Classifying Economic Indicators

1. The Three Types of Economic Indicators

To navigate the business cycle, economists and analysts rely on a dashboard of economic indicators—statistics about economic activity. These indicators are classified into three categories based on their timing relative to the overall business cycle.

As the image shows:

• Leading indicators tend to change direction before the overall economy does. They provide clues about the future direction of the economy.
• Coincident indicators move at roughly the same time as the overall economy. They provide a snapshot of the economy's current health.
• Lagging indicators change direction after the overall economy has already turned. They are useful for confirming that a turning point has occurred.

To begin, let's watch a short video that introduces these three categories.

Now that you have a foundational understanding, let's explore each category with specific examples that are important for the CFA exam.

2. Leading Economic Indicators: Looking Ahead

Leading indicators are the most closely watched because they have predictive value for economic turning points. They signal potential shifts in the business cycle before those shifts become apparent in broad measures like GDP.

To understand the most common leading indicators and the logic behind them, please watch the next segment of the IFT video.

Let's summarize the key takeaways from the video. Understanding the "why" is more important for retention than simple memorization.

• Average weekly hours, manufacturing: Before hiring or laying off staff, firms first adjust overtime hours. An increase in overtime can precede an expansion, while a decrease can signal a coming contraction.
• Stock market indices (e.g., S&P 500): Stock prices are based on investors' expectations of future corporate profits and economic conditions. A rising market reflects optimism about the future, and a falling market reflects pessimism.
• Building permits for new private housing: A permit must be secured before construction begins, making this a clear leading indicator of housing market activity and broader investment.
• Interest rate spread (10-year Treasury yield minus short-term rate): This reflects the slope of the yield curve. A wide, positive spread (steep curve) suggests the market expects strong future growth and higher interest rates. A negative spread (inverted yield curve) indicates expectations of a future slowdown and has historically been a reliable predictor of recessions.
• Manufacturers' new orders for capital goods: Orders for new machinery and equipment reflect businesses' plans for future production and investment. An increase in orders points to an expected pickup in business activity.

3. Coincident and Lagging Indicators: Confirming the Trend

While leading indicators get the most attention for forecasting, coincident and lagging indicators play crucial roles in confirming the economy's current state and the validity of signals from leading indicators.

• Coincident Indicators move in tandem with the economy. They are used to identify the current phase of the business cycle.

  • Examples:
    • Industrial Production: Measures the output of factories, mines, and utilities. It is a direct measure of current economic activity.
    • Manufacturing and Trade Sales: Tracks the total volume of sales by these sectors, reflecting current business health.
    • Personal Income (less transfer payments): Shows the income households are earning from current production, which fuels consumer spending.

• Lagging Indicators only change after a trend in the overall economy is established. They serve as a confirmation signal.

Let's watch one more video segment that explains some important lagging indicators.

Here are the key lagging indicators and the logic behind them:

• Inventory-to-sales ratio: As an expansion peaks and sales begin to slow, firms are often caught with too much inventory. This unplanned buildup causes the ratio to rise after the peak has occurred.
• Average duration of unemployment: It takes time for unemployed individuals to find new jobs, so the average length of unemployment continues to rise even after a recovery has begun.
• Commercial and industrial loans outstanding: Businesses often borrow to finance inventory. As inventories build up late in the cycle, borrowing increases, causing this indicator to peak after the economy does.
• Change in Consumer Price Index (CPI): Inflation tends to be "sticky." Firms are slow to raise prices when demand strengthens and slow to cut them during a downturn. Therefore, inflation often continues to rise into the early stages of a contraction.

The Role of Confirmation:
As the video mentioned, a key use of coincident and lagging indicators is to confirm the signals from leading indicators. If leading indicators suggest a downturn, but coincident and lagging indicators remain strong, analysts may question the strength of the signal. If all three sets of indicators begin to point in the same direction, the case for a turn in the business cycle becomes much stronger.

4. Application and Composite Indicators

Analysts rarely rely on a single indicator. Instead, they look for a consistent message across multiple data points. To facilitate this, organizations like The Conference Board and the OECD create composite indicators (e.g., the Leading Economic Index, or LEI). These combine several individual indicators into a single index to provide a more reliable signal and smooth out the volatility of any one component.

Now, let's put your knowledge to the test.

The correct answer is B because the classification of these indicators is empirical. It's based on observing which data series have historically moved before, during, or after the overall economy over many business cycles. They aren't tied to one specific economic theory, and they can vary between economies.

Conclusion

In this lesson, we have moved from describing the business cycle to analyzing it with a toolkit of economic indicators. Understanding how to classify and interpret these indicators is a fundamental skill for financial analysis.

Key Takeaways:

• Economic indicators are classified by their timing relative to the business cycle into three groups: leading, coincident, and lagging.
• Leading indicators (e.g., stock market, building permits, interest rate spread) are used to forecast future economic activity.
• Coincident indicators (e.g., industrial production, personal income) describe the current state of the economy.
• Lagging indicators (e.g., unemployment rate, inventory-to-sales ratio, CPI) confirm that a turning point has already passed.
• For the CFA exam, it's important to know key examples from each category and, more importantly, the economic reasoning for their classification.

Preview of the Next Lesson:

We noted that inflation (CPI) and unemployment are typically lagging indicators. These two variables are so central to macroeconomic health that they warrant a deeper look. In our next lesson, we will explain how business cycles affect inflation and cyclical unemployment and explore the famous short-run trade-off between them known as the Phillips curve.