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 indicators 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 Examples
Given below are the examples –
US economy list of indicators
|Avg. weekly manufacturing hours||Employees on payroll (excluding agriculture)||Average unemployment duration|
|Avg. weekly unemployment insurance claims||Personal income levels||Inventory to sales ratio (showing inventory turnover/ buildup)|
|Manufacturers’ new orders in consumer goods and non- defense capital goods||Industrial production||Labor cost per unit of output|
|Vendor performance||Manufacturing and trading sales||Average 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
|New orders||Industrial production|
|The yield spread 10 years compared to 3 months||Manufacturing and retail sales|
|Changes in inventories||Persons employed|
|Gross enterprise and property income|
|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.
- 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.
- 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.
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 busts.
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 –