Third, the reset of mortgages to higher payments for many recent buyers has led
to a significant increase in the share of households suffering from financial distress,
as evidenced by the rise in the mortgage default rate. Resets can occur because
borrowers took out adjustable rate mortgages or mortgages with introductory
payments that later increase. During the runup in house prices, both types of
mortgages increased sharply. For some homeowners, a fall in prices would eliminate
the option to refinance to avoid the distress. These homeowners may then be forced
to reduce consumption spending in response. A rise in defaults can feed back
through and deepen the housing downturn.
Fourth, since mortgages are backed by the value of the underlying house, a fall
in prices could feed through to financial sector instability. This channel will be
discussed in the next section.
Liquidity Crunch
Since efficient financial intermediation is vital to a healthy economy, if a
housing downturn caused widespread harm to the financial sector, the overall
economy could suffer.
A change in the value of a house has no direct effect on the value of a loan. But
falling prices would be harmful to the financial system if homeowners responded by
defaulting on existing loans.13 For the value of the mortgage to exceed the value of
the house, even after prices have fallen, the loan would have to have a high loan-to-
value ratio (a loan made fairly recently and probably to a first time homeowner). It
should be noted, however, that loan-to-value ratios have risen significantly in the past
few years, because homes are being purchased with smaller downpayments and
because existing homeowners have borrowed against their equity.
Overall default rates have risen since late 2006 for reasons beyond the
traditional causes of unemployment, illness, divorce, and so on. Default rates on
subprime loans, which are loans made to borrowers with weak credit profiles, have
risen more rapidly. Default rates on all adjustable rate mortgages (prime and
subprime) have risen as well, and the problem may worsen in the near future as a
significant share of existing mortgages are forecast to adjust to higher interest rates.
Falling prices can lead to rising defaults by preventing borrowers from escaping
(through refinancing or selling) a mortgage that they cannot afford. Mortgages can
either be unaffordable because borrowers could not really afford them in the first
place or they can become unaffordable when adjustable mortgages reset to higher
paym ents. 14

13 Lower housing sales would require financial institutions to shift some of their activity
from mortgage lending to other types of lending or investments. While this would not
necessarily affect the overall profitability of the financial sector, some institutions might
find the shift in lending difficult, particularly if they are small and heavily reliant on
mortgage lending.
14 For information on mortgage resets, see CRS Report RL33775, Alternative Mortgages,
by Edward Murphy.

Today, some mortgages are held by depository institutions and some are
securitized and sold on the secondary market as mortgage backed securities (MBSs).
One rationale for the development of a secondary market was to move non-
diversified risk off of bank balance sheets and disperse it throughout financial
markets. So far, the increase in default rates has not resulted in any widespread
problems for depository institutions. There is a fear, however, that as the mortgages
underlying the MBS default, they will be brought back onto the bank’s balance
sheets, either through guarantees made to MBS investors or structured investment
vehicles (SIVs).15
Although securitization may have softened the blow of the housing crash for
commercial banks, it has caused widespread financial turmoil in secondary markets.
Even though subprime MBSs are only a small part of overall financial markets, the
repricing of MBSs to reflect the housing downturn has been untidy, leading to
bankruptcy for many non-bank mortgage lenders that rely on securitization and for
MBS investors. In August 2007, problems with MBSs spilled over into other
financial markets, leading to a widespread “liquidity crunch,” in which financial
intermediation ceased to function smoothly.16 At this point, it is too soon to tell how
quickly financial markets will recover from the liquidity crunch, and if the crunch
will have lasting effects on the rest of the economy.
Since the beginning of the liquidity crunch financial institutions, particularly
investment banks, have written off large losses as a result of the fall in asset prices.
These losses could lead the banks to curtail new lending through a balance sheet
effect. When the value of a bank’s assets declines, then its capital will also decline
if its liabilities remain constant. The bank may then wish to replenish its capital by
taking on fewer new loans. If banks make fewer loans, then all bank-financed
projects could decline, including business capital investment unrelated to housing.
Through this channel, the liquidity crunch could spread to the overall economy.
Energy Shock
Because of the central role energy plays in the functioning of the U.S. economy
and its unusual price volatility, changes in energy prices tend to have a greater short-
term impact on the economy than changes in the prices of most other goods. Energy
“shocks” can have macroeconomic consequences, in terms of higher inflation, higher
unemployment, and lower output. Historically, energy price shocks have proven
particularly troublesome for the U.S. economy. Sharp spikes in the price of oil have

