The terms "leading," "coincident," and "lagging" refer to the timing of the turning points of the indexes relative to those of the business cycle. The leading index turns down before a general recession begins and turns up before the recovery from the recession begins. The coincident index moves in tandem with the cyclical movements of the overall economy, tending to coincide with the designations of expansions and recessions discussed in Chapter 1. The lagging index turns down after the beginning of a recession and turns up after the beginning of a recovery.
The system is based on Wesley Mitchell's theory that expectations of future profits are the motivating force in the economy. When business executives believe their sales and profits will rise, companies expand production of goods and services and investment in new structures and equipment, but when they believe profits will decline, they reduce production and investment. These actions generate the recovery, expansion, recession, and contraction phases of the business cycle. The leading indicator system treats the future course of profits in two alternative perspectives: (1) businesses' expectations of future sales (leading index), and (2) the differential movements between current production (coincident index) and production costs (lagging index).
The system has been criticized for being excessively empirical and lacking a theoretical framework. Reference is often made to a 1947 article by Tjalling Koopmans that criticized the work by Mitchell and Burns in general and particularly attacked their 1946 book, Measuring Business Cycles. The author disagrees with these criticisms and argues below that the system is grounded in economic theory.
THE PRIMARY ROLE OF PROFITS
The leading indicator system is based on the idea that profits are the driving force in the private enterprise economy. Business decisions on production, prices, employment, and investment are understood in relation to profit"- both the trends of past profits and the perception of future profits. Thus, changing expectations of profits affect the direction and pace of economic growth.
The system combines several component economic indicators into a composite leading index, a composite coincident index, and a composite lagging index. The following discussion capsulizes the three composite indexes and the rationale for each of the components.
The composite leading index indicates business perceptions of future profits. It represents businesses' anticipation of future economic developments, and the response in actions and plans to those expectations. The ten component economic indicators of the leading index are:
1. Average weekly hours, manufacturing. Because of uncertainty in the economic outlook, employers are more likely to adjust the hours of previously hired workers before hiring new workers at signs the recession is ending, or laying off workers at signs the expansion is weakening.
2. Initial claims for unemployment insurance. Increases or decreases in unemployment indicate business expectations of the demand for labor.
3. Manufacturers' new orders, consumer goods and materials (constant dollars). Business commitments to buy items indicate future levels of production.
4. Vendor performance, slower deliveries diffusion index. Delivery time reflects the strength of demand, brisk when the time from the placement of the order to delivery is long because of the large backlog of orders, and weak when the delivery time is short.
5. Manufacturers' new orders, nondefense capital goods industries (constant dollars). Business commitments in the volatile cyclical industries that fluctuate considerably between expansions and recessions.
6. New private housing units authorized by local building permits. Permits provide advance indication of housing construction, which is cyclically sensitive to changes in interest rates and expected changes in employment.
7. Stock prices, 500 common stocks. Stock prices reflect investor expectations of economic growth and profits, and thus future investment and household spending. High stock prices make it easier for businesses to raise funds for structures and equipment investment and other ventures by selling new stock to the public (equity financing), which entails no required payback to the buyer of the value of the stock or the payment of dividends. By contrast, low stock prices make it more likely that businesses will obtain funds from the public by selling bonds--that is, debt financing, in which the principal is repaid and there are specified interest payments. Stock prices also affect household wealth, and in turn future consumer spending. Stockholders perceive they have more to spend when stock prices, and thus their wealth, are rising than when they are falling. Stock market prices also reflect speculation, insider trading, and program trading, however, which are not associated with underlying economic factors. When the stock market is dominated by these speculative-type actions, its usefulness as an economic indicator is diminished.
8. Money supply, M2 (constant dollars). The amount of financial liquid assets generated by the interplay of investments, savings, borrowing, and lending affects the purchasing power available for business and household transactions, such as buying materials, hiring labor, investing in structures and equipment, and buying consumer goods.
9. Interest rate spread, ten-year Treasury bonds less federal funds. The interest rate spread is associated with the stance of monetary policy. A wider spread indicates a looser monetary policy tending toward lower interest rates, and a narrower or negative spread indicates a tighter monetary policy tending toward higher interest rates.
10. Consumer expectations. Household attitudes on the outlook for the economy and their own financial well-being give clues to future household spending. In a sense, expectations are self-fulfilling.
The coincident index measures various aspects of production that reflect the current pace of economic output. It indicates whether the economy is growing or declining, and thus is the primary gauge of expansion and recession periods. The four component economic indicators of the coincident index are as follows:
1. Employees on nonagricultural payrolls. Represents the labor inputs in producing goods and services.
2. Personal income less transfer payments (constant dollars). Real income earned by labor and investors reflects the resources used in producing t nation's output.
3. Industrial production. Because manufacturing, mining, and gas and electric utilities tend to be the more cyclically volatile industries, current production levels in these industries are a good indicator of the cyclical elements in the economy.
4. Manufacturing and trade sales (constant dollars). Movement of goods within the economy between manufacturing plants, from manufacturers to wholesalers, from wholesalers to retailers, and from retailers to households an businesses traces the flows of goods in production and from production to distribution.
The lagging index represents production costs and inventory and debt burden; that may encourage or retard economic growth. A slow increase or a decline if the lagging index is conducive to economic growth, while a rapid increase in the lagging index is conducive to a recession. The lagging index also confirms that a cyclical upturn into a recovery and a cyclical downturn into a recession has occurred. The seven component economic indicators of the lagging index are as follows:
1. Average duration of unemployment. This indicator is plotted on an inverted scale, appearing to rise when the average duration of unemployment actually falls. As the labor market strengthens in an expansion, the ranks of the unemployed come to be dominated by people who have just started to look for work. Unlike the long-term unemployed, they may not jump at the first job offer they receive, and so a low average duration of unemployment is associated with rising wage pressures in the economy.
The link between the duration of unemployment and production costs is that persons unemployed for long periods are assumed to have less marketable skills than those unemployed for short periods. Therefore, recruiting and training costs vary directly with changes in the number of long-term unemployed persons, rising as the long-term unemployed increases and declining as the long-term unemployed decreases.
2. Inventories divided by sales (ratio), manufacturing and trade (constant dollars). Inventories are a major cost factor for businesses. The higher inventories are relative to sales, the more expensive they are to hold, because they entail borrowed money, which results in interest costs, or because they tie up company funds.
3. Labor cost per unit of output, manufacturing (monthly change). Labor costs in relation to production affect profits, which in turn influence decisions to expand or contract production, employment, and investment.
4. Average prime rate charged by banks. Interest rates charged for business loans indicate the cost of borrowing, which affects profits and the willingness to borrow.
5. Commercial and industrial loans outstanding (constant dollars). The interest burden on existing loans is higher, and the availability of money for new loans is lower, the greater the level of outstanding loans.
6. Consumer installment credit outstanding divided by personal income (ratio). The debt burden of consumers suggests they are likely to take on more loans when the ratio is low and thus increase spending and to repay existing loans when the ratio is high and thus decrease spending.
7. Consumer price index for services, (monthly change). Prices of services reflect price pressures stemming from production costs in labor-intensive industries.In assessing monthly changes in the leading, coincident, and lagging composite indexes, the analyst should consider whether the movements represent those of most of the component indicators or if they result from relatively large movements of a small number of the component indicators. The movements of the composites are more significant when most of the components move in a similar direction than when they are driven by large movements in a small number of components.