Economics: Index of Leading Economic Indicators

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You want to know where interest rates are headed. You're concerned about whether now is a good time to start a business. Perhaps you're wondering what the economy is going to be like when you graduate from college. Well, short of a crystal ball, your best source for information about where the economy is headed is published by the Conference Board. The Conference Board is a nonprofit group of research and business enthusiasts who collect information and make it available to financial markets, people running businesses, the government, and others who are interested in knowing where the economy is headed.
The most famous indicator published by the Conference Board is the index of leading economic indicators. This index is a single number that averages together information from all corners of the economy to point us to whether the economy is likely to continue to boom, or perhaps to slip into a recession. It's a weighted average of information about expectations and behavior across the economy. And it functions sort of as an early warning; that is, when a storm is coming, often you'll notice that animals are anxious or nervous, and they're behavior gives you a signal about what the weather is going to be like in a couple of hours. In the same way, the index of leading economic indicators tells you where the economy is likely to be headed six to nine months from now. The difference between the weather and the economy is that the economy is actually made up by the decisions and choices of the people who are part of it. So to find out where the economy is headed, the Conference Board tries to figure out what people are thinking and doing right now that's likely to influence what the economy will be doing in terms of employment, output, interest rates, and prices six months from now.
So let's look then at where in the economy we're most likely to get reliable data about what's coming up in the months ahead - that is, which kinds of behaviors and actions and expectations are most likely to have predictive power. The index of leading economic indicators averages together information from manufacturers, from employers, from financial markets, from consumers in the construction industry - and there are ten components that are averaged together to wind up with the final number that's actually published. This number, by the way, is published every month. Here is a list, then, of the ten factors that make up the index of leading economic indicators.
The first is the average weekly hour's work in manufacturing. When that number is increasing, it could be because labor demand is especially strong, and factories are working their workers longer hours to meet increased demand. When that number is bigger, it's likely that the economy will continue to expand.
The second thing is the average weekly initial claims for unemployment insurance. When that number is rising, it could be because people have lost their jobs, or having trouble finding another one, and that could be a signal that a recession is coming.
The third component is manufacturers' new orders for consumer goods and materials. Whenever businesses feel like they can sell more goods and services, they're going to be ordering them to put them on the shelves, or put them in inventory. Whenever those orders slow down, that could be a signal that a recession is coming.
The fourth component is vendor performance - how long does it actually take for you to get delivery of these goods that you've ordered? Whenever it takes longer, that's usually because there's very strong demand, and businesses are having trouble keeping things in stock. That's usually a good sign for continued growth of the economy.
The fifth component is manufacturers' new orders for capital goods - are factories installing new tools, new equipment? If they are, it's because they're planning to increase production, and that usually presages continued expansion of the economy.
The sixth component is new building permits - are companies building new office space, new factories? If they are, that's a sign that the expansion will continue.
The seventh component is the stock prices - that is, what's happening in financial markets right now? Is the prospect of companies strong in the minds of investors? If so, they're going to be bidding up stock prices.
The eighth component is the money supply itself. Is the Federal Reserve increasing the money supply, making credit easier to get so that businesses can borrow and expand their operations? Or is the money supply getting tight, perhaps signaling that interest rates are going to go up, and slowing down the expansion of business activity?
The ninth component is the interest rate spread between long-term securities and short-term securities. When short-term securities have higher interest rates, it's usually because the Fed is tightening short-term credit, and that usually will lead to credit crunches and a slow-down in the economy down the road.
The final, the tenth component of the index, is the index of consumer expectations - that is, a survey among consumers about what they think the prospects are for jobs, higher wages, and a good standard of living a few months from now. When consumers are confident, it usually means that the economy is headed towards more output, more jobs, and growth.
So what happens, then, when we take these numbers, average them together, and get that index? Well, the index typically will peak and turn downwards about six to nine months before employment and output in the economy peak and turn downwards. That is, the index is a predictor of when the recession is coming. The last time that the index showed a protracted downturn was in 1990. By December of 1990, the index of leading economic indicators had shown five consecutive months of decline. And sure enough, the following year a recession hit the economy hard. Now the economy has been booming throughout the 1990s; but here, in February of the year 2000, the index of leading economic indicators has shown the first downturn in many, many months.
So the question is, does this mean that we're about to head into a recession? Is the longest boom in U.S. economic history about to end? Or is this just one month's aberration? You know the answer because you're in the future. But sitting here, we can only wonder as to whether these economic indicators are still going to have the predictive power they've always had, meaning that bad news may be ahead for our economy, or whether they're just off one month. No crystal ball is perfect, but the index of leading economic indicators has a venerable record, and is relied upon by people in finance, government, and economic planning to give an insight into what's ahead.
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Cost of Living
Case Study: The Index of Leading Economic Indicators Page [2 of 2]