Economic indicators - types and application

Most economists have opinions about where an economy is in the business cycle. But if you haven't noticed, many of their predictions turn out to be wrong. For example, Ben Bernanke in 2007 (then chairman of the Federal Reserve) predicted that the US was not headed for a recession and that the stock and mortgage markets would be this strong for a long time to come. As we all know, he was wrong.

Since economic experts' forecasts are often unreliable, it's important to gain a better understanding of the economy. By considering the level of certain economic indicators, you can get an idea of where the economy is (for example, whether it is emerging from a crisis or heading towards one), so that you can plan your finances or even your career accordingly.

An economic indicator is a series of economic statistics that allows for the analysis of the economic situation. One of their applications is the analysis of business cycles. There are a variety of economic indicators, such as: unemployment rate, housing construction, consumer price index, industrial production, gross domestic product, retail sales, and others.

Economic indicators can be classified into three categories depending on their timing in relation to the business cycle: leading indicators, lagging indicators, and those that change with the economy and therefore indicate the current state.

Leading Indicators

These indicators usually, but not always, change before the economy as a whole, and are therefore useful as short-term indicators of its direction. This characteristic makes them particularly important to governments and bankers in their task of preventing recessions or other negative economic events. The main indicators are:

1. Stock Exchange

Stock market returns are a leading indicator - the stock market usually declines before the economy as a whole has entered a recession and rises before the economy as a whole has begun its recovery.

Although the stock market is not the most important indicator, it is the one most people turn to first. Since stock prices are based in part on expectations for corporate earnings, the market can indicate the direction of the economy if analysts' expectations are accurate.

For example, the market may suggest that earnings forecasts have increased and therefore the overall economy is expected to be booming. Conversely, the market may indicate that corporate earnings are expected to decline and therefore the economy is likely headed for a recession.

However, there are inherent disadvantages to this forecasting method. First, earnings forecasts may be wrong. Second, the stock market is vulnerable to manipulation. Governments and central banks may use monetary or even fiscal policy tools to keep markets high in order to prevent the public from panicking in the event of an economic crisis.

2. Industrial production

This is another indicator of the state of the economy. It strongly influences GDP (gross domestic product); its increase suggests greater demand for consumer goods and in turn a strong economy. In addition, as workers are required to produce new goods, an increase in industrial activity also stimulates employment and wages.

However, this indicator can also be misleading. For example, sometimes manufactured goods do not reach the end consumer. They may be held in stock by small or large retailers, which increases the cost of owning the assets. Therefore, when looking at industrial production data, it is also important to look at retail sales data. If both are rising, this indicates that there is increased demand for consumer goods. It is also important to look at inventory levels.

3. Production inventories

High inventory levels can reflect two very different things: either demand for inventory is expected to increase, or that there is a current lack of demand.

In the first scenario, businesses are intentionally stockpiling inventory to prepare for a surge in consumption in the coming months. If consumer activity increases as expected, companies with high inventories can meet demand and thus increase their profits. Both are good things for the economy.

In the second scenario, however, high inventories reflect that supply is outstripping demand. Not only does this cost companies money, but it also indicates that retail sales and consumer confidence are down, further indicating that tough times lie ahead.

4. Retail sales

Retail sales are a particularly important indicator and are closely related to the previous two indicators. Strong levels here are directly reflected in a surge in GDP. When sales are growing, companies can hire additional employees to sell and produce more products.

One drawback to this indicator is that it doesn't take into account how people pay for their purchases. If consumers are borrowing to buy goods, it could signal an impending recession if the debt becomes too large to service. However, in general, an increase in retail sales indicates an improvement in the economy.

5. Building permits

They provide an opportunity to predict future levels of real estate supply. High volume here tells us that the construction industry will be active, which means more jobs and again an increase in GDP.

But just like with inventory levels, if more homes are built than consumers are willing to buy, it eats into the profits of builders. To reach monetary equilibrium, home prices are likely to fall, which in turn causes the entire housing market to fall, not just the new-build market.

