General Economic Concepts
What is Policy?
History of Macroeconomic Policies in the United States
Policy Goals: Maximum Employment
Policy Goals: Maximum Production
Policy Goals: Price Stability
Policy Goals: External Balance
Subsidiary Policy Goals
Conflicting Policy Goals
The Policy Makers
The Policy Instruments
The Decision-Making Processes
The Policy Indicators
The General Economic Model
Monetarist Monetary and Fiscal Policies
Keynesian Monetary and Fiscal Policies
Debt Management Policies
Supply Management Policies
The Long Wave
I. What is an Indicator?
- What is an Indicator?
- Index of Leading Economic Indicators
- Other Leading Indicators
- Diffusion Indexes
- Consumer Sentiment Indexes
- Yield Curves
- Coincident Indicators
- Lagging Indicators
- Ratios of the Leading, Coincident, and Lagging Indexes
- Effectiveness Indicators
An indicator is a variable or group of variables that provide policy makers with information. This information has two different types of value. Ex ante, before a policy measure is implemented, an indicator has predictive value. Ex post, after a policy measure has been implemented, an indicator has effectiveness value.
The first type of indicator predicts what kind of economic activity can be anticipated by policy makers and precedes their decision to act or not to act. These indicators signal policy makers on the need for action. They tell policy makers if the economy is too weak or too strong — if a recession is on its way, or inflationary pressures are building. While some economists debate the quality of established economic indicators, most economists agree that some indicator is better than no indicator. Policy makers do require some measure of the future course of economic activity, if they are to choose the right course of action. They need some variable or variables to serve as a warning signal that a change is policy is desirable. The only question is which variable or variables do the best job of predicting the future course of economic activity. Some established predictive indicators are the Index of Leading Economic Indicators, Diffusion Indexes, Yield Curves, the Index of Coincident Indicators, and the Index of Lagging Indicators.
The second type of indicator shows the effectiveness of policies after decision-makers have implemented their chosen action. They follow from specific policy actions and tell policy makers if the direction and magnitude of the chosen action is having the desired effect on the general level of economic activity. Some economists also debate the merits of indicators for policy effectiveness. However, most economists agree that some indicator is necessary. Future policies depend upon the current thrust of past policies. Policy makers require feedback from their actions, and since the lag time between a change in the policy instruments and their effect on the ultimate goals is rather lengthy, some variable or variables should serve to alert the policy makers on the "thrust" — the magnitude and direction — of current policy actions. The only question is which variable or variables do the best job in signaling to policy makers the effectiveness of policy decisions. The best indicator variables depend upon the type of policy and whether the expected transmission mechanism is Monetarist or Keynesian.
II. Index of Leading Economic Indicators
Leading indicators precede aggregate economic activity to signal policy makers on the current state of the economy. If the economy is expected to expand on its own, no further stimulus is needed. On the other hand, if the leading indicators turn sluggish, then the policy makers can prepare to add more stimulus.
Every month, the Conference Board calculates and publishes the Index of Leading Economic Indicators (LEI). The index is a composite of the values of ten economic series whose behavior and changes in behavior occur prior to changes in aggregate economic activity. The ten economic series are average weekly manufacturing hours, real money supply, interest rate spread, vendor performance, building permits, manufacturers' new orders for consumer goods and materials, average weekly initial claims for unemployment insurance (inverted), manufacturers' new orders for nondefense capital goods, consumer expectations, and stock prices.
The LEI is expected to predict or forecast future economic activity. At the same time, the LEI signals policy makers on the magnitude and direction of current policies and their impact on economic activity. When the index turns up, recovery from a recession can be expected in about three months. Expansionary policies are achieving their goals. As long as it continues to rise, an expansion is under way.
As the expansion proceeds, policy makers can judge whether past policies are having the desired effect, or if they have become overly expansive and inflationary. When the index turns down, the peak of an expansion is near. If it continues to decline (for three months), a recession will generally occur six months after its peak. Past policies may have been too restrictive, in which case, policy makers can vary the instruments to alter the future course of economic activity.
