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Home > Research & Data > Research Publications > Business Review > 1996 > Looking Ahead: Leading Indexes for Pennsylvania and New Jersey

Business Review: MaY-June 1996

Looking Ahead: Leading Indexes for Pennsylvania and New Jersey

Theodore M. Crone and Kevin J. Babyak

The following article refers to tables and figures that are not available on this Internet version. To obtain a copy of the printed document, contact Sally Burke.

Business planners and policymakers regularly look for any sign of a change in the direction of the overall economy. Prudent budget directors will reduce their revenue projections when they see indications of a slowdown in the economy. Likewise, prudent business managers will take steps to curtail their inventories. In these attempts to anticipate general business conditions, people look for signals about the economy.

One signal of the future course of the national economy is the traditional composite index of leading indicators, now published by the Conference Board but maintained for many years by the U.S. Department of Commerce.[1] Recently, the National Bureau of Economic Research (NBER) began publishing an alternative leading index, developed as part of its project on cyclical indicators. Both these indexes are meant to foreshadow the direction of the national economy six to nine months ahead.

Many policymakers and business persons, however, are interested not only in the course of the national economy but also in the course of their region's economy. Since 1994 the Federal Reserve Bank of Philadelphia has published monthly indexes of coincident indicators for the three states in the Third Federal Reserve District (see the 1994 article by Crone). These indexes reveal that state recessions do not necessarily coincide with national recessions. Therefore, a natural complement to the coincident indexes would be a set of leading indexes for the states. This article introduces leading indexes for the two largest states in the District Pennsylvania and New Jersey based on the methodology of the NBER's new alternative index for the nation. They are the first state indexes to be developed using this methodology.[2]

LEADING INDEXES OF THE NATIONAL ECONOMY

The origins of the current leading indexes for the nation go back to the late 1930s when Wesley Mitchell and Arthur Burns drew up a list of 71 statistical series that they considered to be reliable indicators of economic recoveries. The list was later extended to include leading indicators of recessions. Lists of coincident and lagging indicators were developed as well. These lists were periodically revised, and over time, the individual indicators were combined to construct composite indexes intended to summarize the information in the individual indicators and give an overall assessment of the economy.

Both the identification of individual indicators and the development of composite indexes have been part of a broader effort to explain business cycles, which Burns and Mitchell described as "a type of fluctuation found in the aggregate economic activity of nations that organize their work mainly in business enterprises: a cycle consists of expansions occurring at about the same time in many economic activities, followed by similarly general recessions, contractions, and revivals which merge into the expansion phase of the next cycle… .; in duration business cycles vary from more than one year to ten or twelve years; they are not divisible into shorter cycles … [that exhibit swings in economic activity of similar] amplitudes."

From a List of Indicators to a Composite Index. The early development of composite indexes was based on the notion that there is a set of indicators that reflects the current state of the economy, a set that reflects the future state of the economy, and a set that reflects past economic activity. Once researchers identified and categorized individual cyclical indicators as coincident, leading, or lagging, the next step was to combine at least some of those indicators into single composite indexes. Since business cycles are defined as broad-based contractions and expansions, combinations of indicators or composite indexes are generally better at tracking the cycles than any single indicator (see the article by Geoffrey Moore). But which indicators should be included in each composite index? And should they all be given the same weight in forming the composite index?[3]

The components of the traditional composite index of leading indicators and the weights assigned to them have changed over the years. Currently, the index is constructed from 11 components (Table 1). As in the case of the coincident and lagging indexes, changes in the leading index are calculated as a weighted average of the monthly changes in each of the components. The current weights for the monthly changes in the components of the index are primarily designed to keep the more volatile series from dominating month-to-month movements in the index.[4] How well does this leading index lead? A leading index can be evaluated either by how well it predicts turning points in the business cycle or by how well it predicts actual changes in some economic indicator at all points in the cycle (see Gary Gorton's article). The most frequent use of the traditional leading index, however, has been to predict turning points in the business cycle, especially economic downturns or recessions.