15 SIVs are off-balance sheet entities established (but not owned) by commercial banks. An
SIV finances the purchase of long-term MBS by selling short-term notes and commercial
paper. The spread between the long- and short-term rates is profit. For the concept to work,
the SIV must be able to borrow cheaply — a triple-A rating is a basic requirement. To
secure that rating, the SIV generally agrees to maintain certain levels of collateral and the
sponsoring banks often commit themselves to providing lines of credit if the SIV becomes
unable to raise funds in the market.
16 See CRS Report RL34182, Financial Crisis? The Liquidity Crunch of August 2007, by
Darryl Getter, Mark Jickling, Marc Labonte, and Edward Murphy.

preceded nine of the 10 post-war recessions. But since the current economic
expansion began in 2001, energy prices have spiked on several occasions.
Economic theory suggests that economies suffer from recessions due to the
presence of “sticky prices.” If markets adjusted instantly, then recessions could be
avoided: whenever economic conditions changed, price and wage changes would
automatically bring the economy back to full employment. In actuality, however,
there are menu costs,17 information costs, uncertainty, and contracts in the U.S.
economy that make prices sticky. As a result, adjustment takes time, and
unemployment and economic contraction can result in the interim.
When oil prices rise suddenly, it directly raises the energy portion of inflation
measures such as the consumer price index (energy prices make up about 9% of the
consumer price index.) As a result, the overall inflation rate is temporarily pushed
up since other prices do not instantly adjust and fall. If other energy prices rise at the
same time, as has often been the case, then the effect on overall inflation will be
Because energy is an important input in the production process, the price shock
raises the cost of production for many industries. Transportation accounts for a
majority of oil consumption in the United States, but hydrocarbons are also used for
heating and industrial uses, such as the production of plastics. Because other prices
do not instantly fall, the overall cost of production rises and producers respond by
cutting back production, which causes the contraction in output and employment, all
else equal. There may also be adjustment costs to shifting toward less energy
intensive methods of production, and these could temporarily have a negative effect
on output. Typically, the effect on output occurs over a few quarters.18
The effects described thus far can be thought of as occurring on the supply side
of the economy. Oil shocks may also affect aggregate demand. When energy prices
rise, they involve an income transfer from consumers to producers. Since producers
are also consumers, aggregate demand is likely to fall only temporarily as producers
adjust their consumption to their now higher incomes. This adjustment is likely to
be less or to take longer when the income recipients are foreigners than when they
are Americans.
Since the United States is a net importer of oil, the net effect on U.S. aggregate
demand depends on how foreign oil producers use their increase in wealth. The
adjustment to the wealth transfer from consumer to producer is transmitted through
the international balance of payments. How the increase in oil prices affects the
current account deficit (a measure that primarily consists of the trade deficit)
depends, in turn, on how foreign oil producers decide to use this purchasing power.

17 Products with high “menu costs” are those which are costly to re-price, and therefore have
sticky prices. Restaurant menus, periodicals, and catalog items are examples of products
with high menu costs.
18 If rising energy prices affect the economy through this transmission mechanism, then
falling energy prices should have the opposite effect on the economy: they should
temporarily lower inflation and raise output, all else equal.

