I hypothesize that “animal spirits” or confidence levels in the economy are largely a function of how things in the economy are relative to adaptation level. In the model presented up to now I have used the psychologically sensitive unemployment variable as the basis for the calculation. Today I am playing around with Industrial Production. Just as stock market investors become discouraged when a stock’s price slips below a moving average, I hypothesize that much the same pertains to managers of industrial concerns (and throw in an inventory cycle for good measure).
In this case the measure of “animal spirits” would be
A = (IP – IPMEAN) / Sigma (IP)
where A is the “animal spirits” metric, IP is Industrial Production, IPMEAN is its exponential moving average over a the past several years (heavily front-end weighted compared to the unemployment model), and Sigma is its standard deviation over the same period.
The picture that emerges suggests we are just at the cusp of a new recession starting.
One of my back burner research projects is to customize a composite contraction measure using several salient macro variables.
“Animal spirits” matter most in the contraction, when discounting is taking place below an anchor level (we discount losses more than we value gains of same size, in “utility points”).
A simple logistic model using this new “animal spirits” metric and a recent percentage change in Industrial Production produces a quite credible contemporaneous indicator of being in an NBER recession, probability of being in recession now running at about 40 percent:
I will update this new model when new data becomes available. Here is the picture of Industrial Production and its adaptation level, showing that we’re entering the zone of loss discounting:
With one false positive in the period leading up to the 1990-1991 recession, if the exponential moving average used here is down over any six month period then the economy is in recession. It’s not a great leading indicator, but it’s 100 percent accurate coincidentally:
As the data here is up to October 2012, we should know by April if the economy is in recession. The adaptation level is 96.65 of Industrial Production. An April value falling below that will be confirmatory.