Several different rules of thumb have been applied to the leading index to determine whether it is signaling a recession. As Gorton points out, these rules of thumb are inherently arbitrary, but the most common rule is that three successive declines in the index forecast a recession within the next nine months. By this rule the traditional index has successfully predicted eight of the nine U.S. recessions since 1948, with leads of two to eight months.[5] But it has also given seven false signals. Once the economy is in a recession, the traditional leading index has generally been slow to signal a recovery using the popular three-month rule. Only three times in the last nine recessions has the index recorded three successive increases before the official beginning of the recovery.[6]

The record of the traditional leading index has not been perfect, but it has been helpful in predicting recessions. Questions are frequently raised, however, about how the index is constructed. A major issue is how the weights for the components are determined (see Vance Martin's article). While the current weights adjust for the volatility of the various components, they do not reflect differences in how broadly the indicators represent the economy or of how consistent they have been in leading recessions or recoveries. Also, as their names suggest, the index of leading indicators ought to lead the index of coincident indicators. And although the same methodology is used to construct the traditional coincident and leading indexes, no statistical technique is employed to ensure that the leading index actually "leads" the coincident index (see the article by Green and Beckman).

A Forecasting Approach to a Leading Index. In the late 1980s under the auspices of the NBER, James Stock and Mark Watson developed an alternative leading index that attempts to respond to some of the questions raised about the traditional index (see the 1994 article by Crone).

In essence, their leading index is a statistical forecast of future economic conditions. The weights assigned to the various components of the index are not set arbitrarily but are determined by how well each component helps predict future conditions. As a first step in their effort to develop alternative measures of the business cycle, Stock and Watson developed a new index of coincident indicators for the economy. With one slight modification this index includes the same series as the traditional one. The major difference between the two lies in the method by which they are constructed. Rather than use some average of the monthly changes in the individual coincident indicators, Stock and Watson use a modern time-series technique known as dynamic factor analysis to estimate what they term the "unobserved state of the economy." This estimated "state of the economy" is their alternative coincident index, and the implicit weights for the individual components are determined in the process of estimating their model.

In practice, the historical pattern of Stock and Watson's new coincident index differs little from the pattern of the traditional coincident index. Both tend to reach their peaks and troughs at or very near the NBER Dating Committee's official peaks and troughs of U.S. business cycles. But Stock and Watson's coincident index provides the basis for their leading index.

Stock and Watson's new leading index differs from its traditional counterpart in more ways than their coincident index does. First, the list of individual indicators Stock and Watson use to construct their leading index varies substantially from the traditional list (Table 2). Their leading index is constructed from their coincident index and seven other indicators, only two of which appear in the list of 11 leading indicators used to construct the traditional index.

More important than the differences in the lists of individual leading indicators is the difference in Stock and Watson's methodology. Rather than constructing a leading index from some average change in the individual indicators, Stock and Watson tie their leading index more closely to their coincident index. If the coincident index truly reflects the state of the economy, a good forecast of the change in the coincident index should make a good leading index. Therefore, Stock and Watson use past changes in their coincident index as well as a number of other variables that have historically led the business cycle to forecast the change in the coincident index over the next six months. This forecasted six-month change in the coincident index becomes their leading index. To produce the forecast they use a common time-series technique called vector autoregression, or VAR. The effect of each indicator on the composite leading index is statistically determined in the process of estimating the forecast.

How well does this new index forecast recessions? Stock and Watson's leading index is available only from 1960. The U.S. economy experienced a recession that year and has suffered five others since then. How well did this new index signal the past five recessions? Since Stock and Watson's leading index is a forecasted change in economic activity, a negative value of their index is analogous to a decline in the traditional index. If we apply the rule of three consecutive negatives to Stock and Watson's leading index, it forecasts four of the five U.S. recessions since the end of 1960 with leads of two to six months. Like the traditional index, Stock and Watson's would not have forecast the 1990-91 recession using the rule of three consecutive negatives.[7] But the Stock and Watson leading index would have resulted in only one false recession signal since 1960 while the traditional index produced six false signals since then.

Thus, over the period for which it is available, the Stock and Watson index foreshadows the same number of recessions as the traditional index but produces considerably fewer false signals (see Figures 1 and 2). Like the traditional index, Stock and Watson's leading index is less helpful in predicting recoveries than in predicting recessions. Using a rule of three consecutive increases, Stock and Watson's index would have predicted two of the last five national recoveries.

