Opinion - Why the Federal Reserve risks falling behind the curve as recession fears rise

Yahoo

10-05-2025

The disconnect between hard data (which capture measurable performance of the economy and are backward-looking) and soft data (which are typically based on sentiment and expectations and are often forward-looking) is creating challenges and generating data confusion among market participants and Federal Reserve officials.
Even as households and firms turn increasingly pessimistic, the economic slowdown they fear hasn't yet fully materialized in the hard data. Gloomy sentiments do not always translate into actual spending or investment pullbacks.
Advance estimate for the first quarter did show a contraction in the real GDP growth rate. However, the initial GDP growth rate estimate was significantly distorted by front-loading as importers raced to bring in foreign goods before Trump tariffs could fully take effect. As inventory adjustments take place in the second quarter, some of the first quarter distortions will dissipate.
Yet, concerns remain as to whether bringing forward auto and other consumer goods purchases will leave American households and businesses with a hangover in the second quarter that may tilt the economy towards a recession.
As the Trump administration's haphazard implementation of a poorly designed tariff structure unsettles financial markets and generates a spike in economic policy uncertainty indices, survey data suggests that American households are starting to fret about an economic slowdown and a revival of inflationary pressures. There has clearly been a sharp deterioration in the soft data and the hard data may soon start to catch up. Many wonder if we are inexorably heading towards a recession.
In the U.S., the Business Cycle Dating Committee at the National Bureau of Economic Research officially designates the start and end dates of recessions and expansions. Unlike the oft-repeated media description of a recession as constituting two or more consecutive quarters of negative GDP growth, the bureau defines a recession as 'a significant decline in economic activity that is spread across the economy and that lasts more than a few months.'
When determining cyclical turning points, the Business Cycle Dating Committee considers a broad set of measures, which include quarterly data (such as GDP and gross domestic income) as well as monthly data (such as real personal income less transfers, nonfarm payroll employment, real personal consumption expenditures and industrial production).
The advantage of the definition of 'recession' cited above is that it is unlikely to be affected by data quirks associated with preliminary GDP estimates that may ultimately get resolved in future revisions. For instance, the initially reported two consecutive quarters of negative GDP growth in the first half of 2022 was changed to just one quarter of negative print following data revisions.
However, pronouncements of recession start dates can occur well after the downturn is underway — the determination that the Great Recession actually began in December 2007 was made in December 2008.
In contrast, market participants and policymakers seek early indication of potential business cycle turning points. In fact, the holy grail of macroeconomic forecasting is to identify one or more recession indicators that will prove to be infallible and be able to offer a surefire signal of an impending economic downturn. Lamentably, in the post-pandemic era, prognosticators have been frequently confounded as many historically dependable indicators failed to deliver.
Inverted yield curve, for instance, has a good historical track record of predicting U.S. recessions. Typically, the yield curve slopes upward since investors need to be compensated for taking on the risk of lending over a longer duration. However, prior to an impending downturn, yield curve inverts as investors come to believe that the monetary policy stance is too restrictive and thus likely to trigger an economic slowdown (which will ultimately force the Fed to cut policy rates).
Despite its historical efficacy, yield curve inversions in the post-pandemic era have so far failed to correctly forecast a downturn. The yield spread between the 10-year T-note and the 3-month Treasury bill yield was negative between October 2022 and December 2024 (also, the yield differential between the 2-year and 10-year Treasury notes remained inverted for 25 months between July 2022 and August 2024). The yield curve usually does un-invert a few months prior to a recession. So, this indicator may still deliver, albeit belatedly.
The so-called Sahm rule represents a statistical regularity — a recession is typically underway when the 3-month moving average of the unemployment rate rises by 0.5 percent or more above its low over the prior 12 months — that was first highlighted by former Fed economist Claudia Sahm. This indicator has also failed to deliver in recent months — the Sahm rule was triggered following the release of labor market data for July 2024 and yet the U.S. economy has remained resilient so far (4.2 percent unemployment rate in April 2025 was at the same level as in July 2024).
Despite solid headline data, revisions to nonfarm payroll numbers, easing wage pressures, and a hiring pause suggest a cooling labor market. With traditional recession indicators misfiring, some suggest that online prediction markets like Polymarket or Kalshi may offer a more accurate pulse. Additionally, as Trump's trade war may generate supply-side bottlenecks, cargo traffic at major ports can help identify future economic vulnerabilities.
Facing stagflation risk, and handicapped by data confusion and fallible recession indicators, the Fed has taken a wait-and-see approach and is willing to risk falling 'behind the curve.' Given the inherent lags associated with monetary policy, the danger is that delays in Fed action may turn out to be costly.
Vivekanand Jayakumar, Ph.D., is an associate professor of economics at the University of Tampa.
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