1
Chapter 6
Table of Contents
INDICATORS & BAROMETRIC FORECASTING .............................................................. 2
A. SUMMARY OF THE MACROECONOMIC INDICATORS ............................................................. 2
1. OUTPUT: THE NATIONAL AND INTERNATIONAL ACCOUNTS ........................................... 2
EXAMPLE: Using Excel ...................................................................................................................... 5
A.
Deficits on International Accounts ................................................................................................. 7
B. Federal Deficit .................................................................................................................................. 9
2. PRICES AND PRICE INDICES ........................................................................................................... 9
(a)
THE PRICE OF GOODS AND SERVICES. ........................................................................... 10
(b) WAGE RATES. ........................................................................................................................ 11
(c) INTEREST RATES. 11
(d) EXCHANGE RATES. .................................................................................................................. 11
3. MEASURES OF DISEQUILIBRIUM ................................................................................................ 12
(a)
UNEMPLOYMENT, EMPLOYMENT, AND THE LABOR FORCE. ................................... 13
(b)
ORDERS. ....................................................................................................................................... 13
(c) INVENTORIES. ......................................................................................................................... 13
(d) CAPACITY UTILIZATION. . ..................................................................................................... 14
B. Barometric Forecasting....................................................................................................................... 14
1. Index of Leading Indicators ............................................................................................................. 14
2. Coincident Indicators ...................................................................................................................... 16
3. Lagging Indicators .......................................................................................................................... 17
C. Direction of Change in Indicators ....................................................................................................... 17
(1) Inventories and Order Back Logs. ................................................................................................. 17
(2) Prices, Wages, and Interest Rates. ................................................................................................. 18
(3) Employment, Unemployment, Duration of unemployment and Hours Worked. ........................... 18
(4) Income. ........................................................................................................................................ 18
(5) Expectations. . .............................................................................................................................. 19
D. Levels and Changes of an Indicator .................................................................................................... 19
E. Patterns of Indicator Change ............................................................................................................... 19
Chapter 6
2
INDICATORS & BAROMETRIC FORECASTING
Organizations need early warning of changes in the economy. By examining how business
performance has changed in the past, they can find the macroeconomic indicators that provide the
best warning of what will happen in the future. The techniques for using macroeconomic indicators
vary in complexity and accuracy. A technique can be as simple as selecting one indicator that is
closely tied to a firm and watching its performance as a close approximation to what will happen to
the firm; such a technique is called barometric forecasting.
But what macroeconomic indicators are the best? In the first section a review of the
different kinds of indicators is provided so that you can choose what might be most appropriate for
your organization. Then barometric forecasting is presented.
A. SUMMARY OF THE MACROECONOMIC INDICATORS
Most macroeconomic indicators that we use today were systematically collected only after
the depression of 1929. The suddenness and destructiveness of that event forced people to ask
whether or not it might be possible to get warnings of economic catastrophes. When looking back
to the period of time prior to the depression, they found some data that suggested there were signs of
imminent collapse. Particularly there was ample data on stock market and agricultural prices which
suggested volatility and depressed prices. There was anecdotal information on extensive inventories
of goods that could not be sold and extensive visual evidence of unused capacity. But what was
lacking were good measures of output and unemployment which measured the depth of social ills
that resulted from the depression.
1. OUTPUT: THE NATIONAL AND INTERNATIONAL ACCOUNTS
Most importantly a measure was needed of the ability of the economy to churn out new
production. Such an indicator would measure the flow of output over a given time period. But
there were many ways of conceiving of such a flow of product.
There was output which was the amount of goods or services that people actually produced.
But there were so many different kinds of output that it was hard to find a way to aggregate the
output into a single measure. Today the Federal Reserve Board publishes measures of output of
different kinds of goods and services.
Then there was the notion of expenditure. This was the concept of how much buyers
bought over a given time period. This concept had the advantage of being measured in terms of the
money spent on the goods and services and could be aggregated easily into a single figure.
However, being measured in dollars, this aggregate expenditure would be distorted by inflation, or,
as in the depression, by deflation. Expenditure data is collected in the National Accounts by the
Bureau of Economic Analysis of the Commerce Department (www.bea.gov). Here is a break
down of expenditures by the major four groups who buy output:
3
Chapter 6
2001
10,208.10
7,064.50
1,633.90
1,692.40
1,246.00
330.3
915.8
446.3
-58.4
-329.8
1,050.40
1,380.10
Gross domestic product
1. Personal consumption expenditures
2. Gross private domestic investment
Fixed investment
Nonresidential
Structures
Equipment and software
Residential
Change in private inventories
3. Net exports of goods and services
Exports
Imports
4. Government consumption expenditures and gross investment
Federal
State and local
1,839.50
615.7
1,223.80
There are four basic types of organizations that account for expenditures; households with personal
consumption (C), government with government expenditures (G), businesses with gross
investment (I), and foreigners with Net exports ( which equals Exports (Ex) minus Imports
(Im)). When these expenditures are added together they equal the Gross Domestic Product.
