Predicting economic recessions is a challenging yet essential task for businesses, policymakers, and investors. To address this need, the Enki Recession Index (ERI) was developed as a tool to signal impending economic trouble. The ERI, through a combination of three key economic indicators, provides a balanced and reliable gauge for identifying when a recession is approaching or when the economy is already under significant stress.
Over the course of our analysis, the ERI has demonstrated a strong track record in signaling recessions within a 0-12 month window, establishing it as a near-term predictive tool. With its current formula and weighting system, the ERI has successfully captured past recessions, including the economic downturn caused by COVID-19. We aim to refine the index further and release an updated version in September 2024, but the current iteration remains a reliable, historically accurate tool for recession forecasting.
2. The ERI Formula and Component Breakdown
The ERI is built upon three major economic indicators, each carefully weighted to capture different aspects of economic performance:
Yield Curve (40%): A well-known predictor of recessions, the yield curve measures the difference between short-term and long-term interest rates. When short-term rates exceed long-term rates (inversion), it is a strong signal of a recession.
Sahm Rule (25%): This rule indicates labor market stress when the unemployment rate rises sharply (0.50% or more) from its lowest point in the past year.
Purchasing Managers' Index (PMI) (35%): PMI reflects manufacturing sector activity. A PMI reading below 50 indicates contraction, while readings above 50 suggest expansion.
ERI Formula:
ERI = (0.40 Yield Curve Value) + (0.25 Sahm Rule Value) + (0.35 * PMI Value)
2.1 Yield Curve Value (YC)
The yield curve value is derived from the spread between short-term and long-term interest rates (e.g., the difference between 2-year and 10-year U.S. Treasury yields). It is calculated as follows:
1 if the yield curve is inverted (spread ≤ 0.01).
A dynamic value between 0 and 1 if the spread is between 0.01 and 0.10 (approaching inversion).
0 if the spread is greater than 0.10 (normal yield curve).
2.2 Sahm Rule Value
The Sahm Rule value indicates labor market stress and is triggered when unemployment rises by 0.50% or more over the previous 12 months:
1 if the Sahm Rule is triggered (unemployment has risen by 0.50% or more).
0 if the unemployment increase is less than 0.50%.
2.3 PMI Value
The PMI (Purchasing Managers' Index) measures business activity in the manufacturing sector. It is dynamically scaled based on the degree of contraction or expansion:
1 for a PMI below 43 (severe contraction).
A dynamic value between 0.7 and 1 for a PMI between 43 and 50 (moderate contraction).
0.7 for PMI between 50 and 55 (mild expansion).
0.5 for PMI above 55 (strong expansion).
This nuanced scaling of the PMI ensures that the index captures various degrees of economic activity.
3. Methodology and Analysis
3.1 Goal of the ERI
The initial goal of the ERI was to signal economic recessions within a 0-24 month window, giving businesses and policymakers enough lead time to prepare for potential downturns. However, through our historical analysis, we have found that the ERI consistently signaled recessions within a 0-12 month window. This makes it an effective near-term recession predictor.
3.2 Historical Performance
Accurate Signals
The ERI has successfully signaled all major recessions within the past several decades:
1981–1982 Recession: The ERI crossed the 0.68 threshold in April 1981, providing a 3-month warning before the recession began.
2001 Recession: The ERI hit the threshold in January 2001, signaling the recession 2 months in advance.
Great Recession (2007-2009): The ERI signaled recession risk in January 2007, providing an 11-month warning before the recession officially started.
COVID-19 Recession (2020)
The ERI also signaled significant economic trouble in 2020 as the pandemic took hold. The ERI’s high value during this period reflected the widespread economic contraction due to the pandemic, which resulted in a recession. This demonstrates that the ERI is sensitive to extraordinary economic conditions, reinforcing its utility in times of crisis.
3.3 False Positives
While the ERI has been highly accurate in signaling recessions, there were a few instances of false positives, notably in late 2020 and early 2021, where the index remained elevated due to the economic fallout from COVID-19, but the economy didn’t fall into a traditional recession following the initial shock. However, these signals still pointed to significant economic stress, which validates the ERI's sensitivity during critical periods.
3.4 Threshold and Time Recalibration
The 0.68 threshold has proven to be a strong benchmark. While the ERI initially aimed to predict recessions within 24 months, the real-world performance shows that it consistently signals recessions within a 0-12 month timeframe, making it a reliable short-term signal. This level of accuracy provides businesses and decision-makers with enough time to assess risk and take action.
4. Moving Forward: Refining the ERI
As of August 2024, the ERI continues to signal a high likelihood of recession, demonstrating its ongoing relevance. The current ERI formula is functioning well, but we plan to gather more data and refine the formula for a new release in September 2024.
The upcoming refinements will focus on smoothing out responses to temporary economic disruptions and incorporating feedback from our analysis to reduce occasional false positives. However, we are confident that the current ERI is a valuable tool for predicting economic downturns and providing early warnings.
5. Conclusion
The Enki Recession Index (ERI), with its weighting system and dynamic scaling of economic indicators, has proven to be a reliable and historically accurate tool for recession prediction.
The ERI consistently signals recessions within 0-12 months, offering a near-term forecast that helps businesses and policymakers navigate economic uncertainty.
While we continue to refine the index, the current ERI formula has demonstrated its efficacy across major recessions, including the COVID-19 recession and the Great Recession. With more data and ongoing analysis, the ERI will continue to be an important tool for assessing recession risk and providing early signals of economic trouble.
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