Why Don't Economists Follow The Leaders?

By: Paul Kasriel | Mon, May 23, 2005
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The "leaders" to which I am referring are those in the Conference Board's index of leading economic indicators (LEI). The Conference Board on Thursday announced that the LEI fell 0.2% in April after having dropped a downwardly-revised 0.6% in March. On a year-over-year basis, the April LEI index is down 1.2% -- the largest year-over-year percent decline since the 2.0% drop in April 2001. I tuned in CNBC at 10:01 am EDT on Thursday morning, one minute after the release of the April LEI index report. Perhaps the CNBC commentators mentioned the report as it hit the wires, but there was no discussion of it in the minutes immediately after the release. In the Thursday edition of The Wall Street Journal, some economists were disparaging the LEI index as information that not only was "old," but also subject to revision. Moreover, the LEI index, in the opinion of these economists, is irrelevant in today's services-oriented U.S. economy. It is amusing to hear economists deride the LEI index for containing data subject to revision. Economists attach great importance to a report released the first Friday of the month, a report that is a coincident indicator of economic activity, which is subject to huge revisions. As for containing stale information, mainstream economists pay little attention to the two most highly-weighted components of the LEI index when they first become available, namely the yield spread between the Treasury 10-year bond and fed funds and the real M2 money supply. So, I suspect that it is not because the LEI index contains old news that most economists ignore it. Rather, it is because the LEI index contains some variables that most economists believe are uninformative. Why do they find these variables uninformative? Probably because they took the word of some "authority" figure rather than having the curiosity to find out for themselves what the relationships are.

I think I have figured out why economists downplay the significance of the LEI index. It is to preserve their jobs. After all, if the LEI index does a better job of forecasting the behavior of the economy than do economic forecasters, why do we need economic forecasters? A few months ago, we called the Blue Chip survey folks to find out if the consensus of the best and brightest had ever forecast a recession. Blue Chip's answer was "no." As Chart 1 shows, the LEI index has done an excellent job of forecasting recessions. The year-over-year percent change in the LEI monthly index has gone negative prior to the onset of every NBER-designated recession since 1960.

Chart 1
Index of Leading Economic Indicators
(year-over-year percent change)

"P" denotes NBER peak in business cycle.

Now, it is true, that the LEI index has sent some false recession warnings. That is, there have been some occasions when the year-over-year percent change in the LEI index has gone negative and no officially-designated recession ensued. But that does not mean that the weakness in the LEI index was not signaling a developing weakness in the growth of economic activity. Chart 2 shows the relationship between growth in the LEI index and the Coincident Economic Indicators index. (The Coincident Economic Indicators index is made up of nonfarm payrolls, real personal income less transfer payments, real manufacturing and trade sales and the Fed's index of industrial production.) We can see in Chart 2 that although a contraction in the LEI index may not always signal an NBER-designated recession, it does signal weaker growth in the Coincident Economic Indicators index. By the way, the highest correlation, 0.77, between the growth in the Coincident index and the Leading index occurs when the Leading index is advanced by 7 months. A correlation coefficient of 0.77 is not perfect. Perfect would be 1.00. But folks, a correlation of 0.77 is fantastic for government work and its darned good for private sector work, too.

Chart 2
Indexes of Economic Indicators: Coincident vs. Leading
(year-over-year percent change)

"P" denotes NBER peak in business cycle.

But how relevant is the Coincident index to real GDP in today's post-modern economy? Chart 3 shows the relationship between growth in the Coincident Economic Indicators index and growth in real GDP. The correlation between the two has diminished in recent years. Between 1960:Q1 and 1994:Q4 the correlation was 0.91. It has slipped to 0.79 in the period between 1995:Q1 and 2005:Q1. I don't know about you, I would say that a correlation of 0.79 still is relevant.

Chart 3
Coincident Economic Indicators Index vs. Real GDP
(year-over-year percent change growth)

Lastly, another reason you should be paying attention to the behavior of the LEI index is that the Fed has been raising its policy rate. As Chart 4 shows, a rising fed funds rate goes hand-in-hand with a declining growth rate in the LEI index. Perhaps economists are surprised to learn that when the Fed starts to restrict the flow of the credit it creates out of thin air, the pace of economic activity slows down. But I bet you are not surprised by this.

Chart 4
Index of Leading Economic Indicators* vs. Fed Funds Rate**

* year-over-year percent change
** year-over-year percentage point change



Paul Kasriel

Author: Paul Kasriel

Paul L. Kasriel
Director of Economic Research
The Northern Trust Company
Economic Research Department
Positive Economic Commentary
"The economics of what is, rather than what you might like it to be."
50 South LaSalle Street, Chicago, Illinois 60675

Paul Kasriel

Paul joined the economic research unit of The Northern Trust Company in 1986 as Vice President and Economist, being named Senior Vice President and Director of Economic Research in 2000. His economic and interest rate forecasts are used both internally and by clients. The accuracy of the Economic Research Department's forecasts has consistently been highly-ranked in the Blue Chip survey of about 50 forecasters over the years. To that point, Paul received the prestigious 2006 Lawrence R. Klein Award for having the most accurate economic forecast among the Blue Chip survey participants for the years 2002 through 2005. The accuracy of Paul's 2008 economic forecast was ranked in the top five of The Wall Street Journal survey panel of economists. In January 2009, The Wall Street Journal and Forbes cited Paul as one of the few who identified early on the formation of the housing bubble and foresaw the economic and financial market havoc that would ensue after the bubble inevitably burst. Through written commentaries containing his straightforward and often nonconsensus analysis of economic and financial market issues, Paul has developed a loyal following in the financial community. The Northern's economic website was listed as one of the top ten most interesting by The Wall Street Journal. Paul is the co-author of a book entitled Seven Indicators That Move Markets.

Paul began his career as a research economist at the Federal Reserve Bank of Chicago. He has taught courses in finance at the DePaul University Kellstadt Graduate School of Business and at the Northwestern University Kellogg Graduate School of Management. Paul serves on the Economic Advisory Committee of the American Bankers Association.

The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The information herein is based on sources which The Northern Trust Company believes to be reliable, but we cannot warrant its accuracy or completeness. Such information is subject to change and is not intended to influence your investment decisions.

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