Wednesday, 1 February 2012

Business cycle tracking - USA

This is a beginning of a series of quarterly (or half-year) posts on the business cycle conditions of some of the selected world economies. I aim to observe and analyze certain leading business cycle indicators to try and show where the current recovery stands. Even though observing these indicators doesn't necessarily imply a move of the entire variable in that direction, the leading indicators can prove to be good signal of upcoming economic behaviour. 

The analysis will be simple in the beginning, and will add observations and indicators along the way, all in hope of creating a better picture of when the recovery might end, and the period of economic prosperity begin. The series itself will probably be presented in a separate page on the blog, where up to date data on selected indicators and economies will be available. I will provide summaries as a blog post by the end of each quarter to show the direction of the recovery.

In order to avoid having to explain real business cycle theory and its indicator variables (which might take up a lot of time and space), I suggest a few sources to familiarize with it: Roubini's business cycle indicators (outdated, but still excellent as an introduction), the Conference Board (offering the finest measures of leading indices for selected countries - make sure to check out their useful handbook), NBER (officially tracing US cycles, measuring 33 cycles so far from 1854 to 2009; they also provide a downloadable book on the subject), the European Commission (tracks the European cycle based on joint business and consumer surveys), and the best source of data for individual indicators is the St. Louis Fed database (FRED).

One needs to distinguish between three types of economic variables: leading (move before the cycle and predict it; example -  building permits, new orders for investment goods etc.), coincident (move with the cycle; example - personal income, consumption, non-farm employment) and lagging (move after the cycle; example - nominal wages). Also, variables can be counter-cyclical, pro-cyclical and acyclical (implying the direction of their movement with the business cycle). What is most interesting to observe are leading indicators, which could tell us where the economy is currently heading. We can observe both cyclical and counter-cyclical indicators to see the direction of the cycle more clearly. An index comprising of a set of the most powerful leading indicators is the Leading Economic Index (LEI). 

Having known all this, I will randomly select indicators proven to have a history of leading indication and observe them for the following countries (for now): US, UK, eurozone (and some of its members individually). Not all data for all countries is available, but fortunately, for the US, the data is abundant. 

United States

New housing building permits (a good leading indicator, as it provides insight into upcoming activities in housing construction and economic activity - induced in LEI)


We can see that this powerful indicator of future activity still doesn't show any signs of recovery for the economy. This could be biased by the fact that the US housing market experienced an unprecedented slump in housing and is still unable to recover. Hence, there is not so many building permits issued.

New orders in manufacturing: durable goods (maybe not so precise as a leading indicator for recessions, but may signal a potential recovery, although the indicator can be biased due to the volatility in transportation sector and defense, which can drive monthly figures unexpectedly) - depicted upper left on the figure below:


An increasing number of orders in manufacturing in durable goods is showing positive signs for the recovery; however, when looking at the index of new orders (upper right), the picture is slightly different and still inconclusive on the state of recovery. It is obvious that this indicator is highly sensitive to worrying signs of investor confidence that will constrain businesses in their expansion and new orders. Even though currently the situation is improving - as reported by the WSJ - those reports are based on monthly changes, so one should be careful in their interpretation in positive signs of recovery. It is more likely a reaction on positive changes in US GDP growth and investor confidence. Therefore, the manufacturing purchases can be a good indicator but are more likely to be coincident than leading in this case. 

One can also observe hours of production of workers in manufacturing (lower left) or the index of supplier deliveries (lower right) but both serve more as coincident indices and show the same signs as the new orders index. 

Fixed domestic investment (a powerful leading indicator that can drive aggregate demand; it falls faster during a recession and grows faster during a recovery than the GDP) - depicted in the upper left corner of the figure:


It consists of non-residential (lower right) and residential fixed investment (lower left), where residential is still low (for the same reasons as the new housing permits indicator, which is what residential investment mostly comprises of). Within the category of investment, the best thing to look at is the inventories index (upper right) which is showing volatile movement in the past few years. Inventories were the main reason behind the latest US GDP growth data, which can be observed in the graph above in the final observations of the inventory index. Even though they are treated as a positive sign of recovery, there is a caveat - is it due to a higher expected future demand (good), or are they pilling stock due to an overestimated demand ending up with a bunch of unwanted goods (bad)? Currently, it is hard to tell. 

Unemployment insurance claims (these can be a good indicator of falling levels of unemployment, but they fail to predict the unemployment movement if they are biased with exiting labour force data, which is why the employment-population ratio serves as a much more precise indicator)


Consumer confidence (an important leading indicator based on a survey of households - it tends to be correlated with unemployment, real income, stock market prices)


As is obvious from the graph, consumer confidence hasn't yet fully recovered. This could be the ultimate reason behind a still low aggregate demand. 

Finally, here is a joint, weighted-average US Leading economic index (LEI).


Source of all data: St.Louis Fed database; FRED
It fails to currently predict the momentum of recovery, as it is too volatile to be conclusive at this point. Also, its final observations show a move in the negative direction, contrary to the latest GDP growth data. It is possible this is due to signals coming from Europe or the signals of the stock market (which is also one of the components of the LEI index). Also, new building permits and consumer confidence, which are both not very encouraging, could present further downward pressure on the index. 

Verdict: Unable to comply - the current given set of data show positive signs on one end, but still sluggish signs on the other, making the LEI itself become inconclusive. The entire 2012 was signaled as a bad year for the economy, so its best to wait for the first quarter to finish to see where we stand.

6 comments:

  1. by looking at all of these indicators, it seems to me that hardly any predicted the crisis - only building permits and residential investments which reflected the housing bubble burst. Not even the LEI itself predicted the slump. So I don't think they are of much use in predicting actual crises beforehand..

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  2. Nothing can predict crises, if it could, we wouldn’t be experiencing them. There’s always a few people that saw it coming, but in a state of investor and consumer optimism, no-one really cares or listens to them, until we get punished that is

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  3. Simply by observing these indicators, one could have foreseen the housing slump (as some indeed have, like Shiller or Roubini). But the reason I've decided to look at these indicators is to try and see when a possible recovery could occur, as most of them have a better indication of predicting a recovery, rather than the crisis itself.

    Every crisis is different in its causes and effects, and yes, I agree that we need to observe it from a different perspective then the currently acceptable set of leading indicators. Reinhart and Rogoff suggest we should focus on looking at a longer series of financial data such as external debt, total government debt, external debt to exports ratio, CA balance, monetary base to GDP and so on. According to them, these indicators could paint a better picture of when to expect a crisis to arise.

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