Academic journal article Research in Applied Economics

Revisiting the Leading Economic Indicators

Academic journal article Research in Applied Economics

Revisiting the Leading Economic Indicators

Article excerpt

Abstract

Leading economic indicators have long been a tool of American economists, particularly those working in the business sector, for anticipating turning points in the business cycle. Armed with knowledge of likely peaks and troughs in the pace of aggregate economic activity, business economists can advise corporate leaders as to the probable path of the macroeconomy, thereby influencing if not improving the quality of strategic decision making within organizations. This chain of events is predicated on the assumed reliability of leading indicators to forecast correctly the future, an assumption put to the test in this paper via a novel application of statistical process control (SPC) to a well-known set of leading indicators that have been studied for the better part of half a century.

To give context to the overall discussion, the paper begins with a quick review of the historical development of leading indicator forecasting as it evolved in the United States. This is followed with an explanation of statistical process control, the singular methodology used in this paper, but one seldom employed in general economic analysis save for the area of production economics and its emphasis on manufacturing. Once explained, the SPC process is applied to a representative set of eleven leading indicators that have been tracked quarterly or more frequently for anywhere from 38 to 71 years.

The results of the SPC analysis of this data pool of some 7,000+ observations suggest that collectively leading indicators reliably forecast business-cycle turning points, with the caveat that individually the effectiveness with which specific indicators within a set predict the future of the macroeconomy is subject to wide variation.

Keywords: Leading indicator forecasting; statistical process control; forecasting reliability.

JEL Codes: C00; E32

Introduction

Leading economic indicators are an American institution, and as such, most economists, especially those in business, are apt to assume they are reliable signals of the near-future state of the macroeconomy. The purpose of this study is to test that conclusion using statistical process control analysis, an empirical technique seldom applied in economics, with the exception of production economics with its focus on manufacturing. The paper begins with a short history of indicator forecasting. This is followed with a description of statistical process control (SPC) and how it will be used to test the reliability of a publically-available set of leading economic indicators. The third section of the paper summarizes the result of applying SPC analysis to a data set of the leading indicators covering roughly the last 50 years of aggregate economic activity in the United States. The paper concludes with an assessment of leading indicators as a forecasting tool and some caveats about the results of this study.

1. The Development of Indicator Forecasting

In the United States, the desire to see "around economic corners" likely had its first formal expression in Wesley Clair Mitchell's (1874-1948) 1913 publication Business Cycles, a massive treatise on the nature, causes and consequences of the periodic variations in the overall level of aggregate activity in the American economy over the previous 100 years [Burns, 1952]. Beginning in 1920 the statistical study of national income, business cycles, and economic forecasting became the primary focus of Mitchell's scholarship when he became the director of research at the newly established National Bureau of Economic Research (NBER), a private, nonprofit economic think-tank dedicated to empirical studies particularly of the United States economy. Mitchell first demonstrated his inclination for forecasting in the article "The Outlook of 1921 as Seen by Bankers, Business Men and Economists," published in the New York Evening Post in December 1920 [Mitchell]. Seven years later he published an enhanced and revised version of his classic work on business cycles under the new title Business Cycles: The Problem and Its Setting. …

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