If they use it to purchase U.S. goods, then U.S. exports would increase and there
would be little effect on the current account deficit. If they use it to purchase U.S.
assets — whether corporate stocks, Treasury bonds, or by simply leaving the revenue
in a U.S. bank account — then it would represent an inflow of foreign capital to the
United States, which would increase the current account deficit. The purchase of
U.S. assets would stimulate total demand in the United States through lower interest
rates, thereby offsetting the contractionary effects of the larger trade deficit, at least
in part and possibly with a lag. Or the foreign oil producers may use their increased
wealth to purchase other countries’ goods or assets, in which case the adjustment
process in the United States could take longer.
A second effect on demand can be expected to occur because the rise in energy
prices will probably push up the overall price level because other prices do not fall
immediately in the face of a decline in demand. The increase in the price level will
reduce the real value of the available amount of money in the hands of buyers, and
this reduction in the value of money will also reduce spending. A third effect on
demand can occur if the rise in energy prices increases uncertainty and causes buyers
to defer purchases. This effect is also likely to be of a short-run nature. The
magnitude of all three effects will depend on how much energy prices rise and how
long they remain high.
Both the inflation and output effects of energy shocks are temporary: that is,
once prices adjust, the economy returns to full employment and its sustainable
growth path.19 This observation yields an important insight: it is not the level of
energy prices that affects economic growth and inflation, but rather the change in
energy prices. Thus, if policymakers are concerned about the effect of energy prices
on output and inflation, they should focus more on rising energy prices than “high”
energy prices, even if the high prices are permanent. The only permanent
macroeconomic effect of higher energy prices is their negative effect on the terms of
trade. The “terms of trade” is the ratio of export prices to import prices.20 It means
that the United States has to give up more of the goods it produces than previously
to obtain a barrel of oil. Permanently higher energy prices lead to a one-time
permanent decline in the terms of trade and the standard of living of U.S. consumers,
all else equal.
Popular Leading Indicators of Recessions
As discussed below, using policy to avoid a recession requires accurate
predictions of where the economy is heading before it has already slowed down.
Forecasters are always looking for “leading indicators” — reliable signs of where the
economy is headed in the short run. This section focuses on popular leading

19 This point is not always explicitly made in the time series analyses reviewed below, which
tend to end their estimates at the last time lag that yields statistically significant results or
arbitrarily cut off the estimates after a few lags to meet a statistical criterion concerning the
limit on the number of variables allowed.
20 See CRS Report RL32591, U.S. Terms of Trade: Significance, Trends, and Policy, by
Craig K. Elwell.

indicators of recessions. These indicators should not be thought of as the cause of
recessions; rather, forecasters attempt to identify predictable patterns within
economic data. If the same economic forces that cause a recession first surface in
leading indicators, then leading indicators can be watched to spot a recession before
it emerges. A measure could also be a leading indicator because it is more readily
available than GDP data. GDP data is released quarterly, with a lag of about a month
after the quarter has ended, and is subject to significant revisions in later months.
Leading indicators will be successful only if the business cycle features
predictable patterns. If every business cycle is unique, then leading indicators based
on past experience may have little predictive power going forward. Since the
economy is constantly changing and recessions are infrequent, it may be that
indicators that were useful a few recessions ago (i.e., a few decades ago) are no
longer relevant in today’s economy.21
The remainder of this section will discuss some of the most famous leading
indicators to explain why their predictive power is believed to be high.
Yield Curve Inversion
The yield curve inversion is a well-known recession indicator. A “yield curve”
refers to a graph plotting the yield on securities by maturity, from three month to
thirty years in the case of U.S. Treasuries. Typically, interest rates are higher on
securities with a longer time to maturity. Prior to each of the last six NBER-
designated downturns (12/69, 11/73, 01/80, 07/81, 07/90, and 03/01), the yield on all
maturities of U.S. Treasury securities fell below the federal funds rate (the rate that
the Federal Reserve targets to conduct monetary policy).22 In the discussion to
follow, this will be referred to as an inversion of the yield curve.23
It should be noted that the time that elapses between the month the inversion
occurs and the subsequent NBER-designated peak in economic activity is not a
constant. The number of months prior to the peak that the inversion occurred (and the
peak) have been: 20 months/December 1969; 8 months/November 1973; 15
months/January 1980; 9 months/July 1981; 16 months/July 1990; and 9 months/
March 2001.

21 A further objection to leading indicators is that they fall foul of the “Lucas critique.”
Economist Robert Lucas argued that one cannot assume that past relationships between
economic variables will remain stable in the future because economic actors learn about past
relationships and adjust their behavior accordingly. For example, once there is a consensus
that a specific economic variable is a leading indicator of a recession, economic actors are
likely to react to changes in that indicator in a way that they did not previously.
22 For analytical purposes, only the yields on U.S. Treasury securities are used in order to
hold the risk factor constant. The yield on private sector securities can vary across time
because investors change their evaluation of their riskiness. Unlike private sector securities,
Treasury securities have virtually zero default risk.
23 In this report, inversion does not necessarily mean that the yield on all shorter term
Treasury securities was above those on longer term debt. It only means that the federal
funds rate was above the yield on all marketable Treasury securities.