On the other hand, instead of measuring what people spend, the government could measure
what people earned for their work. This concept also had the advantage of being measured in
dollars so that it could be aggregated easily. In the National Accounts, the Bureau of Economic
Analysis also collects this information. Following are the major groups of income earners as
categorized by the Bureau of Economic Analysis:
National income
Compensation of employees
2001
8,217.50
6,010.00
Proprietors' income with inventory valuation and capital
consumption adjustments
743.5
Rental income of persons with capital consumption adjustment
142.6
Corporate profits with inventory valuation and capital
consumption adjustments
Net interest
767.1
554.3
The national income consists of five major groups of income earners: wage earners, proprietors,
owners of property, corporations, and owners of debt (such as bonds). Each of these groups wears
out capital in the process of earning their income and therefore adjustments to capital must be made.
Chapter 6
4
Much of the complexity of this table simply involves the problems of accounting for depreciation of
capital.
Between these two tables, national income and the gross domestic product do not appear to
be that far apart. In fact they are very closely related to each other, and the Bureau of Economic
Analysis makes use of their similarity to check their work. It works very much like the principle of
double entry book keeping used by accountants and it works because of a fundamental identity:
EXPENDITURES = INCOME= the value of OUTPUT
In other words, it was possible to measure output of the economy by the amount buyers paid for it,
the amount that sellers received, or the value of the physical goods or services that were produced.
The differences in the measures reflect differences in the organizations that spend, earn, and
produce.
The most widely used measure of all three is the Gross Domestic Product (GDP). It is
measure of finished goods and services (in other words, the goods and services that will become
extinct after they are purchased by the buyers who are called the final purchasers). Because foreign
owned firms produce goods and services in the United States and American firms produce abroad, it
is sometimes useful to define another concept, the Gross National Product (GNP), which reflects
expenditure by domestically owned operations, whether their income comes from home or abroad,
and to exclude the production of foreign owned companies. Other concepts of income, output and
expenditure will be examined later when we examine government accounting in more detail.
Because capital is used up in the production of new goods and services, the best measure of
output of the economy can be found by subtracting depreciation from the GDP to get the Net
Domestic Product (NDP) (or similarly to subtract depreciation from GNP to get the Net National
Product (NNP)) Because the estimates of depreciation are so uncertain and arbitrary this
theoretically useful concept of production is not very practical and is not often used. Nevertheless
the NDP is probably the best measure of the ability of the economy to produce new goods and
services. This is a particularly useful notion when examining the capability of a country to
undertake a war.
Now, it is possible to find the national income. To find what people actually earn, we only
have to worry about adjusting the effects of indirect taxes (like sales taxes) and subsidies which
substantially alter how much people effectively earn. With these adjustments, National Income
(NI) can be found.
There is a big difference between the income paid by institutions (NI) and the income
earned by households, called Personal Income (PI). To find what households earn it is necessary
to adjust for all government and business withholding and transfers. For example businesses may
retain their profits rather than disbursing them, so households don’t get to spend that money.
Similarly they may not get to spend the interest earned by business or government. Households
may contribute money to various social insurance plans which means they don’t see that money
during the present period of time. On the other hand, they may receive dividends and transfer
payments from businesses and similar transfers from government and these must be added in to give
the best measure of what households receive.
Chapter 6
5
While PI is an often used measure of what income buyers have for the purposes of spending,
it is not necessarily the best. It is still necessary to take out income taxes. When that is taken out,
what is left is called Disposable Income (DI) which measures the actual income that people can
dispose of as they want.
The fact that people can dispose of their income, does not mean that they do so. They may
save some of their income. When Saving (S) is subtracted from DI, what is left is Personal
Consumption Expenditure (C). Notice that we are back to the expenditure concept once saving
and all of the institutional transfers of government, business and the foreign sector have been
eliminated. Consumption is really the core driver of expenditure and income.
The different national accounting measures of the economy are often reported as percentage
changes over previous periods. In other words, the focus is on the change in the measures, not the
one period levels of them. In fact, economists define recessions as sustained two quarter negative
changes in the GDP. Similarly the growth rate of the economy is measured in terms of the
percentage changes in the GDP. Furthermore, when the data on percentage changes is examined,
the trend of the growth rate is considered most important for determining the business cycle of the
economy. If the percentage changes in the GDP are getting larger each quarter the economy is
considered to be in a booming phase of the business cycle. As the percentage changes in the growth
rate decline, the economy is said to be “slowing down.” Here we are talking about the “change of
the change” of the GDP level.
EXAMPLE: Using Excel, it is easy to transform information from the levels in
which variables are reported, to changes, changes of changes, and percentage
changes in levels. Let’s look at the real GDP from 1998 to 2010 in column (b)
below.
To find the change in the GDP, find the difference between the current GDP and the GDP from the
previous year. Notice how there is a loss of information at the top of the column (C3 is blank).
That reflects the fact that there is no data for 1997 with which to compute the change. If the
changes in column C are negative there is very likely to be a recession in the current year (but we
would need quarterly data to be absolutely sure).
To find if the changes are accelerating or not we would look at the change in the change of
the GDP which is computed in column D above. Now there are two years left blank because data
from 1996 as well as 1997 would be needed to compute the entries. As long as the change of the
change is positive there is an acceleration of the series through time, but if it is negative there is a
deceleration through time. The change of the change is a very good leading indicator. Notice how
it turns negative in 2005 and becomes more negative until the recession finally becomes clear in
2008. Even though we lose two years of information in computing it, the appearance of
deceleration often provides a warning of severe changes to come.
