Leading Indicators

Leading Indicator Definition

Leading indicators are set of statistics about economic activities that help in macro-economic forecasts of the economy and emerging stages of business cycles across the industry by acting as a variable with economic linkage providing information about early signs of turning points in business cycles which precedes the coincident and lagging indicators.

How are Leading Indicators Helpful?

For macro-economic policy decision making it is necessary to know the state of economic cycle i.e. whether the economy is in the expansionary phase or whether it is moving towards the recessionary phase so that counter-cyclical stabilization policies can be implemented. For understanding the same, different data points of a series of economic variables are used which gives information about the state of the economy in past, present and future predictions. These data points are called economic indicators.

Economic indicators are categorized based on their timings into three viz leading indicators which forecast the turning points of economic activities, coincident indicators which give a real-time state of economic activities and lagging indicatorsLagging IndicatorsLagging indicators are used to identify long-term trends or economic patterns by referencing to a series of economic activities that occurred in the past. They can't predict the future because lagging indicators only shift when major economic events occur.read more which reflect the past economic activities.

Leading indicators help economists to predict the future trajectory of economic activities forecasts the direction of GDP and thus helps in better macro-economic policy decision making.

Leading Indicator

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Leading Indicator Examples

Given below are the examples –

US economy list of indicators

LeadingCoincidentalLagging
Avg. weekly manufacturing hoursEmployees on payrollPayrollPayroll refers to the overall compensation payable by any organization to its employees on a certain date for a specific period of services they have provided in the entity. This total net pay comprises salary, wages, bonus, commission, deduction, perquisites, and other benefits.read more (excluding agriculture)Average unemployment duration
Avg. weekly unemployment insurance claimsInsurance ClaimsAn insurance claim refers to the demand by the policyholder to the insurance provider for compensating losses incurred due to an event covered by the policy. The company either validates or denies the claim based on their assessment and nature of the incurred losses.read morePersonal income levelsInventory to sales ratio (showing inventory turnover/ buildup)
Manufacturers’ new orders in consumer goods and non- defense capital goodsIndustrial productionLabor cost per unit of output
Vendor performanceManufacturing and trading salesAverage prime rate Commercial and industrial loans
Building Permits Stock Index Consumer installment credit to personal income ratio
Money supply and interest rate spread  
Consumer expectation Index  

Germany economy list of indicators

LeadingCoincidental
New ordersIndustrial production
The yield spread 10 years compared to 3 monthsManufacturing and retail sales
Changes in inventoriesPersons employed
Gross enterprise and property income 
Stock prices 
Residential constructions 
Services consumer price index- a growth rate 
Consumer Confidence Index 

Leading Indicators Methodology

The leading indicator approach was first brought out post-1930 depression by Burns and Mitchell. Economic Cycle Research Institute (ECRI) founded by Dr. Geoffrey Moore established the first list of 8 indicators viz, Commodity prices of sensitive commodities, Average workweek of manufacturing, Building contracts, New incorporations of companies, Orders released, Housing statistics, Index of Stock prices, Liabilities due to Business failures.

Later, the US conference board started publishing these indicators. From 1980, the Organization of Economic Cooperation and Development (OCED) started publishing CLI (Composite Leading Indicator) index for major countries.

  • The first stage of leading indicator identification and indexing is to identify the growth cycles. In the growth cycle, an adjustment needs to be made for seasonality and short-term irregularities. The second is to identify turning points. Tuning points can be identified by Bry and Boschan’s rule and by Artis et al rule.
  • Next, turning point indicators are assessed for quality by measuring the efficiency of leads through mean and standard deviation. Further analysis is done to identify indicators as per OCED guidelines, viz, cross-correlation, coherence and mean delay, Dynamic factor analysis, common component variable, cyclical classifications. Self-organizing maps can also be used for the selection of lead indicators.
  • After the selection of lead indicators, an index is then developed to analyze and compare the movements. The index is developed through linear and non-linear frameworks. The linear framework can be created using the diffusion index – measuring the proportion of indicators of economic activities that are experiencing expansion in a given span of time.

Other methods are the Stock and Watson approach which uses a common trend principle, Autoregressive distributed lag method which uses GDP as a reference point. Nonlinear frameworks are a Probit model or logistics model where discrete regression analysis is used, Markov – switching autoregressive model is also used.

Benefits

  • Help to identify and predict future trends and events in the economy. They are used for forecasting the overall economic activity.
  • Help in identifying and tracking the growth cycles in the economy.
  • Help to take corrective measures in advance to counter economic trends.
  • Lead indicators are major macroeconomic variables and help in macro-economic policy decisions.
  • Monetary policy framework can be used as a countercyclical measure by relying on lead indicators
  • Adequate early warnings of cyclical indicators of economic activities are provided by lead indicators.
  • Help in getting the overall view of the economy, unlike the lagging indicators which focus on short term performance.

Limitations

  • These indicators are difficult to identify.
  • Leading indicator measurement is difficult and may not be accurate.
  • It involves qualitative factors and accurate quantification of the same may be difficult.
  • Validation of lead indicators may be a challenge and they may not match closely with actuals.

Conclusion

Leading indicators are dynamic variables which help in identifying turning points in economic activities. Prediction of economic trends is possible by way of tracking such indicators through an appropriate index. However, as they are not accurate, the actuals may not be equivalent to lead indicators. Lead indicators help in designing macro-economic policies by designing countercyclical policies to tackle economic cycles of boom and bustsCycles Of Boom And BustsBoom and Bust Cycle is the Gross Domestic Product (GDP) cycle of upward and downward movements along with its long term trend. It helps identify the level of production in the economy and the performance of the associated economic indicators such as employment, inflation, stock performance, and investor behavior.read more.

They can provide early signs of upturn or downturn in GDP. Investors and government bodies can use these indicators to predict the direction of the economy and making importing investing and policy decisions. It thus helps in taking proactive actions to achieve economic and other strategic goals.

This has been a guide to what is leading indicators and its definition. Here we discuss the need and methodology for leading indicators along with the examples. You can learn more about finance from the following articles –

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