Although the structure of Treasury interest rates has had a good predictive
record, it is not perfect. There have been two economic contractions since the federal
funds market was developed in 1954 that were not preceded by an inversion (those
beginning in August 1957 and April 1960). In addition, inversions occurred in both
June 1966 and August 1998 with no subsequent economic contraction. The 1957,
1960, and 1966 anomalies may be due to the early and limited nature of the federal
funds markets and the fact that this rate was not then the main vehicle for carrying
out monetary policy. It is now widely accepted that the decline in longer term
Treasury yields in the 1998 episode was associated with an international “flight to
quality” following the financial crisis in East Asia in the last half of 1997 and the
debt default by Russia in the summer of 1998.
Between June 2004 and June 2006, the Federal Reserve executed 17 equal hikes
of ¼ percentage point in the federal funds rate, raising the target rate from 1% to a
high of 5.25%. The yields on short maturity Treasury securities have risen in
harmony with the federal funds target; the yields on longer term Treasuries have not.
This has resulted in a flattening of the yield curve. By late July 2006, the yields on
all Treasury securities were below the target on federal funds, where they remained
until late 2007, when Fed easing brought the federal funds rate below the 30 year
Treasury yield.
To understand why a yield curve inversion might precede a recession, it may
first be useful to explain why the yield curve is usually upward sloping. Investors are
only willing to take on more risk if they receive a higher rate of return. In this case,
the greater riskiness of longer term Treasuries comes not from default risk, but from
interest-rate risk. The price of a bond fluctuates inversely with changes in interest
rates, and bonds with a greater maturity length will change in value more than short-
term bonds for a given change in interest rates. Thus, even if investors expected
interest rates to be constant over the next five years, a five-year bond would have to
offer a higher rate of return than a one-year bond to compensate for interest rate risk
in order for investors to be indifferent between the two, and this results in an upward
sloping yield curve.
Next, consider what could cause a yield curve inversion. An inversion usually
occurs as a result of a rising federal funds rate, which is consistent with a tightening
of monetary policy. The Federal Reserve reduces the supply of federal funds,
pushing up the federal funds rate. With fewer reserves, banks are forced to reduce
loans and sell other assets, leading to a reduction in the growth of money and credit
and, ultimately, a reduced rate of total spending. If this reduction is large enough, it
can cause an economic contraction.24 (An additional incentive for banks to contract
credit following an inversion is that the rate they must now pay to borrow reserves
is above what they can earn using those reserves for the acquisition of very safe
assets.) Borrowing for, say, five years could be financed by issuing a five year note

24 A rising federal funds rate is also consistent with an increased demand for those funds,
the sign of a vigorous economic expansion. By letting the rate rise, the Fed may also be
tightening money and credit growth relative to what would be the case if it had held the rate
constant. However, this tightening will be less than would be the case if it actually reduced
the supply of those funds.

or by issuing a one year note and rolling it over into a new note each time it matures.
As a result, there is a relationship between interest rates at different maturities. If
long-term rates are partly determined by the average of present and future short-term
rates, then the yield curve would become inverted if short-term rates today were
higher than short-term rates expected in the future. This would occur when the
federal funds rate was rising if investors expected it to fall in the future. For
example, if they thought that the higher rate was going to reduce GDP growth, they
might expect that the Fed would be forced to reduce the target rates in the future to
increase GDP growth.
Why is there a time lag between the yield curve inversion and the recession?
In this case, the delay is because of the lag between the change in Fed policy and the
slowdown in economic activity that a tightening of credit conditions eventually
causes. As economists are prone to argue, the time that elapses from a decrease in
the growth of money and credit to a decrease in the growth of money spending is not
uniform (mainly because economic conditions differ when monetary policy is
tightened). It can be both long and of a variable length. This accounts for the
variable lag reported above between the month the inversion occurs and the month
in which the economy reaches a business cycle peak. With a long and variable lag
and cases of “false positives,” such as 1998, some skeptics have questioned whether
the yield curve is really a useful recession predictor.
Credit Spreads
Forecasters have also focused on the “credit spread” as a business cycle
predictor. The credit spread refers to the difference in yield on two assets that have
the same characteristics except that one is riskier than the other. Many different
assets have been used to measure credit spreads, including the spread between
Treasury bills and commercial paper and between highly rated and lower rated bonds.
Credit spreads are seen as a measure of investors’ perception and tolerance of
risk — when spreads are higher, investors require a higher rate of return to be willing
to take on risk. When the economy slows down, more firms fail and investors
become more fearful of risk. The financial turmoil that has gripped markets since
August 2007 has led to a sharp increase in credit spreads, with Treasury yields falling
sharply while other asset yields have risen.25
But just as financial market downturns do not always translate into economic
downturns, a rise in credit spreads does not always accurately predict a recession.
For example, financial turmoil in 1998 led to a sharp rise in credit spreads, but did
not result in a recession. Economists Estrella and Mishkin found the commercial