LEADING INDEXES FOR THE STATES

Since we have previously constructed coincident or current economic activity indexes for Pennsylvania and New Jersey, we can use Stock and Watson's methodology to construct leading indexes for those two states.[8] Like Stock and Watson's national leading index, our state indexes are forecasts of the change in the state's current activity index. We chose a nine-month forecast to produce an index with a reasonable lead time.[9] In other words, our leading index is a forecast of the total change in the coincident index over the next nine months. Among the variables used in the traditional index or in Stock and Watson's index, only three are available at the state level average hours worked in manufacturing, housing permits, and initial unemployment claims.

Our basic model for the leading indexes includes past changes in housing permits and initial unemployment claims for the states plus past changes in the coincident index.[10] It does not include average hours worked as a separate variable because this variable is a component of the current activity indexes for Pennsylvania and New Jersey and past changes in these indexes are already included in the models for the leading indexes.

We expanded these basic models by adding some interest-rate and regional variables that improved the accuracy of the forecasts without diminishing their ability to signal recessions or without increasing the number of false signals. We found that adding the spread between the six-month commercial-paper rate and the six-month Treasury-bill rate improved our basic forecast model for New Jersey.[11] For Pennsylvania, the forecast was improved by adding the spread between the yield on 10-year Treasury bonds and one-year Treasury notes.

From the Philadelphia Fed's Business Outlook Survey of manufacturers we also have some regional variables that correspond to components of the national leading indexes, namely, new orders, unfilled orders, and delivery time (vendor performance).[12] Neither the regional variable for new orders nor the one for unfilled orders improved the performance of the leading indexes for the states. But the Pennsylvania model was improved by adding the diffusion index for delivery time from the Philadelphia Fed's survey. This diffusion index is the difference between the percentage of respondents reporting an increase in delivery time and the percentage reporting a decrease. (For a complete list of variables in the state models, see Table 3.)

Our leading indexes are the predicted nine-month growth rates for each state's current activity index based on these final models. Any positive value of the state index is a prediction of a cumulative increase in activity over the next nine months; any negative value is a prediction of a cumulative decrease in activity. Figures 3 and 4 present the leading indexes for Pennsylvania and New Jersey from January 1973 to the present.[13]

How Well Have These State Indexes Performed? The rationale for developing leading indexes for the states is based on the notion that recessions in the states do not necessarily coincide with national recessions. Using the current economic activity index developed in 1994, we identified dates for four recessions in Pennsylvania and New Jersey between 1973 and 1994.[14] How well would the leading indexes for the two states have forecast those recessions? If we use the rule that three successive negative readings of the index signal a recession, Pennsylvania's leading index has predicted all four of the state recessions since 1973, with leads of 5 months or more. The index also gave a false signal last year when it was negative for seven consecutive months. Pennsylvania's economy was very weak in 1995, but it did not suffer a recession.

New Jersey's leading index has also predicted all four of that state's recessions since 1973, with leads of one to seven months. New Jersey's index has given two false recession signals, one at the beginning of 1979 and one at the end of 1987. Both of these false signals occurred a little more than a year before the onset of the next recession. Thus, in the last 23 years, the new leading indexes for the states would have predicted all four recessions in Pennsylvania and New Jersey. In addition, the Pennsylvania index would have given one false signal, and the New Jersey index two.

The record of the state indexes is only slightly less accurate than the record of the national Stock and Watson index, which would have given no false signals since 1973 but would have missed calling the most recent recession. Like the national indexes, these state indexes are not as reliable in signaling the end of recessions. Using the three-month rule Pennsylvania's leading index would have predicted recovery from two of the state's four recessions since 1973; New Jersey's index would have predicted recovery from only one of four.

At the end of 1995 the economies of both Pennsylvania and New Jersey were growing at a slower rate than the national average. A record-breaking snow storm in January 1996 reduced economic activity at the beginning of the year. New Jersey's leading index remained positive through the period, forecasting no recession this year. Pennsylvania's index was negative in January 1996 but turned positive again in February; so it too is not signaling a recession this year.

CONCLUSION

Although they do not have a perfect record, leading indexes of the national economy have been helpful in foreshadowing turning points, especially economic downturns. The limited data available at the state and regional level and their greater volatility make it more difficult to construct leading indexes for the states. Despite these difficulties, we have been able to construct leading indexes for Pennsylvania and New Jersey. These indexes have been rather successful in predicting downturns in the state economies over the past 23 years. Because there have been few business cycles over that time, however, a longer history will be necessary before we can make a full evaluation of these leading indexes for Pennsylvania and New Jersey.