OLMIS

by Dallas Fridley
Published May-25-2010

Consult the Fortune Tiles Rear Mirror Navigation Enter the Echo Chamber The University of Oregon (UO) Index of Economic IndicatorsTM What We've Learned

Part yardstick, part fortuneteller, the composite index blends and distills cyclical economic indicators. But use caution, for while this potion may provide a glimpse of things to come - its foresight can only be confirmed by learning its true identity. Let the diffusion index be your guide.

With the executive summary out of the way, it's time to rediscover economic terms that are rarely whispered in mixed company. Cyclical indicator is simply a fun way of referring to an economic data series that measures the business cycle, broad economic activity or costs. A leading indicator shifts first, before the business cycle - for example housing permits or average weekly hours. Coincident indicators measure broad economic activity, including employees on nonagricultural payrolls, they are the benchmarks used to follow and define the business cycle. Lagging indicators, like the prime rate or the average duration of unemployment, reflect business, consumer and social costs. Accelerated growth in a lagging indicator could signal an imbalance in the economy - like tightening credit markets for businesses and or consumers.

It would be difficult to discuss a composite index without pointing to The Conference Board and its U.S. Business Cycle Indicators. The Conference Board Leading Economic Index® (LEI) is published monthly and is one of the most followed series as it moves in advance of the business cycle - hopefully predicting turning points in economic activity. The index is based on a set of 10 leading indicators which go through about five steps along the way to becoming a registered trademark. Each indicator is adjusted using a "standardization factor" to remove volatility and ensure an equal opportunity to move the index upward or downward - that's step two. Thank goodness The Conference Board publishes its standardization factors.

What do you mean when you say "come back for five more visits, then I'll read your fortune?"

In March, The Conference Board Leading Economic Index advanced 1.4 percent. That's great news - sort of. One observation is never enough, and when it comes to a composite index, it takes at least three and often six observations before the expert will even speak. When the index moves downward for three months it is thought to signal a decline in economic activity, perhaps signaling a recession. The basic rules used to interpret the movement of an index are its duration, its depth and its diffusion - known as the "Three D's". Even with 3D to help interpret the movement, a three-month decline is still short term for a composite index.

Looking at each component and its contribution to the overall movement of the index is also an important step. Each component has a story to tell, and unfortunately this story doesn't have strong job growth in its mix. The good news is that the LEI has a full year of growth in its wake with balanced gains over the past six months and a diffusion index value of 70.0 - meaning seven of the 10 indicators contributed to its gain.

How will we know when we get there? Exactly!

The Conference Board Coincident Economic Index® (CEI) increased 0.1 percent in March to 100.2, following a 0.1 percent gain in February and a flat month in January. The CEI has four components, including: employees on nonagricultural payrolls; personal income less transfer payments; industrial production; and manufacturing and trade sales. The good news is that three of the four components grew over the six-month period ending in March - with a 75 percent diffusion index for the six-month span.

"NO REFUNDS!" - but I have a receipt.

The Conference Board Lagging Economic Index® (LAG) rose by 0.2 percent in March to 107.9. The March increase followed a revised gain of 0.1 percent in February - but in January the LAG index fell 0.3 percent, leaving it unchanged over the quarter. Three components rose in March, led by commercial and industrial loans outstanding. The four remaining components fell in March, with average duration of unemployment (inverted) being the biggest drag. Its six-month diffusion index reached 28.6 in March, with just two components rising and the index falling 1.5 percent. Although the LAG is still falling, the pace has slowed considerably and its components have settled down. The average duration of unemployment continues to have the biggest negative impact on the LAG index and the ratio of consumer installment credit out-standing to personal income has a chicken vs. egg outlook.

The UO Index follows the same basic route used by The Conference Board in constructing its LEI. For information about the steps involved, see www.globalindicators.org.

Like the LEI, the UO Index is a leading indicator, signaling transition points in economic activity. The UO Index is published monthly under the direction of its author, Timothy A. Duy, Director of the Oregon Economic Forum and Adjunct Assistant Professor of Economics. In addition to the UO Index, the Forum also produces the Central Oregon Business Index, the Lane County Business Index and the Portland Metro Business Index. For more information about the Oregon Economic Forum and the UO Index, see http://econforum.uoregon.edu/index.html.

Like most leading indexes, the UO Index often sends mixed messages. By mid-2006 the index fell 1.3 percent (annualized) over a six-month span and the number of improving indicators slipped, with a diffusion index of 37.5 (3-in-8 rising). In the near term the UO Index still pointed to continued growth back in mid-2006 - but the longer term outlook suggested a slower pace of growth. The index declined over six months - but its depth (-1.3%) and its diffusion didn't necessarily suggest recession; more on that outlook later.

A year later, the index was still bouncing around - gaining 0.6 percent in July 2007 and growing 0.1 percent over six months with a diffusion index of 50.0 (half rising). The index still suggested growth in the short term - but credit conditions became a concern. In August the index dropped 0.4 percent with just two indicators rising and six falling. The August drop was enough to send the index down 0.3 percent (annualized) over a six-month span, still the diffusion index stood at 62.5 (5-up, 3-down). The outlook: near term growth and a cut in key interest rates by The Federal Reserve raising hopes.

By October 2007 the UO Index signaled recession was likely imminent. The general rule calls for a drop in index value of greater than 2 percent over six months, coupled with a decline in more than half of its components. The index slid 2.8 percent over the six-month span ending in October, with a diffusion index of just 18.8. The near term called for a weak and possibly recessionary pace of economic activity with the national drag from housing putting a damper on basically everything. The general rule is subject to ongoing scrutiny and the percentage trigger does shift up or down with revisions in the index and its components. Currently a shift of 2.5 percent and a drop in more than half its components over six months is needed to trigger a recessionary warning.

Back to the present day: The UO Index rose 0.2 percent in March 2010, while its six-month outlook really sizzled, with an 11.1 percent annualized change and a perfect 100.0 score for diffusion. Labor market indicators remain a concern, with initial unemployment claims falling but still too high for comfort, and employment services payrolls still waiting on the sidelines. The outlook suggests sustained growth in Oregon although it will take time for hiring to kick in and for unemployment claims to show substantial improvement.

Taken out of context, a composite index really doesn't have much to say about the economy or the direction it is heading. Rather, a leading indicator like the UO Index or the LEI provides a very valuable framework from which to summarize and follow economic activity over time, effectively pointing out turning points in economic activity. The composite index has the effect of smoothing out volatility in its individual components while still providing a context from which to evaluate its impact and contribution to the overall movement.

How will the economy perform over the next six months? Let the composite index be your guide.