25 Stock and Watson found that the commercial paper-U.S. Treasury spread did not predict
the 2001 recession, but the junk bond yield spread did. James Stock and Mark Watson,
“How Did the Leading Indicator Forecasts Perform During the 2001 Recession?”, Federal
Reserve Bank of Richmond, Economic Quarterly, vol. 89, no. 3, Summer 2003.

paper-Treasury bill spread to be a statistically significant recession predictor only up
to two quarters forward, and it did not perform well in out-of-sample forecasts.26
Stock Prices
Economic theory states that stock prices are determined by the present
discounted value of future earnings. In a recession, corporate earnings would be
expected to fall for the market as a whole, and this would reduce stock prices. If the
slowdown were anticipated by investors, the fall in prices would happen before the
economy began to slow. If the combined wisdom of the marketplace is accurate,
stock prices could potentially offer valuable information about the future path of the
economy. Even if investors cannot accurately forecast future economic growth,
movements in stock prices may provide useful “real time” information about the
current economy given that economic data is released with a lag, and recessions are
not declared until after the fact.
As discussed in the next section, stock prices are seen as providing useful
enough information that they are one of the Conference Board’s leading indicators.
Moreover, stock prices fell in the months before the 2001 recession. But
econometric analysis has mostly found that stock prices do not predict economic
growth.27 One exception is an article by Estrella and Mishkin that found stock prices
to be a statistically significant recession predictor up to four quarters forward.28
Evidence presented by Hamilton and Lin suggests that while recessions and bear
markets go hand in hand, recessions have often started before the decline in the stock
market .29
Index of Leading Indicators
It may be that no single measure can reliably predict a recession, so some
forecasters have attempted to evaluate several measures simultaneously. For
example, the Conference Board, a private firm, compiles a well-known composite
index of leading indicators, and tracks the index on a monthly basis. Its index is
composed of the following measures:
1.Average weekly hours, manufacturing

2.Average weekly initial claims for unemployment insurance

26 Arturo Estrella and Frederic Mishkin, “Predicting U.S. Recessions: Financial Variables
as Leading Indicators,” National Bureau of Economic Research, working paper 5379,
December 1995. A test of the usefulness of an indicator is whether the relationship fitted
to past data holds for future (“out of sample”) data.
27 For a review, see James Stock and Mark Watson, “Forecasting Output and Inflation: The
Role of Asset Prices,” Journal of Economic Literature, vol. XLI, no. 3, September 2003.
28 Arturo Estrella and Frederic Mishkin, “Predicting U.S. Recessions: Financial Variables
as Leading Indicators,” National Bureau of Economic Research, working paper 5379,
December 1995.
29 James Hamilton and Gang Lin, “Stock Market Volatility and the Business Cycle,” Journal
of Econometric Forecasting, v. 11, no. 5, September 1996, p. 573.

