What is a recession? Are we experiencing one now?

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What is a recession?

Are we heading towards one? Are we experiencing one already?

Last week, the Reserve Bank of Australia released documents relating to a freedom of information request.

The documents showed that, late last year, RBA staff were discussing the likelihood of Australia’s economy falling into recession this year and next if the bank kept rapidly lifting interest rates.

But the staff used different definitions of “recession” to tell them things about the economy.

Let’s have a look at both.

Then we’ll see what they say about our economy right now.

Who decides when there’s a recession?

How do you know when a recession is happening?

On the face of it, it seems like a simple question.

A recession is a situation in which something’s gone terribly wrong with the economy.

You’ll see businesses closing down. Workers will be losing their jobs. Unemployment will rise. Banks will foreclose on more mortgages than usual.

But policymakers try to be more precise than that, so they use a specific definition of “recession” to say for sure if one has begun.

In the United States, an institution called the National Bureau of Economic Research (NBER) is responsible for officially declaring when a recession has begun and ended.

But we don’t have anything like that in Australia.

Instead, Australian policymakers use a simpler and more mechanical definition to tell us if our economy has been weakening significantly.

And it’s called a “technical recession”.

What is a technical recession?

According to the definition, we’re technically in recession when the economy contracts for two quarters in a row.

To be precise, we’re in recession when the amount of goods and services we produce in Australia has been shrinking for two consecutive quarters, after taking inflation into account.

However, one problem with the definition is it’s backwards-looking with a lag.

It means we have to wait for the data to come in before we can declare a recession, by which time the collapse in economic activity may have been occurring for nine months already.

Why nine months?

Because the Bureau of Statistics tracks our economic growth by publishing its gross domestic product (GDP) figures every quarter.

The first quarter for the year covers January, February and March (the March quarter), and it takes ABS officials three months to collate that data once the quarter has ended.

That means it takes them until June to collect and release the data for the March quarter.

And the same thing happens again with the next quarter, which covers April, May and June (the June quarter).

It takes until September before we know what happened to GDP in the June quarter.

So, if a “technical recession” is two consecutive quarters of shrinking economic activity, it means we have to wait until September before we know if there was a recession in the first six months of the year.

Not very satisfactory.

And RBA officials know it’s not particularly helpful, and they say as much in the FOI documents released last week.

“The usefulness of this definition to policymakers is limited by the lags involved in National Account statistics,” the documents say.

That’s why RBA staff are willing to consider a different definition of recession that provides a far more timely warning about the economy.

An employment-based measure of recession

Have a look at the graph below.

It was included in the FOI documents.

An RBA analyst made it to show how different definitions of “recession” say different things about the economy.

The top half of the graph (with the blue line) uses the “technical recession” definition we’ve been discussing.

It shows when Australia’s economy experienced a recession over the last 60-odd years.

The technical recessions are marked by the five shaded columns.

Notice how there was no recession between the early 1990s recession and 2020?

That’s the period economists point to when they say Australia recorded 29 years of uninterrupted economic growth before the pandemic.

But now, have a look at the bottom half of the graph (with the pink line). It uses a different definition.

It uses the “Sahm Rule” (named after Dr Claudia Sahm, a former US Federal Reserve economist), which is an employment-based measure of recession.

Those “Sahm recessions” are marked by nine shaded columns.

How does the Sahm rule work?

It uses a “moving average” of the unemployment rate to tell us when things are going awry in the labour market.

Specifically, it takes the average of the unemployment rate for the last three months and, if that average increases by 0.5 percentage points above the lowest unemployment rate recorded in the prior 12 months, it means the economy’s entered a recession.

Conceptually, since it’s an employment-based measure of recession, it’s much more worker-oriented than the “technical recession” definition.

Why? Because jobs matter far more to workers than an aggregate measure of economic activity.

And as the RBA analyst says in the FOI documents, the Sahm rule can capture periods of economic pain for workers that aren’t captured by the “technical recession” definition.

For example, it captures when unemployment is rising quickly (and hurting a lot of people) while GDP growth is weak but not persistently negative.

But to apply the Sahm rule to Australia’s economy, the RBA researcher slightly modified it.

They said Australia’s economy is in a “Sahm recession” when a moving average of the unemployment rate increases by 0.75 percentage points above its minimum from the last 12 months.

And even with that more stringent hurdle, they said it revealed something challenging about our economic record.

“Applying this rule to Australia’s historical data results in more recessions than under the technical definition, particularly in recent decades,” the analyst said.

What exactly does it show?

It shows Australia’s economy actually experienced two (mild) recessions between the early 1990s recession and the 2020 recession, which runs counter to the official narrative.

You can see those two extra recessions on the graph above.

“The dot com bust of 2001 and the Global Financial Crisis would also be classified as (mild) recessions, consistent with broader interpretations of recessions in Australia including previous commentary from the Bank,” the analyst says in the FOI documents.

That means we didn’t avoid recession-type impacts in our labour market during the GFC, even though we avoided a technical recession at the time.

Does that accord more with your experience of those days?

Are we in recession now?

Which leave us with the final section.

According to the definition of a “technical recession,” we’re still a while away from recording a recession this year (if at all).

The most recent GDP data we have is for the December quarter. Economic activity grew by 0.5 per cent in that quarter.

We won’t be getting the March quarter GDP numbers until the first week of June.

So, if there was a contraction in the March quarter, we’ll then have to wait until September to see if the economy also contracted in the June quarter, which will be necessary to record a technical recession.

I haven’t seen any economists suggesting that that will be happening (at this stage).

What about the Sahm rule?

Well, the national unemployment rate is currently sitting at 3.5 per cent (the data are for March), and we’ll be getting new unemployment data this week (it will be April data).

Some economists think the unemployment rate will actually decline to 3.4 per cent.

Now, since June last year, the unemployment rate has been hovering between 3.4 per cent and 3.7 per cent, and it hasn’t shown signs of wanting to jump up quickly.

That could change of course, but at this point it’s been relatively stable for the last 10 months.

The unemployment rate will have to increase noticeably from here to trigger a Sahm recession.

At any rate, I’ll leave you with this thought.

You know what’s fascinating about RBA officials experimenting with the Sahm rule in their internal modelling last year?

It may offer some insight into why RBA governor Philip Lowe hasn’t been even more hawkish with his interest rate increases, and why he’s apparently willing to tolerate inflation sitting just above his 2-3 per cent target range out to the end of his two-year forecast horizon.

If he can manage things in such a way that, while he still gets inflation to fall, any rise in the unemployment rate can be slower or take place over a longer period of time, it could be possible to avoid a “Sahm recession.”

And that’s the type of recession that hits workers in ways that aren’t always captured by a “technical recession.”

Does that mean he has workers front of mind when deciding what to do with interest rates?

By business reporter Gareth Hutchens (Original ABC Article)