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Tracking national economy with leading indicators

We have reviewed a number of economic indicators over the past few months, each of which was linked to a specific sector of the economy: consumption, investment, and net exports.

Since governments tend to work on budgets approved by legislative bodies, there is less short-term movement in this category of spending and thus it is not given the same attention as the market-driven categories. This issue takes a look at an indicator (actually an index composed of 10 different indicators) that is thought to provide insight into the economy as a whole (GDP). This is the “index of leading economic indicators” or LEI.

Since it is quite possible that some of the individual indicators reviewed in this series would point in different directions at any given moment, no reasonable conclusions can be drawn from single indicators. If one indicator moves in such a dramatic fashion that it leads to only one conclusion, it is likely that whatever caused the change is so widely understood that forecasting is basically unnecessary.

Normally, however, we need some way to summarize the direction of change suggested by a variety of conflicting economic indicators. The modern search for such a summary statistic on the nature of business cycles can be dated to the 1930s with the work of Wesley C. Mitchell and Author F. Burns at the National Bureau of Economic Research (NBER). It was this group that first developed the concept of a single “leading” economic indicator which summarizes the movement of other indicators.

A Brief History of the Leading Economic Indicator

As interest in business cycle research continued to grow, the U.S. Department of Commerce’s Bureau of the Census began a collaborative effort with the NBER that led to the publishing of a monthly reported titled “Business Cycle Developments” (1961-1968). The report was renamed “Business Conditions Digest” (1968-1987) and the research program was transferred to the U. S. Commerce Department’s Bureau of Economic Analysis (www.bea.gov) in 1972. Today, the report is called “Economic Indicators” and is prepared monthly by the President’s Council of Economic Advisors for the Joint Economic Committee of Congress and can be accessed on the web through http://jec.senate.gov/index.cfm. The sheer volume of information contained in each issue of “Economic Indicators” clearly illustrates the need for summary statistics that reflect the future of the economy.

In 1995, the BEA privatized its business cycle research program and transferred its responsibility to the non-profit The Conference Board (www.conference-board.org). The Conference Board, which also publishes the Consumer Confidence Index, has continued to expand and refine the cyclical indicator approach to economic forecasting and releases a monthly report called the “Index of Leading Economic Indicators” (www.conference-board.org).

Leading, Lagging and Coincident Indicators

Building on the work of the NBER and the BEA, The Conference Board has continued to refine three basic cyclical indicators: leading, lagging and coincident indicators. Based on extensive research over the years, 10 individual series have been identified whose aggregate performance tends to “lead” that of the overall economy (GDP), four data series whose aggregate performance tend to parallel or is “coincident” with the economy and seven series whose aggregate performance tends to “lag” the economy. Each of these three cyclical indictors is constructed as a composite of the individual indicators with various weights assigned.

The various weights assigned to each “composite” index are noted in the monthly press releases issues by The Conference Board. The 10 indicators that are used in the index of leading economic indicators are listed in Chart 1.

Since each of these 10 individual data points must be available before they can be summarized into a composite indexes, one may ask just what additional information a composite index could provide? According to the Conference Board’s “Business Cycle Indicators Handbook,” “…composite indexes can reveal common turning point patterns in a set of economic data in a clearer and more convincing manner than the behavior of any individual component.” We shall see this “clearer picture” emerge in the next several charts. But before we examine the index of leading economic indicators, we must consider the issue of timing or how much “lead time” should there be between movements in a composite index of leading indicators and the subsequent changes in the national economy (GDP).

‘Lead Time’ and the Three Ds

The basic issue in indicator forecasting is to predict the future of the economy on the basis of movements in the leading economic indicator. As shown in Chart 2, changes in the LEI on a month-to-month basis shows considerable variability. Is a simple drop in the LEI on a month-to-month basis a signal of a recession? Individual monthly changes in the LEI are often not sufficient to accurately forecast impending recessions in the economy. While it is clear from Chart 2 that each recession is preceded by a drop in the Index of Leading Economic Indicators, it is also true that there were other declines that did NOT precede a recession (1966 and 1996 are major examples). Additional information is needed to allow a careful differentiation between monthly “noise” and a clear signal of an impending recession. The solution to this interpretation problem is to add three other criteria to the direction of change in the Index of Leading Economic Indicators. These criteria are collectively known as the “Three D’s”: depth, duration and diversity.

To accurately forecast a recession, the LEI should reflect something longer than a one- or two-month decline (duration). Research has shown that a six-month decline (duration) is most accurate while others consider a three-month decline sufficient in the LEI sufficient. In addition, a decline in one sector of the economy can simply be due to specific circumstances in that sector, thus the more widespread the decline (diversity) the more likely a recession will occur.

Finally, the depth of the decline should be such that small adjustments in one sector are not elevated to recessionary status in the forecast. According to the “Conference Board Handbook,” when the leading index declines for six consecutive months (duration) by at least 3 1/2% (depth) together with declines in more than half of the components (diversity), a reasonable expectation is that a recession is eminent. Thus, while indicator forecasting using the Index of Leading Economic Indicators appears to have substantial merit, it should be used with additional information to prevent false signals from being interpreted as recession signals.

Dr. William D. Gunther is professor of economics and director of the Bureau of Business and Economic Research in the College of Business at the University of Southern Mississippi. Contact him via e-mail at mbj@msbusiness.com.

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