The Probability of Recession: A Critique of a New Forecasting Technique

Abstract

A recent research publication develops a new business cycle forecasting technique using a metric called “Mahalanobis distance.” This measure is intuitive, is based on a straightforward set of computations, is able to identify post-war US recessions with few false positives, and, as claimed by the authors, has a reasonable forward hit rate. In late 2019, according to this new measure, the estimated probability that the US was in a recession had climbed to about 75%, a prediction that was at odds with many other models. However, by early 2020 and still prior to the pandemic, the measure’s probability of recession had retreated, falling below 3%, and remaining subdued through March. The measure’s volatility prompted a closer technical look into its strengths and weaknesses and its potential as a market timing tool.