Advantage of the LEI
The LEI is a first approximation of the prospects for future economic activity.
Disadvantages of the LEI
The LEI has been extremely misleading on many occasions.
The LEI has not been consistent over time. The original index dates back to 1937 when then-Treasury Secretary Henry Morgenthau asked the private National Bureau of Economic Research to draw up a list of statistical measures that would best indicate when the Great Depression was ending. The various indexes were first calculated and published by the Commerce Department in 1938. Since then, the components and formulas have been altered several times. Methodology, Revisions, and Other Information
- The LEI has a wide and variable lead time On average, the LEI has tended to predict recessions with a 9.7 month lead and recoveries with a 4.6 month lead. However, the actual lead times have varied from 2-20 months for a recession and 1-10 months for a recovery. With such wide variations in lead times, policy makers can only anticipate and prepare for a policy change, but must await further evidence that a policy change is, in fact, necessary.
- The LEI predicts recessions which never occur Some economists say that three straight monthly declines in the LEI portend a recession. But based on this approach, the index sometimes predicts recessions that never arrive. For example, the index peaked in the fall of 1987 and fell in the last three months of that year, but the economy grew 3.3% in 1988. Other economists look for sixth months of decline before predicting a recession.
- The LEI rises or falls because of specific factors that cause temporary disturbances For example, in December 1986, a 2.1% increase in the index was considered an aberration because of a change in California law affecting building permits and a surge in new car sales to tale advantage of sales tax deductibility prior to the execution of the Tax Reform Act on January 1, 1987.
- Not all of the components carry the same weight in predicting future economic activity Changes in the money supply are only important if income velocity, the rate at which the money supply is being turned over to buy newly produced goods and services, is stable. Changes in stock prices are only relevant if household and business spending is a function of wealth. On the other hand, changes in the average factory workweek, unemployment claims, vendor deliveries, and raw materials prices, have a much more direct impact on economic activity.
The LEI is more reliable over the longer-term, although its long-term reliability is also debatable. The index relies heavily on factors affecting manufacturing and the production, distribution, and sale of physical goods. As the composition of output shifts from manufactured goods to services, the components of the index become less relevant and the index may prove less valuable as a forecasting technique.
- Deletions In March, 1987, the Index of Net Business Formation was deleted from the aggregate index. The Commerce Department determined that net business formations were no longer an accurate measure of anticipated business activity. Since more new businesses are in the service sector, their establishment became more difficult to monitor. Likewise, deregulation of the telephone industry made it more difficult to calculate new phone connections.
In 1988, the Commerce Department removed Change in Inventories on Hand from the aggregate index. This number was always available, only with a one-month lag. Therefore, the index was subject to revision each succeeding month when the change from two months prior became available.
- Additions In 1989, the Commerce Department added two different categories to the aggregate index: Changes in Manufacturers' unfilled orders and Index of Consumer Expectations.
- Corrections In 1993, the Commerce Department attempted to correct the weighting problem, because the former formula was distorted the cyclical pattern of the index in periods of slow growth. The new index contained the same 11 economic measures, but the weights were changed. The four components dealing specifically with economic activity — weekly hours of manufacturing workers, average weekly new claims for jobless benefits, new factory orders for consumer goods and materials, and changes in manufacturers' backlogs of orders — increased in weight. Six components dealing indirectly with economic activity — consumer expectations, money supply, stock prices, changes in commodity prices, building permits for new houses, and the pace at which vendors are delivering to factories — decreased in weight. One component — orders for plant and equipment — carried the same weight.
In 1996, after the Conference Board assumed responsibility for the LEI, two of the 11 series — change in manufacturers' unfilled orders for durable goods and change in sensitive materials prices — were deleted and a new series, interest rate spread — the difference between the 10-year Treasury bond yield and the federal funds rate — was added. The new series, a variation of the yield curve, has become widely accepted as a useful forecasting variable that is related to the stance of monetary policy.