6
Chapter 6
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
A
Year
B
GDP
C
Change
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
10283.5
10779.8
11226
11347.2
11553
11840.7
12263.8
12638.4
12976.2
13228.9
13228.8
12880.6
13248.2
=B4-B3
=B5-B4
=B6-B5
=B7-B6
=B8-B7
=B9-B8
=B10-B9
=B11-B10
=B12-B11
=B13-B12
=B14-B13
=B15-B14
A
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
B
Year
GDP in
billions of
chained
2000
dollars
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
10283.5
10779.8
11226
11347.2
11553
11840.7
12263.8
12638.4
12976.2
13228.9
13228.8
12880.6
13248.2
D
Change of
the Change
E
Percentage
Change
=C5-C4
=C6-C5
=C7-C6
=C8-C7
=C9-C8
=C10-C9
=C11-C10
=C12-C11
=C13-C12
=C14-C13
=C15-C14
=C4/B3
=C5/B4
=C6/B5
=C7/B6
=C8/B7
=C9/B8
=C10/B9
=C11/B10
=C12/B11
=C13/B12
=C14/B13
=C15/B14
C
D
Change
E
Change of
the Change
496.3
446.2
121.2
205.8
287.7
423.1
374.6
337.8
252.7
-0.1
-348.2
367.6
Percentage
Change
-50.1
-325.0
84.6
81.9
135.4
-48.5
-36.8
-85.1
-252.8
-348.1
715.8
0.048262
0.041392
0.010796
0.018137
0.024903
0.035733
0.030545
0.026728
0.019474
-7.6E-06
-0.02632
0.028539
Because the GDP trends through time percentage changes are used to make
7
Chapter 6
comparisons of changes from one year to the next. To make changes comparable from one
year to the next, it is useful to divide the changes by the base of the PREVIOUS year as
done in column E above. The results of these calculations are shown immediately above.
The business cycle reflects the wave pattern that appears when the measures of income,
output, and expenditures are graphed through time. While this wave pattern does not have a fixed
length of time, it seems to occur within five to twenty year periods. Some analysts also see much
longer or shorter wave patterns, but economists generally focus on the wave patterns that are
defined by recessions. We can see the wave pattern very clearly when examining the annual
percentage changes of income as in the following figure.
Percentage Change
0.4
0.3
Line 1
GDP
Auto Sales
0.2
0.1
0
75
85
95
-0.1
-0.2
-0.3
The wave pattern defined by aggregate incomes and expenditures tend to translate to every sector of
the economy, as is apparent in the percentage changes in auto sales shown in the above figure.
A.
Deficits on International Accounts
The National Income Product Accounts (NIPA) can be used to compute the basic deficit
measures of the economy. The most important of these deficits occurs on what is called “the
current account” which measures international transactions on goods and services which havbe
Chapter 6
8
been recently produced and are used in calculating the GDP. The deficit on this account is called
the trade deficit which is the following difference between imports and exports:
Trade Deficit= Exports – Imports
The exports are paid for by foreign currencies which are used to pay for U.S. dollars which can be
bought in foreign exchange markets. As the flow of money comes to the United States the flow of
goods and services, that are exported, leave the country as shown in the following diagram:
B
A
Currrent account = trade balance= net exports
L
Real goods and services - imports
A
Money
N
Home
Abroad
C
E
Real goods and services - exports
CAPITAL ACCOUNT
O
Titles to foreign wealth sold to Americans
F
Money
Home
Abroad
P
A
Titles to American wealth sold to foreigners
Y
Unilateral transfers
M
E
Home
Abroad
N
T
Money
S
By contrast, the imports are paid for by dollars which are used to pay for foreign currencies which
can be bought in foreign exchange markets. As the flow of money goes toward foreign countries
the flow of goods and services, that are imported, leave the country as shown in the above diagram.
When Imports exceed Exports, the trade deficit is negative. When the trade deficit is negative the
United States is receiving goods and is simply shipping money out of the country.
But this money doesn’t just pile up abroad. It comes back through foreign exchange
markets when foreigners pay for assets in dollars from the U.S. The above diagram shows that
payments for assets occur in the “Capital Account”. These transactions are for existing assets such
as bonds, stocks, gold, real estate- things that are not included in the NIPA accounts; the NIPA
account only includes goods and services newly produced during a give year, not titles to assets.
Also in the capital account are the purchases of foreign assets by Americans which involves the
purchase of foreign currencies in the foreign exchange market in order to purchase the assets
abroad. The balance on the capital account offsets the trade balance, and unilateral transfers must
make up any difference between the two. Unilateral transfers do not involve an exchange of goods
9
Chapter 6
for money but only represent a flow of money which occurs when individuals send gifts abroad or
the government sends foreign aid abroad.
So, when the U.S. runs a trade deficit, it must finance that deficit by selling off its assetsreal estate, ownership to companies, debt instruments like bonds, and anything else of value. The
problem is that selling such assets can mean there are future burdens on the U.S. For example, with
bonds, the U.S. must pay interest to the holders of bonds. With 52% of U.S. government debt being
held by foreigners, heavy interest payments must go through foreign exchange markets to convert
dollars into foreign currencies. That increased supply of dollars lowers the exchange value of
dollars in foreign exchange markets for many years into the future. As interest rates become higher
that burden can rise precipitously.
