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IFT Notes for Level I CFA® Program

R15 Understanding Business Cycles

Part 5


 

5.  Economic Indicators

  • We use economic indicators to assess the state of the overall economy and for providing insights into future economic activity.
  • Economists use these indicators to forecast the prospects of an economy, and classify them based on whether they lag, lead, or coincide with changes in an economy’s growth.
  • Leading indicators have turning points that tend to precede those of the business cycle. They help in forecasting the economy in the near term.
    • Ex: Weekly hours in manufacturing, S&P 500 return, private building permits.
  • Coincident indicators have turning points that tend to coincide with those of the business cycle and are used to indicate the current phase of the business cycle.
    • Ex: Manufacturing activity, personal income, number of non-agricultural employees.
  • Lagging indicators have turning points that tend to occur after those of the business cycle.
    • Ex: Bank prime lending rate, inventory-to-sales ratio, average duration of unemployment.
  • These indicators vary from one economy to the other.

Leading Indicators

Following are a few leading indicators (this is reproduced from exhibit 7 in the curriculum):

  1. Average weekly hours, manufacturing: Firms cut on overtime before a downturn and increase the overtime before hiring full-time workers during a recovery.
  2. Average weekly initial claims for unemployment insurance.
  3. Manufacturers’ new orders for consumer goods and materials.
  4. Vendor performance, slower deliveries diffusion index.
  5. Manufacturers’ new orders for non-defense capital goods.
  6. Building permits for new private housing units.
  7. S&P 500 stock index.
  8. Money supply, real M2: A reduction in money supply will have a contractionary effect.
  9. Interest rate spread between 10-year Treasury yields and overnight borrowing rates: Spread is the difference between long-term yields and short-term yields. If the curve is upward sloping (a wider spread), then we expect short-term rates in the future to be high and more economic growth.
  10. Index of consumer expectations, University of Michigan
  • A composite index of indicators is an index consisting of a certain number of economic indicators. In the U.S., the composite leading indicator is called the Index of Leading Economic Indicators (LEI); it contains ten indicators that include capital goods to changes in the money supply.
  • Different countries will have different composite indices. These indicators are based on empirical observations of an economy.
  • The reason why economists have so many indicators in an index is because some are good indicators of economic expansion but poor indicators of recession.
  • Diffusion Index reflects the proportion of the index’s components that are moving in a pattern consistent with the overall index. This is particularly useful to analyze the breadth of change in the index. In simple words, it shows the common trends based on how the indicators move. For instance, if seven indicators move upward while three move downward, analysts can judge the overall pattern in the economy.

Coincident and Lagging Indicators

Coincident Indicators

  1. Employees on non-agricultural payrolls.
  2. Aggregate real personal income.
  3. Industrial production index.
  4. Manufacturing and trade sales.

Lagging Indicators

  1. Average duration of unemployment.
  2. Inventory-sales ratio: Initially, when there is a decline in demand, sales decline and inventory accumulates as production does not stop immediately. Firms use the existing inventory as sales pick up before starting new production. This ratio lags the cycle. The ratio peaks after the business cycle reaches its peak. Similarly, it hits the lowest point after the business cycle has reached the trough and is in recovery mode.
  3. Change in unit labor costs: At the beginning of a downturn, firms only cut overtime but do not fire workers. Utilization is low and there are idling workers. Costs are higher during early stages of a recession. So, it lags the cycle.
  4. Average bank prime lending rate.
  5. Commercial and industrial loans outstanding: Loans are used to build inventory. So, it is a lagging indicator for the same reason as inventory-sales ratio.
  6. Ratio of consumer installment debt to income.
  7. Change in consumer price index for services.

Coincident and lagging indicators can help confirm what the leading indicators are telling us.

 


Economics Understanding Business Cycles Part 5