The LEI can be a useful leading indicator of short-term interest rate peaks, not in its original form, but as a deviation from its 48 month moving average. The 48 month average approximates the length of the average business cycle. By dividing each month's index value by this 48 month moving average, a clearer picture of the cyclical behavior of the leading indicators over the course of an "average" business cycle emerges. As long as the leading index is above this moving average, it is highly unlikely that the contracting economy has reduced the demand for credit enough to reach a peak in the interest rate cycle. During expansion, a peak in the interest rate cycle is signaled if the leading indicators fall below their 48 month moving average.
III. Other Leading Indicators
Construction Indexes and New Housing Starts
Construction spending and new housing begin with contracting and proceed to the completed building. New construction affects the output of southern pine lumber, oak flooring, and plumbing fixtures, whose indexes also tend to precede economic activity.
The economic activity generated by construction spending is only the beginning in a series of spending decisions. Once the buildings are completed, they need to be furnished. Furnishing the completed buildings accelerates an expansion. Innovations lead to building early in the business cycle, but this spending slows down when plant and equipment have been built to produce the new product.
Since construction is generally financed, the rate of new construction and housing starts indicates the ease of credit relative to the expected profitability of construction. As monetary and fiscal policies become more restrictive, credit tightens, interest rates rise, and new construction and housing starts slow.
New (Private) Home Sales
New home sales are an indicator of the current strength of the economy as well as its near-term health. Since homes are relatively expensive and generally financed with mortgages, an increase in new home sales signals easy credit and loose, expansionary monetary and fiscal policies. Also, since new homes must be furnished, recent sales are an indicator of future spending on home furnishings and further economic activity. A decline in new home sales would indicate restrictive credit and tightness in monetary and fiscal policies. Accompanying a slow down in new home sales will probably be a slow down in additional spending on home furnishings and economic activity.
Inventory conditions play a crucial role in short-term economic behavior. Rapid liquidation of inventories suggests that demand has achieved dominance over supply and that production activity will require increased production in the near future. Rapidly rising inventories suggest that supply has achieved dominance over demand and that production activity will begin to slow in the near future. Inventory accumulation and decumulation are measured in two ways.
Change in Business Inventories indicates the rate at which current production is proceeding and the extent to which businesses are anticipating future sales. If these sales materialize, businesses will continue to produce more. If they do not, production will slow.
Inventory-Sales Ratio is generally a leading indicator of the stance of monetary and fiscal policy. A decrease in the ratio indicates a drain on inventories relative to sales. As inventories decumulate, businesses must spend more on production to replenish their stocks. An increase in the ratio indicates a build up of inventories relative to sales. As inventories accumulate, businesses need to spend much less on the production of more goods. Because the inventory-sales ratio is negatively related to future economic activity, its inverted version — the sales/inventory ratio — has been suggested as a better alternative.
In the course of trade, changes in sales tend to precede changes in the costs of production. Since profits are a residual, what is left over after all expenses have been paid out of sales, an increase in sales will tend to pull up profits before costs during an expansion. As demand slows, profits decline before costs, which are based on contractual arrangements. During a contraction, profits tend to fall faster than costs. Since profits depend on spending, and spending depends on income and money balances, an increase in profits indicates a sufficient amount of income and money balances available for spending and relatively loose or easy monetary and fiscal policies. A decrease in profits indicates insufficient income and money balances and more restrictive demand management policies.
As an economy reaches its peak, the decline in profits is sufficiently large to start a rash of business failures. Firms, which have not managed to remain cost-efficient and whose costs have risen relative to its competitors (or whose demand has fallen faster than that of its competitors), are driven out of the market. As a contraction proceeds and the least efficient firms are forced from the market, the number of firms left is smaller. Those that do remain are generally the stronger ones who have weathered the storm and are less likely to fail. Therefore, the number of business failures falls to virtually zero.