3.Manufacturers’ new orders, consumer goods and materials
4.Vendor performance, slower deliveries diffusion index
5.Manufacturers’ new orders, nondefense capital goods
6.Building permits, new private housing units
7.Stock prices, 500 common stocks
8. Money supply, M2
9.Interest rate spread, 10-year Treasury bonds less federal funds
10.Index of consumer expectations
In recent months, the index has shown a downward trend. The largest drag on the
index recently has been building permits, as a result of the housing downturn.
Including so many different measures in an index could lead to a problem of
“over-identification,” where variables are included that just coincidentally moved in
concert with the economy in the past, without any structural relationship. If the past
correlation was coincidental, it is unlikely to result in accurate predictions in the
Of course, some indicators in the composite may be more important than others.
Weekly manufacturing hours and the money stock have the largest shares in the
index. The index is supposed to provide predictions about all stages of the business
cycle, whereas some indicators may be more useful for predicting a downturn than
others. According to forecaster Edward Leamer, the interest rate spread,
unemployment claims, and building permits, in that order, are the best predictors of30
when a recession will start. Filardo shows that while the composite of leading
indicators has predicted most past recessions successfully, its usefulness is limited
by the fact that the lead time between the prediction and the onset of the recession is
highly variable, and the index has at times predicted false positives (i.e., predicted a31
recession when no recession occurred).
Policy Responses
Just as an economic slowdown is caused by market forces, market adjustment
will also cause economic activity to eventually recover on its own. But policymakers
may prefer to use stimulative policy to attempt to hasten that adjustment process, in
order to avoid, or at least ameliorate, the detrimental effects of cyclical
unemployment. By definition, a stimulus proposal can be judged by its effectiveness
at boosting total spending in the economy. Total spending includes personal
consumption, business investment in plant and equipment, residential investment, net

30 Edward Leamer, “Is a Recession Ahead? The Models Say Yes, but the Mind Says No,”
Economists’ Voice, January 2007. According to a model based on those three measures,
there was a 100% chance of recession in the next twelve months from October 2006 to the
article’s publication in January 2007.
31 Andrew Filardo, “How Reliable Are Recession Prediction Models?”, Federal Reserve
Bank of Kansas City, Economic Review, vol. 84, no. 2, 1999:Q2, p. 35.

exports (exports less imports), and government spending. Stimulus could be aimed
at boosting spending in any of these categories.
Fiscal Stimulus
Fiscal stimulus can take the form of higher government spending (direct
spending or transfer payments) or tax reductions, but either way it can boost spending
only through a larger budget deficit. A deficit-financed increase in government
spending directly boosts spending by borrowing to finance higher government
spending or transfer payments to households. A deficit-financed tax cut indirectly
boosts spending if the recipient uses the tax cut to increase his spending. If an
increase in spending or a tax cut is financed through a decrease in other spending or
increase in other taxes, the economy would not be stimulated since the deficit-
increasing and deficit-decreasing provisions would cancel each other out.
Since total spending can be boosted only temporarily, stimulus has no long-term
benefits, and may have long-term costs. Most notably, the increase in the budget
deficit “crowds out” private investment spending because both must be financed out
of the same finite pool of national saving, with the greater demand for saving pushing
up interest rates.32 To the extent that private investment is crowded out by a larger
deficit, it would reduce the future size of the economy since the economy would
operate with a smaller capital stock in the long run. In recent years, the U.S.
economy has become highly dependent on foreign capital to finance business
investment and budget deficits.33 Since foreign capital can come to the United States
only in the form of a trade deficit, a higher budget deficit could result in a higher
trade deficit, in which case the higher trade deficit could dissipate the boost in
spending. Indeed, conventional economic theory predicts that fiscal policy has no
stimulative effect in an economy with perfectly mobile capital flows.34 Some
economists argue that these costs outweigh the benefits of fiscal stimulus.
The most important determinant of a stimulus’ macroeconomic effect is its size.
The recently adopted stimulus package (P.L. 110-185) increases the budget deficit
by about 1% of gross domestic product (GDP). The major provisions of the package
were tax rebates for individuals and investment tax incentives for corporations,
which would be expected to boost consumption and capital investment,
respectively.35 In a healthy year, GDP grows about 3%. In the moderate recessions
that the U.S. experienced in 1990-1991 and 2001, GDP contracted in some quarters
by annualized rates of 0.5% to 3%. (The U.S. economy has not experienced

32 Crowding out is likely to be less of a concern if the economy enters a recession since
recessions are typically characterized by falling business investment.
33 If foreign borrowing prevents crowding out, the future size of the economy will not
decrease but capital income will accrue to foreigners instead of Americans.
34 For more information, see CRS Report RS21409, The Budget Deficit and the Trade
Deficit: What Is Their Relationship?, by Marc Labonte and Gail E. Makinen.
35 For details of the stimulus package, see CRS Report RL34349, Economic Slowdown:
Issues and Policies, by Jane G. Gravelle, Thomas L. Hungerford, Marc Labonte, N. Eric
Weiss, and Julie M. Whittaker.

