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8: Business Cycle
8.5: Leading, Coincident, and Lagging Economic Indicators

8.5: Leading, Coincident, and Lagging Economic Indicators

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Martin Medeiros
Chabot College

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To better analyze the health of the economy, market participants need to view economic indicators through the lenses of the business cycle. But it is also possible to reverse the focus and have indicators give insight into certain aspects of the business cycle.

If market participants could predict the timing of a business cycle turning point they could make far better decisions. Think of the CEO (chief executive officer) of a large retail corporation. If she knows when the peak turning point of the business cycle will hit, she can make critical adjustments to purchasing and inventory that will allow her firm to better handle the approaching economic downturn. Or picture an unemployed steel worker who was laid off due to a slowdown in business. If he knows when the trough turning point of the business cycle will occur, then he may want to wait before taking another job because the upcoming increase in economic activity may allow him to return to his former job.

How do you predict business cycle turning points? By examining these three types of indicators:

Leading
Coincident
Lagging

Leading indicators anticipate the direction in which the economy is heading. Leading indicators, like business cycles, have peaks and troughs (turning points). Turning points associated with leading indicators take place before the business cycle turning points. Below are some examples of leading indicators:

Building permits, new private housing units: The number of residential building permits issued is an indication of construction activity, which typically leads most other types of economic production.
Stock prices, 500 common stocks: The Standard & Poor’s 500 stock index reflects the price movements of a broad selection of common stocks traded on the New York Stock Exchange. Increases (decreases of the stock index can reflect both the general sentiments of investors and the movements of interest rates, which is usually another good indicator for future economic activity.
Index of consumer expectations: This index reflects changes in consumer attitudes concerning future economic conditions and, therefore, is the only indicator in the leading index that is completely expectations-based. Data are collected in a monthly survey and responses to the questions concerning various economic conditions are classified as positive, negative or unchanged.
Money supply: In inflation-adjusted dollars, this is the M2 version of the money supply. When the money supply does not keep pace with inflation, bank lending may fall in real terms, making it more difficult for the economy to expand. M2 includes currency, demand deposits, other checkable deposits, traveler’s checks, savings deposits, small denomination time deposits, and balances in money market mutual funds.

Coincident

Coincident indicators provide information on the current status of the economy. Turning points associated with coincident indicators take place at roughly the same time as business cycle turning points. Below are some examples of coincident indicators:

Employees on non-agricultural payrolls: It includes full-time and part-time workers and does not distinguish between permanent and temporary employees. Because the changes in this series reflect the actual net hiring and firing of all but agricultural establishments and the smallest businesses in the nation, it is one of the most closely watched series for gauging the health of the economy.
Personal incomeless transfer payments (in 1996 $): The value of the income received from all sources is stated in inflation-adjusted dollars to measure the real salaries and other earnings of all people. Income levels are important because they help determine both aggregate spending and the general health of the economy.
Index of industrial production: This index covers the physical output of all stages of production in the manufacturing, mining, and gas and electric utility industries. It is constructed from numerous sources that measure physical product counts, values of shipments and employment levels.

Lagging indicators turning points change months after a downturn or upturn in the economy has begun and help economists predict the duration of economic downturns or upturns. Below are some examples of lagging indicators:

Average duration of unemployment: This series measures the average duration (in weeks) that individuals counted as unemployed have been out of work. Decreases in the average duration of unemployment invariably occur after an expansion gains strength and the sharpest increases tend to occur after a recession has begun. 
Average prime rate charged by banks: Although the prime rate is considered the benchmark that banks use to establish their interest rates for different types of loans, changes tend to lag behind the movements of general economic activities.
Consumer installment credit outstanding to personal income: This measures the relationship between consumer debt and income. Because consumers tend to hold off personal borrowing until months after a recession ends, this ratio typically shows a trough after personal income has risen for a year or longer.

Wouldn’t it be great if you had a magical device that lets you know when a certain horse will win a race? Or the winning lottery numbers for the upcoming drawing? Life would be a lot easier if we could foretell the future.

Now, talk of fortune-telling may be overselling the benefits the leading indicator provides market participants, but the goal behind using this data is clear: anticipate the direction in which the economy is heading.

Over the years, analysts who have closely followed economic indicators discovered that some indicators behaved in a certain way when compared to past business cycles. See figure 6.

Group 67, Grouped object

Figure 6

Figure 6 is a simplified representation of a fictitious leading indicator that hits its cyclical turning points before those of the business cycle. Figure 7 shows data of an indicator that experiences peaks before the start of most recessions.

Note

An economic indicator that moves in the same direction as the business cycle (up in expansions, down in contractions) is considered to be ‘pro-cyclical’. And an economic indicator that moves in the opposite direction as the business cycle (down in expansions, up in contractions) is ‘counter-cyclical.’ The indicator depicted in figure 6 would be considered a leading, pro-cyclical indicator.

Figure 7

Figure 7 shows New Privately-Owned Housing Units Started, with the blue line representing the raw data and the red line showing a 12-month moving average to smooth out volatility. The peak in housing starts occurred around mid-2005, well before the official start of the 2008 recession (marked by the gray-shaded area). This decline in housing construction was an early warning sign of economic trouble, as the housing market downturn eventually led to the financial crisis. The housing collapse reduced consumer wealth, triggered financial instability, and contributed to a broader economic slowdown, aligning with the peak turning point of the business cycle. This pattern highlights how housing starts serve as a leading economic indicator, often signaling shifts in the business cycle before recessions officially begin.

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