Producer Price Index
The Producer Price Index (PPI) is generally a leading indicator of inflation (deflation) in the Consumer Price Index. Since the PPI represents changes in the costs of production, these costs will generally be reflected in the prices of final goods and services about six months later (the average production gestation period). When the PPI rises, the CPI will rise. When the PPI falls, the CPI will fall or increase more slowly. (Generally, the changes in the CPI are not so large as changes in the PPI because of administered pricing in most retail markets.) A rising PPI indicates an expansionary (inflationary) set of demand management policies, while a decline indicates a contractionary (deflationary) set of demand management policies. Many of the same arguments can be made for farm prices or raw materials prices, since any change is, first, felt at the wholesale level and, second, at the retail level.
Expected Capital Outlays
The Department of Commerce surveys businesses for their expected outlays on plant and equipment in the next six months to a year. While these plans can be withdrawn without cost and are thus much more erratic and less dependable than ongoing production, they act as an indicator of business optimism or pessimism for the future and signal to policy makers whether policies are too loose or restrictive.
The Anxious Index is a concensus of a group of panelists on the probability of a decline in GDP in the next quarter. It is published by the Philadelphia Federal Reserve District Bank. The index often goes up just before recessions begin, peaks during recessions, and declines when recovery seems near. Anxious Index Chart
IV. Diffusion Indexes
The Conference Board keeps a tabulation of twenty economic series and then calculates the Diffusion Index based on the percentage of rising series. A diffusion index measures the dispersion of variation about a mean. It tells policy makers how wide spread the trend in economic activity is. During an expansion, more than half of the series are rising, and, during a contraction or period of slow growth, less than half of the series are rising. A diffusion index tends to peak about half way through an expansion and to bottom out about half way through a recession. A reversal in the index signals to policy makers to expect a reversal in the general economic trend in the near future.
V. Consumer Sentiment Indexes
The Conference Board and the University of Michigan calculate indexes of consumer sentiment from random surveys of households. These indexes measure consumers' attitudes, their satisfaction with their financial condition, their personal expectations of the future, and their buying plans for individual consumer products. While consumers can change their minds, the indexes tell policy makers what consumers would do if current trends continue. Since consumer spending accounts for about 75% of all final GNP transactions, policy makers knowledge of prospective spending plans is important in their calculation of policy decisions. In addition, policy makers can gauge the effectiveness of their policies from prospective expectations and spending plans of households. When policies are expansionary and the economy is growing, consumers generally have a better outlook for the future than when policies are restrictive and the economy is contracting or growing very slowly.
In addition, the Conference Board generates a Help-Wanted Advertising Index
and a CEO Confidence Survey. The Help-Wanted Advertising Index is a key barometer of supply and demand in the U.S. job market. It is constructed from surveys of the help-wanted advertising volume in 51 major newspapers across the country every month. When the index increases, businesses are expected to hire more workers. When it declines, businesses are expected to hire fewer workers. The CEO Confidence Survey is a measure of business expectations for sales and profits for the next six months. It is constructed from a survey of 100 CEOs in a wide variety of industries. When the index increases, businesses are expecting sales and profits to increase. When it declines, businesses are expecting sales and profits to decrease.
VI. Yield Curves
The Term Structure of Interest Rates
The term structure of interest rates shows the relationship between the yields (rates of return) on financial instruments of comparable unsytematic risk and their maturities. The difference between long-term rates and short-term rates is a measure of risk over time.
