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August 8, 2022

From: Steve Ambler

To: Canadians Concerned about Recession

Date: August 8, 2022

Re: Calling a Recession: A US Game with Fluid Rules

The US Bureau of Economic Analysis (BEA) published its first estimate of second-quarter GDP on July 28, minus 0.9 percent on an annualized basis (a 0.23 percent drop quarter-over-quarter).

The US has now had two quarters of negative GDP growth. This has led to a lively debate in the press and on Capitol Hill over whether the US economy is now in a recession and if two quarters of negative growth constitute the “official” definition of “recession.”

This makes it important to understand what a recession is, how this applies to the current situation in the US, and the implications for Canada’s economic prospects and for Canadian monetary policy.

If there is an official definition in the US, it is the one used by the National Bureau of Economic Research (NBER), a private, non-profit organization that focuses on understanding the US economy, and which is accepted by the BEA itself. The NBER’s Business Cycle Dating Committee defines a recession as “a significant decline in economic activity that is spread across the economy and that lasts more than a few months.” This is very close to the definition used by the C.D. Howe Institute’s Business Cycle Council. It means that the decline in activity must be sufficiently pronounced, sufficiently persistent, and it must affect many or most sectors of the economy. The two-quarter rule is not enough.

It is uncertain whether the NBER’s criteria for a recession are (or will be) satisfied. The labour market in the US remains relatively strong. Unemployment is currently 3.6 percent, down from 4 percent in January. Employment growth over the first two quarters of 2022 has been positive. The depth of the contraction will not be clear until the BEA’s final estimate of second-quarter GDP is released in several months. Gross Domestic Income, an alternate measure of economic activity, increased in the first quarter at an annualized rate of 1.8 percent. Industrial production, which is strongly correlated with GDP, decreased by 0.2 percent in June after growing in every previous month of 2022.

The NBER committee is not likely to make a call (one way or the other) before accumulating more economic data, and this will take some time. In the US, the business cycle peak before the Great Recession of 2008 occurred in December 2007. The committee did not call the recession until December 1, 2008, more than four months after the preliminary estimate of GDP in the second quarter of 2008 was published by the BEA (in July).

In any case, the NBER committee’s goal is to provide a definitive historical account of the US business cycle for the purposes of economic research and modelling, not an up-to-the-minute measure of the state of the economy. It prefers to make correct calls rather than speedy ones.

On the other hand, there have been 10 periods since 1948 with two or more quarters of negative economic growth in the US. The NBER committee declared all of these periods to be recessions. If the two-quarter rule is a signal of a recession, the two-quarter rule has had no false positives over the last 78 years in the US. This is not the case in Canada, which experienced two quarters of mildly negative growth in 2015 that were confined mostly to the energy sector and mostly to Alberta and to Newfoundland and Labrador: the BCC decided in 2018 not to classify this downturn as a recession.

Meanwhile, the two-quarter rule is such a strong signal that it will have an impact on consumer and business confidence, in both the US and Canada. The latest number on Canadian GDP growth was that it was flat in May, possibly indicating the beginning of a slowdown. Downturns in US growth, which affect the demand for Canadian exports, typically strongly affect the Canadian economy but with a lag. For example, the Great Recession began in the US in January 2008, but growth did not turn negative in Canada until November.

In turn, this will affect monetary policy in both the US and Canada. The Fed will be more cautious about raising its policy rate to bring down inflation. The rationale for raising interest rates is to slow demand in order for supply to catch up. Consequently, the Bank of Canada may also reckon that it needs to be less aggressive in raising its overnight rate target as the Canadian economy cools in response to the US downturn.

Each new data point concerning product and labour markets on both sides of the border will be unusually important for the likelihood of an eventual recession call by the NBER, the likelihood of Canada entering a recession, and the likely responses of both the Fed and the Bank of Canada.

Steve Ambler, a professor of economics at the Université du Québec à Montréal, is the David Dodge Chair in Monetary Policy at the C.D. Howe Institute.

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The views expressed here are those of the authors. The C.D. Howe Institute does not take corporate positions on policy matters.