Economic indicators: how to look for economic recovery in 2009

An economic indicator is any statistic (e.g. the unemployment rate or GDP) which indicates the past, current or future strength of the economy

THERE is talk about town and in the media of an economic upturn in the final quarter of 2009 – “banks are lending, consumers are buying, and companies are hiring.”  While it is not possible to predict the movement of the economy with any level of certainty, and recent history has reminded us of this fact, it is important for business people and government policy makers to have some idea of what lies ahead.

The practice of reading omens in order to foretell the future has been employed since ancient times. In ancient Rome, priests known as “Augurs” would determine the will of the gods by studying the flight of birds, while other persons known as “Haruspices” practiced a form of divination which involved inspecting the entrails of sacrificed animals.

Things have progressed a little since then. Today economists devine the future by examining “economic indicators”.

Economic Indicators

In order to assess the likely strength of the economy in the future, economists look at “economic indicators”.

An economic indicator is any economic statistic (e.g. the unemployment rate, GDP, or the inflation rate), which indicates the current strength of the economy and/or the future strength of the economy.

Economic indicators are generally classified by reference to  two attributes:

  1. Correlation with the strength economy; and
  2. Contemporaneousness with the strength of the economy (let me know if you can think of a simpler word)

1. Correlation

If an economic indicator is “correlated” with the economy, then we would expect a change in the value of the economic indicator to correspond with a movement in the economy.  The correlation of an economic indicator may be described as procyclical, countercyclical, or acyclical:

  1. Procyclical: A procyclical economic indicator is one that moves in the same direction as the economy. For example, Gross Domestic Product (GDP) is a procyclic economic indicator because it gets larger as the economy gets stronger.
  2. Countercyclical: A countercyclical economic indicator is one that moves in the opposite direction as the economy. For example, the unemployment rate is a countercyclical economic indicator because it gets larger as the economy gets weaker.
  3. Acyclical: An acyclical economic indicator is one that has no relationship to the economy and is generally of little use in predicting the future strength of the economy.

2. Contemporaneousness

Contemporaneousness refers to the timing of the change in the economic indicator relative to the movement in the economy.  The contemporaneousness of an economic indicator may be described as leading, lagged, or coincident:

  1. Leading: A leading economic indicator changes before the economy changes. For example, construction activity is a leading indicator as the level of construction activity usually begins to decline before the economy declines and improve before the economy improves. Leading economic indicators are the most important type of indicator for investors, business people and policy makers because they help to predict the future performance of the economy.
  2. Lagged: A lagged economic indicator is one that does not change direction until a few quarters after the economy does. For example, the unemployment rate is a lagged economic indicator because it typically takes at least two quarters to decrease after the economy begins to recover.
  3. Coincident: A coincident economic indicator is one that moves at the same time as the economy does. For example, Gross Domestic Product is a coincident indicator.

Economic recession 2008: measuring the strength of the economy

It’s the economy, stupid

IT’S THE economy, stupid” is a well known phrase that was widely used during Bill Clinton‘s 1992 presidential campaign against George Bush senior. The phrase was coined by Clinton campaign strategist James Carville and refers to the notion that Clinton was a better choice because Bush had not adequately addressed the economy, which had recently headed into a recession. Clinton went on to win a decisive victory.

Having entered the second quarter of 2008, the American economy may be heading towards a recession once again.

What is a recession?

Broadly speaking, a recession is a period of slow or negative economic growth, usually accompanied by rising unemployment. Economists have other more precise definitions of a recession, the easiest of which to understand is “two consecutive quarters of falling GDP”.

This definition was borrowed from the Economist A-Z, which is a really useful resource for understanding economic terms. I have added it to my list of useful links.

Strength of the US economy

A key contributor to the current weakness of the US economy is the sub-prime mortgage crisis. To indicate the magnitude of the losses suffered from the crisis, it is useful to note that the largest US bank, Citigroup Inc., has alone incurred more than US$45 billion of write-downs and credit losses since 30 June 2007.

In order to stimulate the American economy, the Federal Reserve has slashed the Federal Funds Rate by 2.75% between 18 September 2007 and 30 April 2008.

Gordon Brown, George Soros and Warren Buffett are all of the opinion that America, and the world at large, is currently facing its worst financial crisis since the 1930s. In particular, Warren Buffet was quoted by the LA Times on May 5 saying, “I would say that we’re in a recession, clearly”.

In the first three months of 2008, the US economy managed to achieve a modest annual growth rate of 0.6%. So, at least according to the precise Economists’ definition provided above, the US is not yet in a recession.

However, things are far from in the clear. Reuters reports that Scotia Capital senior currency strategist Camilla Sutton outlined that there are some very negative indicators for the strength of the US economy in the short term,

[T]he housing market has yet to bottom, consumer confidence is at multi-decade lows, employment growth has evaporated and high commodity prices are … exacerbating an already weak economic backdrop.

Bearing all of this in mind, concern about the short term strength of the US economy was sparked yesterday, May 6, when US crude oil prices hit a record high of US$120.36 a barrel. The rising price of oil (and food) is contributing to a higher US inflation rate. The US inflation rate, for the 12 months ending March 2008, was 4.0%. This compares with an inflation rate for the same period last year of 2.8%. Inflation is a procyclical coincident economic indicator because price levels tend to rise when the economy is booming. However, the rising price of oil is being driven by booming developing economies, in particular India and China, and not from growth in the US economy. Higher oil prices are also being driven by the uncertainty of oil supply resulting from political unrest in certain oil producing countries and interruptions in supply due to extreme weather conditions, leading to higher prices and slower growth in the US economy.

There is some cause for optimism however. According to the Times Online, recent economic data on the American economy (measuring things like jobs, GDP, business confidence, industrial orders and consumer spending) indicates that, although the US economy weakened abruptly in the final quarter of 2007 (October to December), the US economy is not nearly as weak as it has been at the start of previous recessions.

Strength of the world economy

According to the IMF, the growth prospects for the world economy in 2008 appear to be strong.

In the IMF’s World Economic Outlook, published in October 2007, the IMF indicates that global economic growth is predicted to be 4.75% in 2008. Interestingly, this prediction is made in light of the fact that financial market strains might trigger a more pronounced slowdown in the world economy.

Growth in developing countries appears to be the main driver for the expected strong global economic growth in 2008. In 2007, economic growth in China, Russia and India accounted for half of global economic growth. The IMF indicates that in 2008, the Chinese economy is expected to grow by 10% and the Indian economy by 8.4%. This is an extremely fast rate of economic growth, which would see the size of the Chinese economy double in less than 8 years.

If you enjoyed this article, you may want to read about The benefits of an economic recession and how to prepare for one, on the James Cox finance blog.