The Yield Curve
The yield curve is a graphical representation of the term structure of interest rates. The graph to the right is a pictorial representation of the yield curve for U.S. government securities. The yield curve is often measured as the spread between a long-term interest rate and a short-term interest rate. The Conference Board uses the spread between the 10-year T-bond rate and the federal funds rate. Other researchers use the spread between the 10-year T-bond rate and the 3-month T-bill rate, the 10-year T-bond rate and the 12-month T-bill rate, and the 30-year T-bond rate and the 12-month T-bill rate.
|PROTOTYPICAL SHAPES OF THE YIELD CURVES
||Inverted yield curve: Slopes downward (C). Yields fall as maturity lengthens. Spread between long-term interest rate and short-term interest rate is negative.
Flat yield curve: Flat; no slope (B). Yields remain constant as maturity lengthens. Spread between long-term interest rate and short-term interest rate is zero.
Normal yield curve: Slopes upward (A). Yields rise as maturity lengthens. Spread between long-term interest rate and short-term interest rate is positive.
Interest Rate Cycles
Interest rates move up and down in cyclical fashion. The yield curve "wiggle-waggles" over the interest rate cycle. Interest rate cycles may be caused by changing expectations, business cycles, or monetary policy. The shape of the yield curve (direction and magnitude of long-term/short-term interest rate spread) predicts economic activity. A normal yield curve (positive spread) generally predicts expansion, an inverted yield curve (negative spread) generally predicts contraction, and a flat yield curve (no spread) generally predicts slow growth or no change in current economic conditions.
|REAL WORLD YIELD CURVES
Interest rates fluctuate in response to changing expectations about the direction of interest rate movements. When interest rates are low, expectations are that interest rates will rise. At this point in the cycle, most lenders prefer to stay liquid (short-term) in anticipation of rising interest rates. Very few lenders are willing to finance long-term for fear of capital losses from rising interest rates. Excess demand for short-term securities raises their prices and depresses their yields. At the same time, a dearth of lenders in the long-term markets creates an excess supply of long-term securities, depressing their prices and raising their yields. Thus, when interest rates are low, the yield curve is normal.
As interest rates rise, borrowers and lenders revise their expectations about the future course of interest rates. With each rise in interest rates, the yield curve shifts up. As lenders expect that interest rates are reaching some peak, they shift from short-term securities into long-term securities. Initially, this shift has the effect of "flattening" the yield curve. When all lenders expect that interest rates have peaked, they shift out of short-term securities completely and into long-term securities. The sell-off in the short-term markets creates an excess supply of short-term securities, depressing their prices and raising their yields. At the same time, the shift to long-term securities creates excess demand for long-term securities, pulling up their prices and depressing their yields. At the peak of an interest rate cycle, the yield curve is inverted.
As interest rates fall, the yield curve initially shifts down parallel to its inverted shape at the peak. However, as interest rates continue to fall, various lenders expect that interest rates have bottomed out. They sell off long-term securities, take capital gains, and buy short-term securities in anticipation of the next rise in interest rates. This gradual sell-off has the tendency to flatten, the yield curve, until interest rates have reached some low level, at which time, all lenders shift from long-term securities into short-term securities and the yield curve resorts to its normal shape.
Interest rates fluctuate over the life of a business cycle. Interest rates are low coming out of a recession and rise as the economy expands. Interest rates are high at the peak of an expansion and fall as the economy contracts.
During a contraction, businesses are pessimistic about the future. Instead of borrowing to finance new capital projects, they liquidate debt and accumulate cash. Households are similarly pessimistic and also liquidate debt and accumulate cash. At the trough of a business cycle, households and businesses are cash-rich, but the preference for liquidity is paramount. No one is sure if the contraction is over and no one wants to lend long-term for fear of defaults. The demand for short-term securities is high, pulling up their prices and depressing their yields, while the demand for long term securities is low, pushing down their prices and raising their yields. Thus, the yield curve is normal after the trough in a business cycle.
