[Mb-civic] FW: An article for you from an Economist.com reader.

Tue Jan 18 10:49:30 PST 2005

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From: michael at intrafi.com
Date: Tue, 18 Jan 2005 12:48:02 -0500
To: michael at intrafi.com
Subject: An article for you from an Economist.com reader.

DIVINING THE FUTURE
Jan 13th 2005  

The case for keeping a close eye on leading economic indicators

IS THIS a good time for your company to expand? Or for you to splash
out on that new car? The answer may well depend on the likelihood of a
sharp economic downturn in the next year or two. Economic forecasts say
the risk is slight: in THE ECONOMIST's most recent monthly poll, the
average prediction of America's GDP growth this year was a robust
3.5%--less than in 2004, but above the long-term trend. However, other
guides to the future, known as leading economic indicators, tell a
different story. Several of these suggest that the slowdown in many
economies in the second half of last year was not just a "soft patch",
but may prove more prolonged.

Take the OECD's composite leading indicator for the G7 economies. Its
six-month rate of growth has fallen for ten consecutive months (see
chart). Similarly, the growth rate of the most closely watched leading
indicator for the American economy, published by the Conference Board,
a business-backed group, has plunged in the past year. On past
experience, this points to a sharp slowing of GDP growth in the first
half of this year. 

Should you trust the leading indicators or the forecasts?
Embarrassingly, conventional economic forecasts have rarely correctly
predicted a recession. In late 1981, when (it later transpired)
America's economy was already shrinking, the average forecast for GDP
growth in 1982 was over 2%. In the event, output fell by 2%. In August
1990, the very month that America dipped into its next recession, the
consensus was that the economy would grow by 2% in 1991; again, output
declined. In early 2001, the average forecast for growth that year was
also close to 2%. We now know that a recession was already under way.

Some economists argue that recessions are typically caused by
unpredictable shocks, such as the events of September 11th 2001 or a
sudden rise in oil prices. But that excuse will not do, at least for
2001: official figures show that the recession started months before
the September attacks. The trouble is not the unpredictability of
events, but that the economic models on which forecasts are based are
not up to the job. Despite containing hundreds of equations, models are
notoriously bad at predicting recessions because they tend to
extrapolate the past, for most of which the economy has been expanding.
Yet recessions stem from abrupt changes in the behaviour of firms and
consumers. 

Scrutinising indicators that have given advance warning of downturns in
the past, such as share prices, order books or the shape of the yield
curve, seems more helpful than relying on models. There is no single
magic measure; each leading indicator has failed to predict a turning
point at one time or another. But leading indicators are unlikely all
to give false signals at the same time, so a composite index that
combines several economic and financial measures stands a good chance
of spotting changes in the economic weather.

In a survey in March 2001, 95% of American economists said there would
not be a recession. One of the few exceptions was the Economic Cycle
Research Institute (ECRI), an independent research firm, which that
same month correctly forecast, on the basis of its leading economic
indicators, that a recession was unavoidable. ECRI was set up by the
late Geoffrey Moore, an early pioneer of business-cycle research who in
the 1960s developed the American government's first leading indicator
(which is now published by the Conference Board).

PROPHET MAXIMISATION
ECRI tracks around a dozen leading indices for different parts of the
economy. Some of these have a longer lead time relative to economic
activity than others, so the firm publishes both a longer leading
index, which signals changes in activity about a year in advance, and a
shorter leading index, which looks six months ahead. This is one
advantage over the Conference Board's leading economic indicator, which
conceals useful information by combining longer- and shorter-term
indicators in a single measure.

A second advantage is that ECRI publishes a weekly index and is thus
always up to date. Moreover, this weekly index largely comprises
indicators that are not revised later, such as share prices, bond
yields and commodity prices. In contrast, the OECD's and the Conference
Board's current historical time series differ from what was published
at the time, because the data from which they are constructed have been
revised. As a result, the indicators' predictive power is not as good
as the revised series imply.

ECRI is perhaps the only organisation to give advance warning of each
of the past three recessions; just as impressive, it has never issued a
false alarm. In their book "Beating the Business Cycle", Lakshman
Achuthan and Anirvan Banerji (both of ECRI) claim that the firm's
weekly leading index has consistently predicted downturns before the
Conference Board's measure. Indeed, in April 2001, after ECRI had
called a recession, the Conference Board said: "No recession is on the
horizon." ECRI's indices for other economies have also fared well. For
instance, it correctly forecast the Japanese recessions that started in
1997 and 2001. 

Over the years the Conference Board has used several rules of thumb to
decide whether its leading economic indicator is signalling a
recession. On its website is a note suggesting that a 2% annualised
fall in its indicator over a six-month period, with more than half of
the components worsening, provides a reliable though not perfect
warning of recession. The rule suggests trouble: the index has fallen
at an annual rate of more than 2% in the past six months. More likely,
this is a false alarm.

ECRI has no simple rule for determining when the economy is headed for
recession. It compares recent movements in its indices with previous
business cycles. In order to signal a genuine turn in the cycle the
indices must change direction in a way that is pronounced in size,
pervasive across individual components and persistent. For example, the
weekly leading index fell sharply in 1987 but no recession was called.
This was because the decline was not pervasive, but due almost entirely
to that year's stockmarket crash.

So how should one interpret the plunge in the past year in all three
series of leading indicators? When America's growth weakened in
mid-2004, the economy was widely thought to be in a soft patch that
would soon pass. The persistent fall in the leading indicators suggests
that growth could remain disappointing in the first half of this year.
The more timely and (so far) more reliable ECRI index, however, rose in
both November and December, tentatively suggesting that the economic
slowdown could end by around the middle of this year. A new recession
is certainly nowhere in sight. But keep checking those leading economic
indicators over the coming months.

See this article with graphics and related items at
http://www.economist.com/research/articlesBySubject/displayStory.cfm?story_i
d=3561492&subjectID=348918&emailauth=%2527%2528%2540%252A1%2525LD630%255D4%2
50A

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