B. Federal Deficit
The Federal Deficit can also be computed from the NIPA accounts. It involves the
difference between the government expenditures and the taxes that pay for the government:
Federal Deficit = Government Expenditures – Taxes
Unfortunately this way of computing the balance treats the government deficit as a positive number
and the government surplus as a negative number! So be careful not to reverse these numbers.
A deficit is paid for by issuing new debt in the form of treasury bills and government bonds
of different kinds. Like the financing of a trade deficit, the government deficit involves an interest
rate burden in the future and this burden can rise as interest rates on the debt rise. This burden is not
trivial. Suppose the debt on the federal budget were 10 times the GDP of the economy and the
interest on the debt was 10% per year. That would mean the entire GDP of the economy would
have to be used to pay the holders of the government debt. What would be left to pay the people
who actually work to create the GDP. Some Latin American countries have in fact had debt in the
order of three times the country’s GDP; no wonder they had to default on their debt, leaving their
countries incapable of financing new businesses or even imports.
All of these different national accounting indicators are flows measured over a given period
of time. They are the most important measures of our economic output, even though they appear to
be measured in dollars. To avoid having these dollar measures distorted by inflation it is necessary
to use price indexes to “deflate” these dollar measures. But before trying to make inflation
adjustments, it is necessary to understand what a price index is.
2. PRICES AND PRICE INDICES
Prices are a measure of the way goods are exchanged. They are a ratio of how much of one
good is exchanged for another good. Following are the most important price ratios that are used in
economics:
Chapter 6
10
(a) THE PRICE OF GOODS AND SERVICES. The ratio usually represents the
amount of money (placed in the numerator) that is exchanged for a certain
amount of goods (placed in the denominator). For example, the price of a CD
might be quoted as “ten dollars”. The price is the ratio of the $10 to the one CD
and is properly written as:
$10
1 CD
A price index is constructed by choosing a base year from which to compare the prices in all years.
There is nothing significant about the choice of a particular base year. It can be any year. In fact
agricultural subsidies often are computed using the base year of 1917, which was one of the best
years for farm subsidies. Suppose, we chose a base year of 1995 for CDs and suppose the 1995
price was $20 per CD. Then the CD price index would be:
Price index of a CD (with a 1995 base year)= ($10/CD)/ ($20/CD)= .50
Instead of using the fraction, indexes are often quoted as if they were percentages. That requires the
multiplication of the price index by 100 to get 50.
Once we have the base year, we can then divide the prices in any year by the price of the
base year so that the index shows the rate of change in prices since the base year. What would the
price index for the base year be? It is always 100 because the 1995 price divided by itself equals
1.0.
The Bureau of Labor Statistics provides many different price indices for specific products
and services. However, it provides two major types of price indexes; the Consumer Price Index and
the Producer Price Index. The Consumer Price Index measures what the consumer pays, while the
Producer Price Index measures what the producers charge. Why might they be different? The
middleman. Sometimes Consumer demand pulls the producer prices upward. However, usually the
Producer Price Index leads the Consumer Price index in time.
The Bureau of Economic Analysis also provides price indexes. They use the Bureau of
labor statistics data to compute price indexes with which to correct for inflation in the National
Accounts. The price indices are often referred to as the “GDP deflator” although there are also
special price indexes computed for each of the items in the national accounts. The GDP deflator is
an index with a standard base year (the most recent one is 1997). The Nominal GDP is divided by
the GDP deflator index to arrive at the Real GDP:
Real GDP= Nominal GDP/GDP deflator
Chapter 6
11
To do this calculation the GDP deflator must be put back into its fractional form. For example if
the nominal GDP were $24 trillion and the GDP deflator with a 1997 base year were 120, then Real
GDP would be:
Real GDP= $24 trillion/1.2= $20 trillion
This would be interpreted to mean that the real GDP today would have been worth $20 trillion if
there had been no inflation since 1997. Unfortunately the price indexes used for deflating the
national accounts are not available very quickly and they are not as commonly used as the
Consumer Price Index.
(b) WAGE RATES. Wage rates measure the ratio of money exchanged for units
of labor. For example the minimum wage is quoted as the minimum dollars that
can be paid for an hour of work. If the minimum wage is $6.00 the correct way
to represent it as a price would be:
six dollars
1 hour of work
The Bureau of Labor Statistics compiles wage rate data for most professions.
(c) INTEREST RATES. Interest rates are the ratio of the dollars that must be
paid back at some future date relative to the dollars that are received today. For
example the prime rate is quoted as the percentage by which the dollars paid
back will exceed the dollars received. If the prime rate is 5% then $1.05 must be
paid back for every $1.00 borrowed. In effect, interest rates are quoted as a
percentage which is a shorthand way to describe the ratio at which future
dollars are to be exchanged for current dollars. The way to view the interest
rate as a price would be to say that the interest rate is:
Dollars paid back next year
Dollars received this year
(d) EXCHANGE RATES. Exchange rates are the ratio of the amount of one
currency (shown in the numerator of the exchange ratio) that is exchanged for
another currency (shown in the denominator). So the exchange rate for the
dollar might be quoted as “100 yen”. The correct way to describe the exchange
rate would be:
100 yen
12
Chapter 6
one dollar
There are numerous historical records on different kinds of prices. Some ratios such as the amount
of gold exchanged for silver have remained remarkably constant since Roman times. On the other
hand some ratios between items such as food, transportation, and housing have changed
dramatically as technologies have changed.
