A better way of knowing if we’re in a recession

How do we know if we’re in a recession? The conventional measure in Australia is straightforward – if ‘real gross domestic product’ (the amount of goods and services produced in Australia, measured after taking inflation into account) falls for two consecutive quarters, we’re in a recession. Things are a little more complicated in the US, where a committee of economists determines when recessions start and end based on ‘the behaviour of various measures of broad activity’ – including real GDP but also a range of other indicators.

The problem is that both these approaches involve looking at the economy in the rear-view mirror. We won’t know how much the Australian economy grew or shrank in the second quarter of this year – April, May and June – until September. Even then, real GDP numbers are often revised, sometimes by meaningful amounts, so the read we get in September won’t tell us definitively whether we’re in a recession.

This isn’t much use to policy makers, who need timely information to decide whether economic stimulus might be required – and how much.

This problem led Claudia Sahm, an economist at the US Federal Reserve, to devise a new indicator that diagnoses recessions based on a rolling average of the unemployment rate (jobless figure are released monthly, whereas the GDP figures are released quarterly).

The Sahm Recession Indicator is fairly straightforward. You take the average of the unemployment rate for the past three months, and compare that average to the lowest unemployment rate over the past year. If the rolling average is at least half a percentage point above the low point – say if the latest three-month average is 5.5 per cent, and the lowest over the past year is 5 per cent – then the economy has crossed into recession territory. In a recent paper for the Brookings Institution, Dr Sahm shows that her indicator reliably ‘calls’ US recessions, and argues that it could be used to trigger automatic fiscal stimulus.

So what does the Sahm indicator say about Australia? It’s not diagnosing a recession, at least not yet. Our average unemployment rate for the past three months was 5.2 per cent – only 0.2 percentage points above the 5 per cent low in the December-February period. But watch this space: unemployment is clearly rising.

Interestingly, the Sahm indicator challenges the conventional view that Australia hasn’t had a recession since the early 1990s. The ’90s recession, as well as its savage early-80s predecessor, show up quite clearly in the graph, but so do smaller downturns since the turn of the century. The 2001 ‘tech wreck’ and the 2008 Global Financial Crisis didn’t lead to recessions in Australia, at least by the conventional two-quarters-of-shrinking-GDP measure, but the unemployment rate did rise sharply and quickly enough to call a recession based on the Sahm measure. A more recent episode around the end of the mining construction boom in 2012 also flirted with the recession threshold, according to this unemployment-based metric.

The Sahm indicator is also useful at the state level in Australia. The national quarterly GDP figures don’t tell us whether individual states are in recession, and the gross state product figures – the state equivalent of GDP – are only released annually.

Using the Sahm indicator, the monthly state unemployment figures suggest the Tasmanian economy is in the doldrums, South Australia isn’t far behind, and Western Australia has struggled intermittently since the end of the mining construction boom. The depth of the early 1990s recession in Victoria in particular is also very clear on the chart. The state-level unemployment numbers are noisy – particularly for the smaller states – but averaging them over several months as the Sahm Indicator does allows us to turn down the noise and get a good sense of how the states are travelling.

Policy makers need up-to-date indicators, such as the monthly unemployment figures, to assess the state of the economy. Federal Treasurer Josh Frydenberg and his state counterparts would be wise to keep an eye on the Sahm Recession Indicator over the coming months.