contraction in a full calendar year since 1991.) Thus, a swing from expansion to
recession would result in a change in GDP growth equal to at least 3.5 percentage
points. A stimulus package of 1% of GDP could be expected to increase total
spending by about 1% for the year (with the effect concentrated in the quarters that
the stimulus was delivered).36 To the extent that spending begets new spending, there
could be a multiplier effect that makes the total increase in spending larger than the
increase in the deficit. Offsetting the multiplier effect, the increase in spending could
be neutralized if it results in crowding out of investment spending, a larger trade
deficit, or higher inflation. The extent to which the increase in spending would be
offset by these three factors depends on how quickly the economy is growing at the
time of the stimulus — an increase in the budget deficit would lead to less of an
increase in spending if the economy were growing faster.
The effectiveness of the stimulus package in the current environment may also
depend on the nature of the slowdown. If the fundamental problem retarding
economic growth is a credit crunch, caused by banks’ desire to repair their balance
sheets, it is unclear how much a general boost to consumer spending and tax
incentives for firms to invest can solve the problem.
In judging the need for fiscal stimulus, policymakers might also consider that
stimulus is already being delivered, in addition to the stimulus package passed in
February, from two other sources. First, the federal budget has automatic stabilizers
that cause the budget deficit to automatically increase (and thereby stimulate the
economy) during a downturn in the absence of policy changes. When the economy
slows, spending on entitlement programs such as unemployment compensation
benefits automatically increases as program participation rates rise and the growth
in tax revenues automatically declines as the recession causes the growth in taxable
income to decline. In addition to the stimulus package, the Congressional Budget
Office projected in March 2008 that under current policy, the budget deficit would
increase by another $42 billion in 2008 compared to 2007.37
Second, the Federal Reserve has already delivered a large monetary stimulus.
Its actions will be discussed in the next section.
Monetary Policy
The Federal Reserve can use expansionary monetary policy to boost spending
in the economy by lowering the overnight interest rate, called the federal funds rate.
The Fed alters interest rates by adding or withdrawing reserves from the banking
system. Lower interest rates increase interest-sensitive spending, which includes
physical investment (i.e., plant and equipment) by firms, residential investment

36 See, for example, “Options for Responding to Short-term Economic Weakness,”
Testimony of CBO Director Peter Orszag before the Committee on Finance, January 22,


37 Note also that, in January 2008, CBO estimated that if supplemental military spending to
maintain current troop levels overseas and an alternative minimum tax patch are enacted,
and expiring tax provisions are extended, the 2008 deficit could increase by another $42
billion compared to 2007.

(housing construction), and consumer durable spending (e.g., automobiles and
appliances) by households. In addition, lower interest rates would stimulate the
economy by reducing the value of the dollar, all else equal, which would lead to
higher exports and lower imports. Changes in the federal funds rate lead to changes
in spending with a lag.38
Beginning in September 2007, before data were publicly available to
demonstrate that economic growth had slowed, the Fed began lowering the federal
funds rate. Since then it has lowered the rate several times. The Fed has also greatly
increased its direct lending to the financial sector, through the discount window and
a series of new lending initiatives, including lending to non-depository institutions
for the first time. In March 2008, it financed the purchase of $30 billion of assets
from the investment bank Bear Stearns to prevent it from filing for bankruptcy. The
assistance was unprecedented for its size, nature, and recipient (Bear Stearns was not
a member of the Federal Reserve system).39
Some critics have argued that financial institutions will be relatively
unresponsive to interest rate cuts until they have strengthened their balance sheets.
Thus they argue that the Fed’s moves are well-intentioned, but will prove ineffective.
Others argue that the Fed has neglected the risk that excessive monetary expansion
will result in a problem of rising inflation. They argue allowing market forces to
adjust would be better for the economy than rate cuts in the long run, even if it
deepened the downturn in the short run. Since monetary policy affects the economy
with a lag, it is too soon to say whether the Fed or its critics are correct.
Are Recessions Unavoidable?
If recessions are usually caused by declines in aggregate spending, and the
government can alter aggregate spending through changes in monetary and fiscal
policy, then why is it that the government cannot use policy to prevent recessions
from occurring in the first place? While recessions should theoretically be avoidable,
there are several real world problems that keep stabilization from working with
perfect efficiency in practice.
First, many of the economic shocks that cause recessions are unforeseeable. By
the time policymakers can react to the shocks, it may be too late to avoid a recession.
As their name suggests, economic shocks tend to be sudden and unexpected. Few
energy analysts predicted that the price of oil would rise from less than $20 per barrel
in 2001 to about six times as high today; if the rise in price could not be predicted,
then neither could its effects on the economy.
Second, there is a time lag between a change to monetary or fiscal policy and
its effect on the economy because individual behavior adjusts to interest rate or tax
changes slowly. It will take time for firms to boost investment in response to lower