Prices play a crucial role in both reflecting and regulating the business cycle, and this gives
them great importance in barometric forecasting. They reflect the level of business activity. As
demand for business activity rises at the beginning of a business cycle, prices tend to rise to their
new equilibrium levels. A rise in the a price index like the Consumer Price Index is defined to be
inflation. On the upswing of a business cycle the rising demand tends to raise inflation rates.
Similarly on the downswing of the business cycle the falling demand tends to lower inflation rates
or even result in deflation (lowering prices as measured by a general price index). The change in
the price index is a valuable piece of information about where the economy has been in the last year
and where it currently is.
However, prices don't just reflect where the economy has been. As prices rise, they raise the
costs that all businesses must pay. When prices of goods and services rise, wage earners want to
renegotiate their contracts to protect against inflation, so wages must rise. When inflation occurs,
interest rates must rise so that lenders don't lose money when they lend (if the inflation rate exceeds
the interest rate as it did in 1978, then lenders find that the fall in the value of money more than
offsets the interest received from lending). On the upside of a business cycle, prices, wages, and
interest rates are all likely to be rising. But as wages catch up an exceed price increases and as
interest costs take a bigger and bigger slice of the income statement, it becomes harder for firms to
stay in business, much less to expand their businesses. The growth rate of income slows down and
may even become negative as a result.
Once the economy enters a recession, prices work in reverse. As inventories of unsold
goods pile up, prices are lowered to eliminate the costly inventories. Production lines are slowed
down and people are let go which places downward pressure on wages; people want to hang onto
their jobs and may sacrifice wage demands in order to do so. Interest rates gradually follow
inflation rates downward. As prices generally fall, the economy faces a lot of slack in its productive
resources which provides incentives for new businesses to enter markets. As they enter, the market
begins to expand and to "recover." Soon the economy is back on the upswing into another business
cycle.
Key to this whole story is the role of prices much like the thermostat in your house. As the
economy overheats the thermostat (prices) cuts off the heating units. After the economy cools the
thermostat turns on the heating units. The prices are crucial signals that prevent the economy from
overheating too much or getting too cold. The prices are an important reason that the business cycle
occurs. But prices themselves are determined by the disequilibrium situations that occur in the
market.
3. MEASURES OF DISEQUILIBRIUM
There are a variety of different measures that provide indicators of disequilibrium between
supply and demand within markets. These measures often are defined as stocks at a specific point
Chapter 6
13
in time. In other words, there is no time dimension to them. We might even be able to take a
picture of them at that point in time. Some of the most important stocks involve resources,
particularly human resources:
(a) UNEMPLOYMENT, EMPLOYMENT, AND THE LABOR FORCE. The labor force
consists of the people who are over the age of 16 who are willing and able to
work. The employed members of the labor force are those who can find work,
while the unemployed are members who are not willing and able to work. Some
people, who are not working because they are not willing to work are not
included in the unemployment figures. Some people who say they are willing to
work, but do not accept any work when offered may be included in the
unemployment figures but are often referred to as the “phantom unemployed”.
The Bureau of Labor Statistics takes great pains to survey workers to determine
who is truly unemployed.
While there are many economic concepts which define a basic unemployment rate- such as
the natural unemployment rate or core unemployment rate or the structurally unemployed- the
attention getting unemployment data concerns a change in the unemployment rate (eg. “is it getting
worse”) or a change in the trend of the unemployment rate (eg. “is there an upward trend in the
unemployment rate”). Because such changes or trends must be measured over a period of time,
they become similar to the flows measured in the national accounts and are quite closely related to
the performance of the items in the national accounts.
As the unemployment rate rises, the economy is often viewed as being worse off and better
off as the unemployment rate goes down. So it is the trend in the unemployment rate which is most
closely watched by macroeconomists and politicians.
(b) ORDERS. Companies receive orders for business continually. As business
increases they often fall behind in filling those orders. If you have ever gone to a
crowded fast food restaurant wanting to get your food fast, you may have
watched as the cook received more and more paper that was posted on the wall
reflecting new orders. As more paper comes in, the cook feels “backlogged” with
orders and it takes longer to fulfill each order. The economy works exactly in
the same way as the growth of the GDP increases. With a fast growing economy
orders stack up and the economy becomes “backlogged.” It is not the level of
orders at any one time that we watch but the change of orders- are they rising or
falling. At the beginning of a growth cycle the backlog of orders may even begin
to accelerate, a very clear sign of economic growth.
(c) INVENTORIES. Inventories are just stacks of goods. But it is expensive to
have inventories. They take up space, they must be managed, and they
14
Chapter 6
deteriorate. A business survives by selling the inventories, not holding them.
When demand suddenly falls, the first indication of the change in demand may
show up as rising inventories. That's why businesses want to use point of sale
computer equipment with bar codes; they want to know every item that leaves
the store so that they can focus on the items that aren't leaving the store and to
find a way to reprice them to get rid of them. It is that downward repricing
which causes inflation rates to fall. So inventory changes are a very good leading
indicator of what will be happening in a business cycle. When the change in
inventory becomes positive, the economy may be headed toward the downside
of a business cycle. When the change in inventory is negative, the demand for
goods is usually picking up and the economy may be headed upward in the
cycle.
