The Conference Board has released changes to its Leading Economic Index designed to improve its ability to predict business cycles.
The release of the December 2011 Conference Board Leading Economic Index (LEI) included comprehensive benchmark revisions in addition to the standard annual revision. After reevaluating the ability of the index to provide accurate predictions of future economic conditions, the Conference Board has made changes to four LEI components and has produced a revised set of historical data back to 1959 for the index (as well as the coincident and lagging indexes).This was the second major overhaul since 1996, when the Conference Board assumed ownership of the LEI (revisions were made in 2005 to trend adjustments, as well as to the interest rate component).
The new methodology shows a much sharper decline in the LEI as the Great Recession hit, followed by a more gradual recovery; under the prior methodology, the LEI was at an all-time high by November 2009, while the new LEI has to this point made up just half of the decline from its prerecession peak.
Four of the ten LEI components have been affected by the benchmark revisions:
- The ISM Supplier Delivery Index has been replaced with the ISM New Orders Index, and the level, rather than the month-to-month change, will contribute to the LEI.
Over the past two decades, the ISM supplier delivery index has become less reliable with regard to predicting future economic conditions, so the ISM new orders index has been substituted. As these indicators are themselves diffusion indexes, it is more sensible that the level, rather than the change, factors into the LEI calculation.
- New Orders for Nondefense Capital Goods will now exclude the purchase of aircraft.
Aircraft orders often come in spurts, and it can take years before production begins. The new series excluding aircraft is less volatile and better represents new orders as they relate to production in the short and medium terms.
- Previously standing alone, the Reuters/University of Michigan Consumer Expectations Index will now be averaged with consumer expectations derived from the Conference Board’s Consumer Confidence Survey from 1978 onward.
As for new orders, the level of averaged expectations will contribute to the index. The new consumer expectations component has contributed negatively to the LEI in each of the past six months, while the previous input’s contribution was positive in every month since August. Since the level, not the change, is now driving the component’s contribution, we get a more accurate representation of consumer expectations, which are still well below their normalized averages. This component is likely to continue dragging down the LEI until consumer expectations regain their prerecession levels.
- Beginning in 1990, real money supply (M2) has been replaced with a new Leading Credit Index. Prior to 1990, the real money supply stays in the index.
One of the major criticisms of the index of leading economic indicators was that the three financial components—stock prices, the real money supply, and the slope of the yield curve—were being given too much weight, particularly since the financial crisis. Between May and November of last year, the real money supply and the slope of the yield curve added an average of 0.6% to the LEI each month. The average monthly change in the LEI over that period was 0.5%; the other eight components subtracted an average of 0.1% per month. Removing these two financial components from the index would have resulted in a negative change in the LEI in four of the seven months.
As the Federal Reserve has pumped more money into the economy, the real money supply component has shot up, delivering a significant positive contribution to the LEI in most months (the component has only contributed negatively in five months since January 2010). But a rise in the real money supply could be a signal of fear—a flight to liquidity—rather than a sign that real growth is about to accelerate. The Conference Board has decided to replace the real money supply with a proprietary Leading Credit Index, which they describe as a “small, carefully selected set of component indicators that specifically target business-cycle turning points rather than financial stress or instability.” These include: the two-year swap spread; the spread between three-month LIBOR and three-month T-bill rates; debit balances at margin account at broker dealers; AAII Investors Sentiment; Senior Loan Officers C&I Loan Survey (bank tightening credit to large and medium firms); and Total Finance: Liabilities—Securities Repurchase.
No adjustment has been made to the interest-rate spread component of the LEI. This too has been misleading: if the yield curve is sloped upward (long-term interest rates are higher than short-term rates), the contribution to the LEI is positive, suggesting that future economic conditions will be better. But when short-term interest rates are at zero, it is impossible for the yield curve to be sloped downward. The present upward slope in the yield curve is a signal that investors expect economic conditions to be better at some point in the future, but is not a sign that they expect improvement any time soon.
There is no single indicator that can predict business cycles without fail. The LEI is not a substitute for considered analysis of individual economic indicators. But the newly revised LEI does capture the recent cycle much better than its predecessor.
by Erik Johnson