A lesser-known economic gauge is worth watching

William Hester, CFA
December 2004
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Steady as she goes. That is the forecast for U.S. economic growth in 2005, according to a survey by the Philadelphia Federal Reserve Bank. Output is projected to expand at a consistent 3.4 percent rate throughout the year.

How much faith should investors put in these forecasts? Like weathermen, economists are remembered for their misses more than their hits. Unfortunately, economists tend to miss the biggest storms.

That's according to 2002 research from the Atlanta Federal Reserve: Evaluating Wall Street Journal Survey Forecasters: A Multivariate Approach. The study looked at 16 years of predictions in the Wall Street Journal's economic survey. Each was ranked from 0 to 100, with 100 showing the highest accuracy and 0 showing the lowest. When the economy was growing in a stable manner, accuracy scores were between 60 and 80. At turning points, accuracy collapsed to the mid-teens. The errors were especially dramatic at the start of recessions, including the summer of 1990 and January, 2001.

There are a few reasons why economists, as a group, have missed calling the most recent recessions. First, even though the $11 trillion US economy doesn't turn on a dime, it accelerates and decelerates faster than many assume.

Forecasting a recession is also a dangerous business for many of the economists working on Wall Street. Expected growth in the economy can buoy the market, fuel investor demand, and support new stock issuance. That's good for business. The incentive to make upbeat forecasts can compete with the incentive to be accurate.

So, as the economy nears a turning point, you need to adjust economists' forecasts for their inherent optimism. One way to do that is to consult the Anxious Index.

The Anxious Index

The Anxious Index resides in data collected in the Survey of Professional Forecasters , a little-publicized Philadelphia Federal Reserve Bank publication released near the middle of each calendar quarter.

The Survey of Professional Forecasters is the oldest quarterly survey of economic forecasts in the US, beginning in 1968. One of its best qualities is that it surveys a diverse group of forecasters, including regional bank economists, corporate forecasters, and independent economists. And their forecasts are anonymous.

That diversity and anonymity is important. According to 1999 research published by the Federal Reserve Bank of New York, forecasters whose wages are most closely tied to publicity, as opposed to accuracy, produce forecasts that deviate most from the consensus. In this study, and others, the consensus regularly outperforms individual forecasters.

In addition to questions in the Philadelphia Fed's survey about traditional economic measures, like inflation and unemployment trends, forecasters are asked to estimate the probability of a decline in GDP in the quarter the survey is taken, and in each of the subsequent four quarters.

The probability of a decline in GDP next quarter is commonly referred to as the Anxious Index, a term coined by a New York Times reporter a few years ago.

Tracking this data is like a direct line into economists' super-ego. How confident are they in their estimates? Is the risk of a recession - which may not yet be part of their forecast - growing?

Reading the Index

Judging from forecasts at the time, the slowdown that began in March of 2001 seemed to catch most economists by surprise. Many were predicting the economy to grow briskly throughout the year. In March of that year, only 3 of 43 economists forecasted two back-to-back quarters of contraction, the shorthand definition of a recession, according to a Bloomberg poll.

But many of those same forecasters, surveyed anonymously by the Philadelphia Fed, predicted a 32 percent chance of a decline in GDP in the second quarter of 2001, the highest level for the index since the previous recession. So before the risk of a contraction entered into economists' public forecasts, it showed up in the Anxious Index.

Historically, it has been useful to watch the trend of the index as well as its absolute level. Leading up to the first three recessions beginning in 1970, the fear of a slowdown grew strongly. In each occurrence, the probability of a declining quarter quickly rose above 40 percent.

During the first two quarters of 1990, however, the probability of a decline averaged just 20 percent prior to the beginning of that year's recession. That reading was a strong advance over 1989 readings.

Once economists begin to feel strongly about a possible slowdown - by placing a 45 percent probability or greater on the chance of a decline in GDP in the next quarter - it's likely that the recession has already begun.

The Anxious Index has done a fairly good job of forecasting the end of recessions, often turning down as the economy is bottoming. The most recent recession was an exception. During the fourth quarter of 2001 - which would eventually mark the official end of the recession - economists predicted a 49 percent chance of continued weakness in the first quarter of 2002.

Another pattern in the data is that economists often fear a second recession following closely behind the first. But only the 1981 recession was close enough to be called a double-dip.

The only significant miss in the performance of the index was a brief spike following the market crash in October 1987, which did not materialize into a recession.

In the most recent survey, forecasters think that there is a 10 percent chance of recession in the first quarter of 2005, up from 8 percent three months ago. For the remaining three quarters of 2005, economists place between an 11 percent and 13 percent chance of a recession.

A 10 percent chance is still low, but is worth watching closely. Forecasts can shift quickly between the quarterly surveys. Between the second and third quarter of 1981, the probability economists placed on a decline in GDP in the next quarter tripled from 20 percent to 60 percent. The economists would later learn that a recession had already begun.

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The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.

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