(d) CAPACITY UTILIZATION. The capacity of businesses to produce is expensive
to keep around unused. There are maintenance costs, the capacity may be
increasingly obsolescent, and the debt from buying the equipment has to be
serviced. Capacity utilization records how much the economy is producing as
well as how much more could be produced without leading to high inflation
rates. When capacity utilization rates are low, the economy is typically in
recession. If the economy stays in recession too long, businesses may go
bankrupt and the capacity to produce declines. While capacity utilization may
appear higher, the capacity of the economy to produce is reduced.
B. Barometric Forecasting
Barometric forecasting requires the identification of a leading indicator. The best such
leading indicator is the one that most correctly indicates the direction of change in a firm’s business,
that provides the earliest warning, and that consistently changes the same number of periods before
the firm’s business. If such a leading indicator can be identified, then an executive can use
barometric forecasting to predict the direction of airline traffic.
1. Index of Leading Indicators
If a firm’s business is related to the GDP of the economy, then the Conference Board
(http://www.conference-board.org/) provides a very useful measure of leading indictors. In fact
there are many such leading indicators. Table 5 presents the leading indicators that are used by the
Conference Board today. While these are useful, through time they change. In table 5 we can see
six leading indicators have been dropped since 1972 when the Commerce Department chose the
leading indicators, and they have been replaced by six new leading indicators. There is nothing
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precise or long lasting about a leading indicator. The criteria for choosing the best indicator is based
on (1) its economic significance, (2) statistical adequacy, (3) consistency in signaling the direction
and magnitude of changes in the economy, (4) smoothness, (5) availability of data, and (6) accuracy
in predicting turning points in the economy. It is possible to use regression analysis to find how
well leading indictors actually lead the GDP.
Business cycle analysts categorize leading indicators into two groups: (1) diffusion indices
and (2) composite indices. A diffusion index is based on the percentage of leading indicators that
are rising. If there are twelve commonly used leading indicators and only three of them indicate a
rising trend then the diffusion index is 25% (=3/12). Such an indicator is easy to use; if half of the
indicators or more indicate a rising economy then the outlook for economic growth is considered
positive.
Table 5 Leading, Coincident, and Lagging Indicators
==============================================================
Business
Title of Series
Conditions
(asterisks indicate series reported or is
Digest Series related closely to series reported weekly in
Number
Business Week)
______________________________________________________________
Leading Indicators used for the Composite Index of 10 Leading Indicators (as of 2010)
The index of leading economic indicators (LEI) is a composite of the following 11 leading
indicators:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
Average weekly hours of production for nonsupervisory workers, manufacturing.
Average weekly initial claims for unemployment insurance, state programs.
Manufacturers' new orders in 1992 dollars, consumer goods and materials industries.
Index of stock prices (Standard&Poor's 500).
Index of new private housing units authorized by local building permits.
Vendor performance, percent of companies receiving slower deliveries.
Money supply M2
Manufacturers' new orders in nondefense capital goods industries
Sensitive material prices
Index of Consumer Expectations.
Plant and equipment orders
Leading indicators dropped since 1972.
Change in manufacturing and trade inventories on hand and on order in 1972 dollars.
Change in sensitive materials prices
Change in business and consumer credit outstanding.
Index of net business formation.(Business Failures)
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Contracts and orders for new plant and equipment in 1972 dollars
Interest rate spread, 10-year Treasury bonds less Federal funds.
Coincident Indicators used in Index of 4 coincident indicators
1.
Employees on nonagricultural payrolls.
2.
Index of industrial production
3.
Personal income less transfer payments
4.
Manufacturing and trade sales
Lagging Indicators used in Index of 6 lagging indicators
1.
Change in Index of labor cost per unit of output, manufacturing
2.
Ratio of manufacturing and trade inventories to sales
3.
The inverted average length of employment
4.
Ratio of consumer installment credit outstanding to personal income
5.
Commercial and industrial loans outstanding
6.
Average prime rate charged by banks.
7.
The change in the Consumer Price Index for services from the previous month
==============================================================
Each leading indicator is given the same weight in a diffusion index. However, there may
be important interactions between indicators and differing capabilities in predicting turning points in
the economy. Econometric methods can be used to determine the weights for the indicators which
produce the best predictions of turning points. A composite index typically provides different
weights for each of the leading indicators. For example, if a firm found only two indicators, the
stock market (S) and the money supply (M), to be important leading indicators for its business it
might construct the following composite index on the basis of past experience:
Composite Index = .6*S +.4*M
In effect, the stock market index is weighted fifty percent more heavily than the money supply
index.
2. Coincident Indicators
Two indices which move at roughly the same time are referred to as coincident indicators.
The indices chosen as coincident indicators have stayed pretty much the same over the last thirty
years.
