Recession Heuristics

The following summarises simple recession indicators for Australia. Data is included through to .

Sahm Rule

Or:

where is the 3 month moving average of the seasonally adjusted national unemployment rate.

There are a number of permutations to the rule using different labour market measures:

• Original Sahm rule: uses the unemployment rate;
• Alternative Sahm rule: uses the employment to population ratio, because recent labour market changes such as access to benefits and work tests have reduced the relevance of unemployment as a measure of economic health;
• Vacancy rate test looks at the change in job openings, for Australia the ABS publishes this data quarterly;
• Hours worked as a proportion of potential hours for full and part time employees, combines reductions in hours as employers reduce demand, the measure has additional smoothing;
• Underemployment rate, the proportion of the labour force that is unemployed, plus those looking for additional hours;
• Underutilisation rate, the proportion of the labour force that is underemployed plus persons actively looking for work but not available to start immediately;
• Michez test uses the minimum of the unemployment and vacancy rate series.

The vacancy rate and employment to population ratio rules are calculated inverse to the unemployment rate:

where is the vacancy rate, the number of job vacancies divided by all employed persons (plus vacancies).

Although the original Sahm rule used the trailing 12 months (excluding the current month), consistent with the Michez rule the calculation here uses the last 13 months (including the current month). This index can never be negative.

Output Gap

The simplest measure of the output gap is the difference between long term trend GDP and the latest GDP. The gap is defined as:

where is output, usually measured by log of real Gross Domestic Product, potentially seasonally adjusted, and is the trend output. Trend output is not directly observed and is therefore estimated. The output gap is a useful economic performance measure, when gap is positive (economic growth is above potential) this can be associated with inflationary pressures in the economy, conversely when negative (economic growth is below potential) there should not be strong inflationary pressures and a highly negative gap is associated with high unemployment.

The following summarise a range of common approaches to estimating the output gap. The simplest methods are based on various trend filters, more useful measures incorporate other economic indicators such as unemployment and inflation and build on fundamental economic relationships inherent in the Philips Curve and Okun's Law.

Term Spread

Term spreads, the difference between short and long term interest rates, indicate the market's expectations for future policy rate changes. The term spread is calculated as the difference in the nominal interest rates. A number of different horizons can be used, two common definitions are:

• the long horizon term spread: the difference between the 10 year fixed and 1 year fixed :
• the short horizon forward spread: the difference between the 3 month bill rate 18 months forward and the current 3 month bill rate.

The implied recession probability is derived from a probit regression by the US Federal Reserve and applied crudely to Australian term spreads as:

Using the US Federal Reserve estimates a flat yield curve (the 10 year government bond rate equals the overnight rate) is associated with a recession probability of 30%. The more inverted the yield curve the greater the probability of recession from this simple model.

The recession probability produced from the yield spread, as it reflects the occurrence of recessions in the US, has a significantly higher probability than estimates calibrated to Australia (at least as measured using data for the last 30 years).