Forecasting Business Trends, Part One: Leading Indicators

 

Many techniques have been developed for predicting changes in economic activity. We have found the analysis of selected statistical series to be useful in forecasting reversals in business cycles just prior to or shortly after their occurrence and in forecasting continuations of trends.

 

The method behind using statistical indicators is to find economic series that consistently lead, coincide, or lag turns in business activity. The leading indicators can be used to forecast turning points in the cycle. The coincident indicators define the turning points; the lagging indicators confirm cyclical turns in business activity.

 

A change in the trend of business activity is more difficult to forecast than a continuation of trends. The economy is always changing, and the past is not a sure guide to the future. Moreover, the statistical indicators would provide little or no warning of a sudden economic collapse precipitated by, say, a natural catastrophe or financial shock. Nor does the statistical indicator approach provide a basis for forecasting magnitudes of changes in any aspect of economic activity.

 

To qualify as a useful indicator, a statistical series must have economic relevance, and its data must be collected and processed in a statistically acceptable way. The data should be fresh and not subject to frequent revision. The series must move reliably with general business activity and exhibit a consistent pattern over time as a leading, coincident, or lagging indicator.

 

We have chosen 24 series—12 leading, 6 roughly coincident, and 6 lagging indicators. Most reflect activity in the goods-producing sector. Goods-producing industries are more cyclically sensitive than service-producing industries and are more apt to signal turning points in the business cycle.

 

In this posting, we describe AIER’s leading indicators. Although the leading indicators are useful for forecasting turns, advance warning may be short. As the late Geoffrey H. Moore, renowned business-cycle economist, said, “The leaders often tell you where you’re going only about the time you get there.”

 

Leading Indicators (All dollar-denominated series are adjusted for price inflation.)

 

M1 money supply. An estimate of money balances (primarily currency and demand deposits). When M1 does not keep pace with inflation, bank lending may contract, and hence economic activity.

 

Yield Curve Index. The cumulative total of the monthly spread between the 10-year Treasury note and the effective federal funds rate. When the yield on the 10-year note is lower than the effective federal funds rate, the index will turn downward (i.e., the yield curve inverts), a signal that interest rates and the economy are headed even lower in the future.

 

Index of manufacturers’ supply prices.  The percentage of purchasing agents who report paying higher prices in the current month compared with the preceding month. A higher index indicates stronger demand for business inputs relative to their supply.

 

New orders for consumer goods and materials. All new orders for goods and materials used primarily by consumers (less food and energy). The placing of such orders tends to precede production of consumer goods.

 

New orders for core capital goods. The value of new orders received by manufacturers of nondefense and non-aircraft capital goods. The placing of such orders tends to lead machinery production and production of the goods that machinery later produces.

 

New housing permits.  Tends to lead construction expenditures.