A coincident indicator is not very useful for forecasting. It takes time to adjust to changes in
demand. A company would like to have an early warning of changes in demand. However real
GDP sometimes lags demand. Data on the real GDP is reported quarterly which reduces the
frequency with which changes in the economy can be monitored. Thirdly, the government requires
a substantial amount of time after each quarter to process the data necessary to calculate the gross
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domestic product. Finally, even when an estimate is made, substantial adjustments to the estimate
are often necessary up to two years later. All of these factors contribute to a "recognition lag" which
lessens the predictive power of the real GDP and therefore prevents it from being an ideal
barometric indicator.
3. Lagging Indicators
To gain a full picture of economic changes, more than turning points of economic growth
should be identified by executives. Leading indicators help predict changes in the economy, but
lagging indicators help to confirm where the economy has been. For example, the high
unemployment rate of 2003 is a reflection of economic conditions as much as two years before.
The lagging indicators that have been chosen have stayed the same over the last thirty years.
A change in an indicator is followed in time by a change in its lagging indicator. The
Conference Board compiles a composite index of six lagging indicators. The composite index
varies in the number of months by which it lags the economy.
C. Direction of Change in Indicators
Many indicators measure phenomena which have both leading and lagging components.
The following indicators reflect aggregate supply and demand changes while simultaneously
determining future changes in aggregate supply and demand:
(1) Inventories and Order Back Logs. When inventories begin to pile up, and
rise above desired levels, firms curtail orders. Unfilled orders begin to fall. High
inventories and low order backlogs are therefore warning signals of impending
recession.
On the other hand, high inventories may also reflect high past production rates. Therefore,
the inventories are often divided by sales to provide an indicator. If inventories and sales are rising
in tandem, then they do not reflect an impending recession, but may in fact be registering the effects
of a booming economy. However, the ratio of inventories to sales indicates a recession if
inventories rise and sales are falling. Not surprisingly one of the six lagging indicators in Table 5 is
therefore the ratio of manufacturing and trade inventories to sales.
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(2) Prices, Wages, and Interest Rates. When an economy expands prices, wages,
and interest rates should eventually begin to rise. The Commerce department
therefore uses the prime rate, the rate charged by banks for loans to their most
credit worthy customers, and the index of unit labor cost as one of the lagging
indicators.
On the other hand, as prices rise rapidly they can start to shut the economy down. If the
economy is in a booming period and prices are rising because inventories are low and capacity is
tight then prices rise enough to ration existing supplies among customers. High inflation rates,
wage rates, and interest rates may be leading indicators of "stagflation"- low growth with high
inflation- even as they are lagging indicators of a short run booming economy. The Commerce
Department's index of leading indicators includes an index of stock prices and the change in
sensitive materials prices. Because changes in the money supply affect interest rates and inflation
rates, the money supply is also a leading indicator.
(3) Employment, Unemployment, Duration of unemployment and Hours
Worked. When businesses discover that orders are increasing, they do not
immediately go out and hire more workers. Instead they are likely to respond
by running more shifts and working more hours, which means that average
hours worked begins to rise. Increased hours worked is some of the first
evidence that economists receive of increased growth rates. Not surprisingly,
(a) average weekly hours of production for nonsupervisory workers in
manufacturing and (b) average weekly initial claims for unemployment
insurance are both included in the Commerce Department's index of leading
indicators. Employees on nonagricultural payrolls is a coincident indicator for
the economy.
Only after confidence builds in sustained growth will firms begin hiring additional workers.
However, this new hiring requires time; time to announce a position, to interview for it, and to get a
new employee on board. For these reasons employment and the unemployment rate are lagging
indicators. Average duration of unemployment appears as one of the Commerce Department's
lagging indicators.
(4) Income. As employment increases, people receive more income and this
greater income eventually is used to purchase consumption goods. Greater
purchases of consumption goods boost the sales of businesses which respond
with greater production. The indicators, (a) personal income less transfer
payments, (b) the index of industrial production, and (c) manufacturing and
trade sales, are included in the Commerce Department's coincident indicators
because they are so closely linked to the gross national product.
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19
(5) Expectations. Expectations of firms and consumers about the direction of
the economy provide self fulfilling prophesies about the direction of the
economy. When firms expect the economy to do well, they will hire more people
and buy more. When consumers expect the economy to do well, they will
generally be more willing to go into debt to buy more goods. Both kinds of
behavior increase income and expenditures.
The Commerce Department's leading indicators include the following reflections of business
expectations which generate further demand: (a) manufacturers' new orders (b) contracts and
orders for new plant and equipment, (c) index of net business formation, (d) vendor performance
(percent of companies receiving slower deliveries), and (e) index of new private housing units
authorized by local building permits. The Commerce Department's lagging indicators contain two
measures which reflect peoples' expectations about the strength of the economy through choices
about debt; (a) ratio of consumer installment credit outstanding to personal income, and (b)
commercial and industrial loans outstanding.
D. Levels and Changes of an Indicator
Because of the leading and lagging information provided by each of these different series, it
is important to look at the trend in the changes of the indicators. The direction of change points to
strengthening or weakening of the economy.
The media implicitly focus on the changes rather than the level of variables when they
report on the trends of a variable for past time periods. For example if Business Week reports that
prices rose .4% in the previous month, we might conclude that inflation is serious. However, when
it reports that this monthly percentage change is the lowest in two years, we realize that the change
in the rate of inflation is downward. A sustained downward movement of inflation might indicate a
movement from a period high growth and inflation to a period of lower growth and price stability.