During the recovery, businesses first use their cash to buy working capital. As cash is exhausted, businesses turn to banks and the financial markets to borrow short-term to finance working capital. As short-term borrowing increases, short-term securities prices fall and short-term interest rates rise. As the economy expands, businesses become more optimistic and confident about the future. When excess capacity is exhausted, they borrow long-term to finance capital expansion. As long-term borrowing increases, long-term prices fall and long-term interest rates rise. Households similarly become more optimistic and confident about the future. They spend down their cash balances first and then extend themselves with new borrowing. Household borrowing is generally medium to long-term for durable goods and homes, which pulls up medium to long-term interest rates. Thus, the yield curve is normal throughout the expansion phase of a business cycle even as interest rates rise across the board.
As interest rates rise, more saving is directed out of short-term securities and into long-term securities to take advantage of their higher returns. Short-term rates rise as long-term rates fall, and the yield curve flattens out. At the same time, the fixed coverage ratio for households and businesses falls. More income is needed to service the additional debt. During an expansion, businesses are generally able to raise prices to service their debt, and households generally get generous wage increases to service their debt. At the peak of an expansion, however, households become resistant to price increases and the demand goods and services falls. Businesses must seek additional short-term financing to keep up production and service their debt. Short-term interest rates rise above long-term interest rates, inverting the yield curve at the peak of a business cycle.
At the peak of a business cycle, profits are squeezed from higher interest rates and lower revenues. Businesses become pessimistic and less confident about the future. They stop borrowing long-term for capital expansion, cut back on production, slow wage increases, and start laying off workers. Households also become pessimistic and less confident and stop borrowing long-term. Unemployment rises as income falls. Banks raise lending rates and tighten credit standards. As the general level of economic activity declines, businesses and households borrow less and try to liquidate their high-interest debt either through repayment, which causes spending to fall further, or through bankruptcy, which causes lenders to be more cautious. Interest rates fall and the yield curve initially shifts down parallel to its inverted shape at the peak. Thus, the yield curve is inverted throughout the contraction phase of a business cycle even as interest rates fall across the board.
As interest rates fall, lenders sell long-term securities and buy short-term securities or hold cash. The sell-off in the long-term markets creates an excess supply of long-term securities, depressing their prices and raising their yields. At the same time, the shift to short-term securities creates excess demand for short-term securities, pulling up their prices and depressing their yields. With each decline in interest rates, the yield curve flattens out. At the trough of a business cycle, the yield curve is flat. With signs of a recovery, the yield curve returns to its normal shape.
Monetary Policy Cycles
Interest rates fluctuate in response to monetary policy changes. The central bank is the monetary policy maker. Its primary goal is to achieve non-inflationary economic growth. When the economy is growing too fast and inflation is increasing, the central bank raises interest rates. It sells T-bills, which causes short-term securities prices to fall and their yields to rise. This action inverts the yield curve and tends to slow the economy or induce a contraction. When the economy is growing too slowly (or contracting) and inflation is low (or deflation is present), the central bank lowers interest rates. It buys T-bills, which causes short-term securities prices to rise and their yields to fall. This action creates a normal yield curve and tends to foster economic recovery and/or faster growth.
VII. Coincident Indicators
Coincident indicators respond fairly closely to current economic activity. However, since there is generally a lag in the execution of monetary and fiscal policies, the coincident indicators, per se, are a reflection of past policies, not the current ones.
Index of Coincident Economic Indicators
Every month, the Conference Board calculates and publishes the Index of Coincident Economic Indicators. The index is a composite of the values of four economic series that move in tandem with the general level of economic activity. The four economic series industrial production, employees on nonagricultural payrolls, manufacturing and trade sales, and personal income less transfer payments. The purpose of the indicator is to assess the current strength of economic activity. At the same time, it signals policy makers on the effectiveness of past policies and their impact on current economic activity. When the index turns up, recovery from a recession is under way. Previous expansionary policies are achieving their goals. As long as it continues to rise, an expansion is under way. As the expansion proceeds, policy makers can adjudge whether past policies are having the desired effect, or if they have become overly expansive and inflationary. When the index turns down, the expansion has peaked. If it continues to decline (for three months), a recession is generally under way. Past policies may have been too restrictive, in which case, policy makers can vary the instruments to alter the future course of economic activity.
