Business Cycles and Economic Indicators

One of the leading uses of economists (one that tends to give us a bad name) is in forecasting the economy. But as John Kenneth Galbraith put it (Wall Street Journal, Jan 22, 1993, C1): "There are two kinds of forecasters: those who don't know, and those who don't know they don't know.'' Still, forecasting is the next subject, so let's see what we can make of it. The national income and product accounts give us, as we've seen, some idea of the current state of the economy as a whole. We'd also like to know, if (say) we're planning to expand capacity, what the economy is likely to be doing in the next few months or years. The answer, if we are honest about it, is we know a little about the future, but not much. In fact we typically don't even know where we are now. Thus on October 27, 1992, the BEA announced its preliminary estimates of third quarter GDP for 1992: in 1987 prices, real GDP was 4924.5. Compared with the previous quarter of 4891.0, the growth rate was 2.6 percent annually (you multiply by 4 to get an annual growth rate). One month later, the estimate was revised upwards to 4933.7, a growth rate of 3.5 percent. This may not sound like a big difference, but it might have had a significant impact on the election, and on Clinton's thinking about whether to focus policy on long term growth or the short term. The fact is, it's difficult to compute GDP until all the data is in, sometimes a year or more down the road. The best advice I can give you is to realize that there is an unavoidable amount of uncertainty in the economy. This is even more true of firms and their financial statements. So what do we do? My choice is to get out of this game altogether, but not everyone has this option---a firm, for example, has to forge ahead the best it can. The first thing you should know is that there's a lot of uncertainty out there, and no amount of commercial forecasting is going to change that. If you're Al Checchi at Northwest Airlines, it doesn't help to say that your forecasters didn't predict the Gulf War, the 1991 recession, and the related decline in air traffic. Or GM: their forecasters reportedly came up with three scenarios for 1991, and what happened was worse than all of them. But you still want to get the best forecasts possible. Business economists look at anything and everything to get an idea where the economy is headed. Among the best variables are those related to financial markets. One of these is the stock of "money,'' by which I mean the stock of cash and bank deposits held by firms and households. There are a number of different monetary aggregates, as we'll see later, but we'll focus for now on M2, which includes most of the deposits at commercial banks and other other financial institutions that accept deposits. You see in Figure 1 that the growth rate of the money stock moves up and down, roughly, with the growth rate of GDP. In this sense it is a good indicator of the state of the economy. And since money stock measures are generally made available more quickly than GDP, it tells us something about the current state of the economy as well.

Even better indicators are financial prices and yields, which have the additional advantage of being available immediately. As you might expect if you've ever taken a finance course, asset prices tend to incorporate "the market's'' best guess of future events and, by and large, they are as good predictors of the economy as we have. Maybe the best of these is the stock market. In Figure 2 I've plotted the annual growth rate of real GDP with the annual growth rate of the S&P 500 composite stock index. What you might expect is that the stock market anticipates movements in the economy: in recessions profits and earnings are down so stock prices should fall as soon as a recession is anticipated by the market. That's pretty much what you see. In the figure we see that every postwar downturn in the economy has been at least matched, if not anticipated, by the stock market. The problem is that there have been several downturns in the stock market that didn't turn into recessions---so-called false signals. A classic case is the October 1987 crash, which was followed by several years of continued growth. As we say in the trade, the stock market has predicted twelve of the last eight recessions. Other useful financial variables are yield spreads, especially the long-short spread (the difference between yields on long- and short-term government bonds) and the junk bond spread (the difference between yields on high- and low-grade bonds). Both of these have been useful in predicting downturns in the economy. Recent work by Stock and Watson for the NBER suggests that stock prices and yield spreads contain almost all the usable statistical information about the future of the economy. Financial variables and some others are combined in the official index of leading indicators, which is constructed every month by the Conference Board and reported in the Wall Street Journal and other business publications. The current index of leading indicators (it changes from time to time) combines the following series: Leading Indicators 1. Hours of production workers in manufacturing 5. New claims for unemployment insurance 8. Value of new orders for consumer goods 19. S&P 500 Composite Stock Index 20. New orders for plant and equipment 29. Building permits for private houses 32. Fraction of companies reporting slower deliveries

83. Index of consumer confidence 99. Change in commodity prices 106. Money growth rate (M2) (The numbers are labels assigned in Business Conditions Digest, a Commerce Department publication on the state of the economy.) We see in Figure 3 that the index is closely related to the cycle, but only leads it by a month or two (which is hard to see in the quarterly data that I've graphed). Nevertheless, this is useful, since we don't know yet what GDP was last month. A related index of coincident indicators (Figure 4) does not lead the cycle, but has a stronger correlation with it. Its components are Coincident Indicators 41. Nonagricultural employment 47. Index of industrial production 51. Personal income 57. Manufacturing and trade sales