Fiscal Cliff Risk In Perspective

-- R.E.M.

The Congressional Budget Office warned yesterday that there's a recession coming next year if Congress doesn't act to soften the blow from the scheduled expiration of tax and automatic budget cuts.

The so-called 'fiscal cliff', in short, is moving closer. What can you do with this information? Nothing. Unless, of course, you're prone to making decisions today based on forecasts six months or more into the future. But history suggests you should think twice before jumping off the forecasting cliff, regardless of who's dispensing the prediction.

Real And Imminent Threat
The scheduled expiration of tax cuts and automatic budget cuts represent real, albeit potential, threats to the economy. But so is the economic blowback via higher oil prices if Israel attacks Iran in a pre-emptive strike; or if Syria's civil war worsens and turns into a regional war. In fact, anyone can come up with a laundry list of plausible scenarios, both here and abroad, that would probably push the economy into recession. The fiscal-cliff scenario is one of them, and it's a risk that we should take seriously, but not too seriously... at least not yet.

The problem is that there are always risks lurking that could derail economic growth. But it's also true that recessions rarely arrive as bolts out of the blue with no advance warning. The idea that you could go to sleep on Monday -- when all is fine -- and wake up on Tuesday to find the economy contracting is the macro equivalent of worrying about hobgoblins under your bed.

Keep Doing What You Always Do
A better approach is to monitor a broad set of indicators for signs that the economy is deteriorating and generating conservative assumptions about the very near future. In other words, use something approximating real-time analysis in an intelligently designed framework to guide your decisions for deploying capital, running your business, etc.

By that standard, recession risk still looks low, as I discussed earlier this week. Yes, that too will change, and perhaps soon. When it does, you'll see the accumulating evidence in the economic and financial reports. The critical issue is recognizing when the preponderance of indicators slip over to the dark side, at which point recession risk will truly be a threat. When that day comes, you'll read about it here.

Meantime, cherry-picking risks and thinking that they represent fate for, say, next spring, is short-sighted. Yes, the fiscal cliff could kill us. But Congress may get its act together. There are also plenty of potential positive surprises that could alter the outlook for the better, even if the fiscal cliff strikes. We can play this game of "What if?" all day. Qualitative forecasting is an interesting exercise, and it can be productive up to a point. But it's prone to lots of error. The same can be said for quantitative forecasts, particularly attempts at looking too far into the future.

'Nowcast' The Future
For my money, "nowcasting" recession risk -- analyzing a diversified set of published indicators that collectively offer a robust read on the economy -- provides a more reliable method. Sure, the latest numbers are subject to revision, but that’s why a broad set of indicators is essential -- some of the revisions cancel each other out.

We can and should supplement the latest information with short-term forecasts via econometric modeling to get a "feel" for what the next batch of numbers is likely to tell us. This is hardly a perfect solution, but it's light years ahead of getting all worked up about a report du jour that singles out one particular hazard on the uncertain horizon.