Other Coincident Indicators
General Economic Activity Gross National Product (Gross Domestic Product), Industrial Production, and Capacity Utilization tend to reflect the current level of economic activity, since all of these measures represent current spending on newly produced goods and services.
Employment and Hours of Work Employment in nonagricultural establishments tends to rise and fall in tandem with the general level of economic activity. However, the Bureau of Labor Statistics' index of average hours worked per week tends to lead economic activity, indicating a preference by business for adjusting world hours before actual employment decisions are revised.
VIII. Lagging Indicators
Lagging indicators follow the general trend in economic activity. When the lagging indicators turn up, a recession is over and the economy is definitely in an expansion. When the lagging indicators turn down, a boom is over and the economy is definitely in a contraction. Lagging indicators can be used to evaluate the success of past policies.
Index of Lagging Economic Indicators
Every month the Conference Board calculates and publishes its Index of Lagging Economic Indicators. The index is a composite of the values of seven economic series that lag the general level of economic activity. The seven economic series are CPI for services, commercial and industrial loans outstanding, average duration of unemployment (inverted), change in labor cost per unit of output, ratio of manufacturing and trade inventories to sales, average prime rate charged by banks, and ratio of consumer installment credit to personal income. The purpose of the indicator is to determine when recession or boom is over. At the same time, it signals policy makers on the success or failure of past policies. When the index turns up, a recession is over. Expansionary policies have achieved their goals. As long as it continues to rise, an expansion is under way. As the expansion proceeds, policy makers can judge whether past policies have had the desired effect, or if they have become overly expansive and inflationary. Or, perhaps, the parameters used to set policy are changing, in which case the lagging indicators signal policy makers to review the assumptions under which current policy is being developed and executed.
Other Lagging Indicators
Wages Most labor is locked into a bargaining agreement for one to three years at a time. Thus, changes in demand are only slowly reflected in changing wage contracts for labor. The more accommodating management is in successive negotiations, the more liberal are current monetary and fiscal policies. Management can finance wage increases on favorable terms.
Interest rates Typically, interest rates lag prices by about two years. Interest rates on loans, notes, bonds, and other debt instruments are also contracted, sometimes for as little as ninety days, but in many cases for ten to thirty years. As such, interest rates are generally "sticky" and tend to lag economic activity. The actual stickiness of interest rates depends on the average maturity of borrowings and the ability of lenders to reprice debt instruments. Since 1980, the extensive use of variable-rate instruments to offset interest-rate risk from longer-term lending has probably reduced the lag between changes in prices and economic activity and changes in interest rates.
IX. Ratios of the Leading, Coincident, and Lagging Indexes
Ratios of the Leading, Coincident, and Lagging Indexes indicate inflections and turning points in economic activity.
Leading Index/Coincident Index Ratio
The ratio of leading indicators to coincident indicators precedes major turning points in economic activity.
The ratio increases if the leading index rises and/or the coincident index falls It also increases if the leading index rises faster than the coincident index or if the leading index falls more slowly than the coincident index. The ratio indicates an inflection during the downturn of a business cycle, signaling that a contraction is beginning to bottom out. The ratio rises during the latter stages of a contraction, indicating that a recovery is near. As long as the ratio is rising, the severity of the contraction is slowing and/or a recovery is under way.
The ratio decreases if the leading index falls and/or the coincident index rises It also decreases if the leading index falls faster than the coincident index or if the leading index rises more slowly than the coincident index. The ratio indicates an inflection during the upturn of a business cycle, signaling that an expansion is beginning to peak. The ratio falls during the latter stages of expansion, indicating that a recession is near. As long as the ratio is falling, the magnitude of the expansion is slowing and/or a recession is under way.
