Macroeconomic Indicators: Leading, Coincident, and Lagging
Yes; and that's how they work.
Suppose you read on the front page of _The Wall Street Journal_ that payrolls expanded by 420,000 in the past month. This is presumably good news for the people who got new jobs. Other than being happy for them, though, why should investors care about this news item?
No, actually, there's a good reason for investors to take an interest in this news.
Not really; payroll data is a fairly important news item for the typical reader of _The Wall Street Journal_.
Exactly.
An expansion of US payrolls by 420,000 in a month represents quite strong employment growth, and is a signal of a strengthening economy. Payrolls are one of many __economic indicators__, variables that are correlated with the broader movements of the macroeconomy, such that by observing them, investors can get a clearer idea of the state the macroeconomy is in, and where is likely to be headed in the near future.
Economic indicators can be classified into three categories: __leading__, __coincident__, and __lagging__. A leading indicator tends to move up or down in advance of similar movements of the economy as a whole. A downturn in a leading indicator forecasts an economic slowdown. For example, if the spread between the 10-year US Treasury and the federal funds rate narrows, an economic downturn could potentially occur.
Not exactly. A coincident indicator moves at the same time as the macroeconomy.
Yes!
A coincident indicator moves at the same time as the macroeconomy, so an upturn in a coincident indicator suggests that the economy is currently turning a corner. While it may seem that coincident indicators just tell investors what they already know, in fact, it does not automatically become obvious that a recession or a recovery has begun. Coincident indicators include rising (or falling) payrolls, incomes, industrial production, and sales.
Not exactly. A coincident indicator moves at the same time as the macroeconomy.
A coincident indicator tends to move at the same time as the macroeconomy as a whole. If, when the economy has been in recession, investors observe an upturn in a coincident indicator, what does that tell them about the macroeconomy?
In summary:
[[summary]]
Finally, there are lagging indicators, which tend to move up and down _after_ the macroeconomy as a whole does.
Does the indicator always follow the economy in this representation?
Not always.
Finally, consider the __diffusion index__. To construct a diffusion index, you assign a value of 1.0 to what rose, a value of 0.5 for what is changed by less than 0.05%, and a value of 0.0 for what fell. Then average these and multiply it by 100. Suppose changes in the Conference Board's leading indicators from April to May are as shown below:
| Indicator | Change from April to May | Contribution to index |
|---|---|---|
| Average weekly hours, manufacturing | +2.23% | 1.0 |
| Average weekly initial claims for unemployment insurance | +1.68% | 1.0 |
| Vendor performance index | +0.01% | 0.5 |
| Non-defense capital goods | +5.49% | 1.0 |
| Building permits for new units | +3.32% | 1.0 |
| S&P 500 | -1.46% | 0.0 |
| Index of Consumer Expectations | -1.14% | 0.0 |
Since four indicators went up, two went down, and one stayed almost the same, the value of the index turns out to be:
$$\displaystyle \text{Diffusion Index} = \frac{1.0 + 1.0 + 0.5 + 1.0 + 1.0 + 0 + 0}{7} \times 100 = 64.29 $$.
An index of industrial production measures current economic activity in manufacturing, making it a coincident indicator. But what makes manufacturing particularly useful as a way to track the business cycle?
Incorrect.
In developed economies, manufacturing is smaller than services as a share of GDP.
Incorrect.
Manufacturing is more volatile than services.
Exactly.
Partly because most manufactured goods are storable, demand for new manufactured goods is comparatively volatile. Consequently, the ups and downs of manufacturing are easier to recognize. That's also why manufacturing and trade sales is an important economic indicator.
Rising real personal income, rising employment, and rising industrial production are crucial, defining features of a strengthening economy. Conversely, falling real personal income, falling employment, and falling industrial production are crucial, defining features of a weakening economy. In contrast with leading indicators, which suggest probable movements in the macroeconomy, these coincident indicators provide strong evidence that recovery has arrived.
Lagging indicator _usually_ follows the movements of GDP, but not always. Examples of lagging indicators include:
* Average duration of unemployment
* Inventory-sales ratio
* Change in unit labor costs
* Average bank prime lending rate
* Commercial and industrial loans outstanding
* Ratio of consumer installment debt to income
* Change in consumer price index for services
Why do you think changes in unit labor costs and changes in the consumer price index (CPI) are lagging indicators?
Yes.
During a recession, bosses are reluctant to reduce employee morale by cutting nominal wages. They prefer to lay off some workers, then cancel raises, and let unit labor costs fall through deflation and rising productivity.
Also, wages are often fixed by long-term contracts or institutional rules, so unit labor costs don't fall right away in a recession. Similarly, in a recovery, some time passes before competition among employers starts driving up wages fast enough to outpace productivity growth and raise unit labor costs.
Prices too are famously "sticky" and take time to adjust to new macroeconomic conditions.
Incorrect. Payrolls and sales are coincident economic indicators.
Incorrect. That might be a good explanation of why unit labor costs lag the business cycle, but it doesn't work for consumer prices. If recoveries put consumers in a stronger negotiating position, prices would _fall_. Instead, they rise.
They shouldn't; it doesn't affect them
Because it must have been a slow news day, and no news is good news
Because robust payroll expansion is evidence of a strengthening economy
The recession will probably soon end
The recession is probably just now ending
The recession has already ended, and a recovery is underway
Yes
No
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Manufacturing is the largest sector in the economy
Manufacturing is less volatile than services, so the data are less noisy
Manufacturing is more volatile than services, so its ups and downs are easier to discern
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Because wages and prices are "sticky" in the short run
Because it takes time for recessions and recoveries to affect hiring and consumer demand
Because a recovery gradually puts workers and consumers in a better negotiating position with firms
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