38 For more information, see CRS Report RL30354, Monetary Policy and the Federal
Reserve, by Marc Labonte and Gail E. Makinen.
39 For more information, see CRS Report RL34427, Financial Turmoil: Federal Reserve
Policy Responses, by Marc Labonte.

interest rates and the tax incentives included in the stimulus package. Also, although
the stimulus bill became law in February 2008, consumers did not begin receiving
their “rebate” checks until May. Because of lags, an optimal policy would need to
be able to respond to a change in economic conditions before it occurred. For
example, if the economy were going to fall below full employment next year, policy
would need to be changed this year to prevent it.
Third, for stabilization policy to be effective given lags, policymakers must have
accurate economic forecasts. Yet even short-term economic forecasting —
particularly in the case of turning points in the business cycle — is notoriously
inaccurate. In January 2001, the Congressional Budget Office, the Office of
Management and Budget, the Federal Reserve, and virtually all major private
forecasts predicted growth between 2.0% and 3.1% for the year.40 In reality, the
economy entered a recession two months later, and grew by 0.8% for the year. Given
the important role of unpredictable shocks in the business cycle, perhaps this should
not be a surprise.
Fourth, since forecasts are not always accurate, our understanding of the
economy is limited, and the economy does not always respond to policy changes as
expected, policy changes do not always prove to be optimal in hindsight. For
example, if the natural rate of unemployment (NAIRU) rises and policymakers do not
realize it, they may think that expansionary policy is needed to reduce
unemployment. Economists believe that this is one reason inflation rose in the


Fifth, in the case of monetary policy, changes in short-term interest rates do not
lead to one-for-one changes in long-term interest rates. Long-term interest rates are
determined by supply and demand, and many factors enter that equation besides
short-term interest rates. Yet many types of spending may be more sensitive to long-
term rates, reducing monetary policy’s effectiveness. One reason the housing boom
continued after 2004 was that mortgage rates increased far less than the federal funds
Sixth, since policy changes do not lead to large and rapid changes in economic
activity for the reasons listed above, it may take extremely large policy changes to
forestall a recession. Yet policy changes of that magnitude could be destabilizing in
their own right. Extremely large swings in interest rates could impede the smooth
functioning of the financial system and lead to large swings in the value of the dollar.
Large increases in the budget deficit could hamper the government’s future budgetary
flexibility. Uncertainty is an argument in favor of more modest policy changes.
Finally, policy’s influence on the economy is blunted by the open nature of the
U.S. economy in an era of increasing globalization. As discussed above, the
expansionary effects of increases in the budget deficit have been largely offset by
increases in the trade deficit in recent years. Likewise, the contractionary effects of
higher short-term interest rates have not led to significantly higher long-term rates
because of the ready supply of foreign capital. Nevertheless, higher short-term

40 Blue Chip, Economic Indicators, January 2001.

interest rates would still have a contractionary effect on the economy through the
larger trade deficit that accompanies foreign capital inflows. But if foreign capital
flows kept long-term interest rates (such as mortgage rates) from rising in response
to contractionary monetary policy, capital mobility may have rendered monetary
policy unable to effectively counteract the housing bubble. An open economy is also
one that is more influenced by developments abroad — as the economy’s openness
has increased over time, foreign economic shocks (positive or negative) have had a
larger effect on the United States, and domestic events, including policy changes,
have had a smaller effect.