Coincident Index/Lagging Index Ratio
The ratio of coincident indicators to lagging indicators parallels or mimics economic activity throughout the business cycle. Indicates major turning points.
The ratio increases if the coincident index rises and/or the lagging index falls It also increases if the coincident index rises faster than the lagging index or if the coincident index falls more slowly than the lagging index. The ratio indicates a trough of a business cycle, signaling that a recovery is beginning. It rises during an expansion. As long as the ratio is rising, the economy is expanding.
The ratio decreases if the coincident index falls and/or the lagging index rises It also decreases if the coincident index falls faster than the lagging index or if the coincident index rises more slowly than the lagging index. The ratio indicates a peak of a business cycle, signaling that a recession is beginning. It falls during a contraction. As long as the ratio is falling, the economy is contracting.
X. Effectiveness Indicators
Some economic variables are specifically representative of the impact of individual policies under certain conditions. These variables are called effectiveness indicators. The effectiveness of a given monetary or fiscal policy is measured by different variables.
Fiscal Policy Indicators
Prices and interest rates If monetary policy has been relatively consistent, then interest rates, the money supply, raw material prices, etc., and changes in these variables will signal the ease or restrictiveness of fiscal policy. For example, if the federal budget deficit is too large, financing will put upward pressure on interest rates and spending will put upward pressure on prices. If the federal budget is in surplus or the deficit is too small, interest rates and prices may fall, indicating recessionary tendencies.
The full employment or high employment budget surplus (HES) The full-employment or high employment surplus budget is also an indicator of the impact of fiscal policy. If the government is trying to stimulate the economy, but the HES is in surplus, then fiscal policy is too contractionary. If the government is trying to restrain the economy, but the HES budget is in deficit, then fiscal policy is too expansionary.
Monetary Policy Indicators
Even though monetary policy is a macroeconomic policy measure, designed to influence the general level of economic activity and prices, its effect is distributed unevenly throughout the economy. Since monetary policy has its most direct impact on the money markets and interest rates, the interest-sensitive sectors are the first to respond to changes in monetary policy. Therefore, to determine the ease or restrictiveness of monetary policy such variables as housing permits or starts, capital spending, inventory levels, consumer spending on durable goods (versus nondurable goods), raw material prices, etc. are key indicators of the looseness or tightness of monetary policy.
Monetary-policy Targets and Indicators, T.R. Saving, Journal of Political Economy: Supplement, 75 1967: 446-65
Making Monetary and Fiscal Policy, G.L. Bach, Brookings Institute, Washington, DC, 1971: ch. 3
Targets, Instruments, and Indicators of Monetary Policy, B.M. Friedman, Journal of Monetary Economics, I 1975: 443-73
The U.S. Economy Demystified, Albert T. Sommers, D.C. Heath and Co., Lexington, MA, 1985: chs. 2, 3, 4
Economy: Leading Index to be Prepared by New Method - Agency Goal is a Better Job of Predicting Changes in Economy's Direction, David Wessel, Wall Street Journal, 23 Nov 1993: A2
Predicting Real Growth Using the Yield Curve, Joseph G. Haubrich and Ann M. Dombrosky, Economic Review (FRBClev). 32(1) 1Q96
Strengthening the Case for the Yield Curve as a Predictor of U.S. Recessions, Michael Dueker, Review (FRBStL), 79(2) Mar/Apr 1997
Accelerating Money Growth: Is M2 Telling Us Something? John B. Carlson, Economic Commentary (FRBClev), Nov 1997
U.S. Monetary Policy and Financial Markets, Anne-Marie Meulendyke, FRBNY, 1998
What is the single most important economic indicator for policymakers: Gross Domestic Product, job growth, the stock market, the unemployment rate, the Consumer Price Index, or the index of leading economic indicators? Dr. Econ, FRBSF, Nov 1999
Press Release Calendar, Conference Board
Surveys of Consumers, University of Michigan