U.S. Economic Trend Update

Thinking positively about the economy isn't getting any easier these days. From worries about fiscal uncertainty in Washington to fears that America's long-run growth prospects have been impaired, the case for pessimism is in full swing in the final days of the year. The rear view mirror for economic data, however, suggests that the game isn't over yet, as today's update of The Capital Spectator Economic Trend Index (CS-ETI) reminds.

November's economic profile, based on the data published so far, reveals minimal signs of deterioration. The one exception is the latest return to a state of contraction in manufacturing via the ISM data. For now, however, that's an outlier and the broad trend remains positive. There's a lot of debate about whether the business cycle has taken a turn for the worse, but arguing in the affirmative still doesn't come with much econometric support, as this broad review of CS-ETI's indicators reminds:

Plugging the data into a diffusion index shows that the economy's overall momentum remains positive in the sense that a recession hasn't started in the recent past. The majority of indicators are still trending positive. That's not a qualitative statement about the economy per se; rather, it's a quantitative summary of how the data is behaving, primarily on a year-over-year basis, albeit with a few exceptions (as noted in the "Transformation" column in the table above). Boiling it all down to one metric gives us the following chart, which advises that the current batch of numbers isn't currently signaling a new economic downturn:

Converting the data in the diffusion index into probabilities via a probit model tells us more directly that recession has been a low-risk event recently:

Finally, let's consider what the data's telling us about the near-term future by way of a sophisticated econometric technique that's applied in a relatively straightforward way here. In particular, I've generated forecasts for each of CS-ETI's indicators, independently of one another, using an ARIMA model. I then aggregate the results to estimate CS-ETI for the next several months.1 The process starts by filling in the missing numbers as a bridge to estimating each of the monthly data sets. It's safe to assume that a fair amount of error infects any one forecast, although aggregating the individual estimates can minimize the risk a bit if some of the errors cancel each other out. One source for cautious optimism on this front is the recent record in estimating CS-ETI's future path, an exercise that's produced fairly reliable results lately. With that in mind, the near-term outlook is encouraging for thinking that CS-ETI will continue to post readings that are associated with economic growth.

A separate set of forecasts for CS-ETI using a vector autoregression technique dispenses a similar set of estimates for expecting that the next month or two won't bring a dramatic reversal of fortune for this index.

All of this comes with the usual caveats, of course. Indeed, the range of outcomes implied by the confidence intervals associated with CS-ETI's projections inspires a fair amount of humility. But there's another factor that's considerably more worrisome at the moment. The big risk for the economy may be a threat that's immune to econometric modeling and forecasting: the U.S. government. "Time running out on ‘fiscal cliff’ deal," according to The Washington Post.

It's unclear as to exactly what failure on this matter means for the economy. But on the topic of the economy's trend so far, a subject that comes with a touch more clarity, the numbers still look encouraging overall. That's no assurance that the various macro hazards won't derail the trend in the weeks and months ahead, but for now it's still premature to argue that growth has hit a wall.

The bottom line: as we go into the economy's year-end finale, there's quite a bit more positive momentum in the macro trend than some analysts recognize. That may not be enough to keep us out of trouble going forward, but for now the case for cautious optimism is still reasonable--particularly if Washington finds a way to deliver a pro-growth compromise in the current fiscal debate.

1. The ARIMA forecasts are calculated in R software, using Professor Rob Hyndman’s "forecast" package, which optimizes the model's parameters based on each data set's historical record. ^