The trend or changes in levels provide the basis for identifying where the economy is in the business
cycle.
E. Patterns of Indicator Change
While barometric forecasting often focuses on one indicator or a composite of different
indicators, a manager should recognize patterns of changes among the indicators. The indicators
serve as a kind of grand thermostat for the economy. As the economy overheats, inventories drop
causing prices to rise to shut off the economy. As work hours fall, expectations worsen, and the
temperature of the real GDP drops. The economy goes into a deep freeze as people are laid off and
reduce their spending. However, with their lower aggregate demand, prices begin to fall.
Once prices fall far enough, inventories are reduced to a minimum, and employment is low,
the thermostat of the economy turns on again. Consumers need to replace their durable items such
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as cars and appliances, and the prices of these goods are low enough to make such purchases
possible. Expectations reverse, inventories drop to very low levels, and the cycle starts all over
again.
While leading and lagging indicators together provide good barometers- or thermometersfor the economy, they often do not tell a consistent story. A manager must weigh the relative
importance of different indicators. Experience can help in determining which indicators are the
most important for a given market, but econometric models provide a more methodical basis for
weighing, testing, and selecting these influences. Prices as a Homeostatic Control
There are numerous historical records on different kinds of prices. Some ratios such as the
amount of gold exchanged for silver have remained remarkably constant since Roman times. On
the other hand some ratios between items such as food, transportation, and housing have changed
dramatically as technologies have changed.
Prices play a crucial role in both reflecting and regulating the business cycle, and this gives
them great importance in barometric forecasting. They reflect the level of business activity. As
demand for business activity rises at the beginning of a business cycle, prices tend to rise to their
new equilibrium levels. A rise in the a price index like the Consumer Price Index is defined to be
inflation. On the upswing of a business cycle the rising demand tends to raise inflation rates.
Similarly on the downswing of the business cycle the falling demand tends to lower inflation rates
or even result in deflation (lowering prices as measured by a general price index). The change in
the price index is a valuable piece of information about where the economy has been in the last year
and where it currently is.
However, prices don't just reflect where the economy has been. As prices rise, they raise the
costs that all businesses must pay. When prices of goods and services rise, wage earners want to
renegotiate their contracts to protect against inflation, so wages must rise. When inflation occurs,
interest rates must rise so that lenders don't lose money when they lend (if the inflation rate exceeds
the interest rate as it did in 1978, then lenders find that the fall in the value of money more than
offsets the interest received from lending). On the upside of a business cycle, prices, wages, and
interest rates are all likely to be rising. But as wages catch up an exceed price increases and as
interest costs take a bigger and bigger slice of the income statement, it becomes harder for firms to
stay in business, much less to expand their businesses. The growth rate of income slows down and
may even become negative as a result.
Once the economy enters a recession, prices work in reverse. As inventories of unsold
goods pile up, prices are lowered to eliminate the costly inventories. Production lines are slowed
down and people are let go which places downward pressure on wages; people want to hang onto
their jobs and may sacrifice wage demands in order to do so. Interest rates gradually follow
inflation rates downward. As prices generally fall, the economy faces a lot of slack in its productive
resources which provides incentives for new businesses to enter markets. As they enter, the market
begins to expand and to "recover." Soon the economy is back on the upswing into another business
cycle.
Key to this whole story is the role of prices much like the thermostat in your house. In fact
they are called a homeostatic mechanism because they keep the economy at equilibrium. As the
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Chapter 6
economy overheats the thermostat (prices) cuts off the heating units. After the economy cools the
thermostat turns on the heating units. The prices are crucial signals that prevent the economy from
overheating too much or getting too cold. The prices are an important reason that the business cycle
occurs. But prices themselves are determined by the disequilibrium situations that occur in the
market.
B
barometric forecasting, 2
Barometric Forecasting, 14
business cycle, 5
C
CAPACITY UTILIZATION, 14
Capital Account, 8
change in the GDP, 5
Coincident Indicators, 16
composite indices, 15
consumption (C),, 3
current account, 8
D
diffusion indices, 15
DISEQUILIBRIUM, 13
Disposable Income (DI), 5
E
EMPLOYMENT, 13
EXCHANGE RATES, 11
Expectations, 19
expenditure, 2
Exports (Ex), 3
F
Federal Deficit, 9
flow, 2
G
GDP deflator, 10
government expenditures (G), 3
Gross Domestic Product (GDP), 4
gross investment (I), 3
Gross National Product (GNP), 4
H
Homeostatic Control, 20
I
Imports (Im, 3
income earners, 4
inflation, 12
INTEREST RATES, 11
INVENTORIES, 14
L
LABOR FORCE, 13
lagging indicator, 17
Leading Indicators, 15
N
National Income, 4
Net Domestic Product (NDP), 4
Net exports, 3
Net National Product (NNP), 4
Nominal GDP, 11
O
ORDERS, 13
P
percentage changes, 6
Personal Consumption Expenditure (C), 5
Personal Income (PI, 4
PRICE, 10
R
Real GDP, 11
recessions, 5
T
the change in the change, 5
Trade Deficit, 8
U
UNEMPLOYMENT, 13
unilateral transfers, 9
22
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W
Copyright
WAGE RATES, 11