6. Housing market

A decline in house prices could mean that supply exceeds demand, that assets are unaffordable, or that prices are inflated and need to be adjusted downward. In either case, it has a negative impact on the economy for several key reasons:

– the wealth of the owners is declining;

– the number of construction jobs needed to build new homes is declining, thus increasing unemployment;

– property tax revenues are declining, which limits state resources.

When looking at real estate market data, two of them are key – a change in the value of transactions and the number of transactions. A decline in sales (number of transactions) usually indicates that prices will also fall.

7. Newly created businesses

The number of new businesses entering the economy is another indicator of economic health. Some argue that small businesses employ more workers than larger corporations and thus contribute more to overcoming unemployment.

Furthermore, small businesses can contribute significantly to GDP by introducing innovative ideas and products that stimulate growth. Therefore, the increase in the number of small businesses is an extremely important indicator of the economic well-being of any capitalist country.

8. Government Bond Yield Curve

The difference (spread) between the yields on short-term and long-term (most often 2-year versus 10-year) government securities is also an important indicator of the direction of the economy. From an economic perspective, due to the individual time preferences of individuals, the yield on longer-term bonds should be higher due to the time value of money. You can read more about what the interest rate tells us here. There are cases when this yield curve inverts, i.e. long-term bonds do not yield higher than short-term ones, and this is a strong indicator of an impending crisis.

(Lagging) indicators of economic activity (Lagging Indicator)

Unlike the previous type, this type of indicator marks a change after a corresponding change in the economy. While they usually do not tell us what phase the economy is in, they do show how it is changing over time and can help us identify long-term trends. They usually take several quarters after the initial change in the economy to register a subsequent change.

1. Gross Domestic Product (GDP)

GDP is generally considered by economists to be the most important indicator of the health of an economy. However, it is not a perfect indicator and, like the stock market, GDP can be misleading due to programs such as quantitative easing (monetary policy) and excessive government spending (fiscal policy).

For example, post-crisis measures by governments around the world have at least partially contributed to GDP growth. Furthermore, it is debatable what nominal gross domestic product actually tells us. After all, it simply tells us what has happened, not what will happen. Many economists prefer to use GDP at purchasing power parity. Despite all its shortcomings, GDP is a key indicator of whether a country is in recession or not, and the basic rule here is that when we observe a decline in it for two consecutive quarters, then there is a recession.

2. Income and wages

In a well-functioning economy, profits are rising. When incomes are falling, however, it is a sign that employers are either cutting wages, laying off workers, or hiring them for fewer hours. A decline in incomes can also reflect an environment in which investments are not performing well. Incomes are broken down by various demographics such as gender, age, ethnicity, and education level, showing how wages are changing for different groups.

3. Unemployment rate

This indicator tells us how many people in the labor force are looking for work. In a healthy economy, the unemployment rate will be between 3% and 5%. When unemployment is high, consumers have less money to spend, which negatively affects retail sales, GDP, real estate, stock markets, and other markets. Government debt can also increase through spending stimulus programs and unemployment benefits.

However, like most other indicators, the unemployment rate can be misleading because it reflects only the portion of the unemployed who have actively sought work in the past few months and does not distinguish between those who work full-time and those who work part-time.

4. Индекс на потребителските цени (инфлация)

The Consumer Price Index (CPI) is calculated by measuring the cost of basic goods and services, including vehicles, medical care, professional services, shelter, clothing, transportation, and electronics. Thus, inflation is determined by the average price of a basket of goods and services over a given period of time.

A high rate of inflation can depreciate a currency faster than consumers' incomes can compensate for the depreciation in the currency, thereby reducing consumers' purchasing power and lowering their standard of living.

According to some schools of economics, inflation is not entirely a bad phenomenon, especially if it is in line with changes in consumer income. This is because it is believed to encourage consumption and investment, which can help develop an economy. Otherwise, the value of money held in cash will depreciate under the influence of price inflation.

Deflation is the opposite of inflation, i.e. it is a condition in which prices fall. Although to the average consumer this sounds like a good thing, to mainstream economists it is an indicator that the economy is in bad shape. It occurs when consumers decide to reduce their spending and is often due to a decrease in the money supply. This forces producers to reduce their prices to meet the lower demand, which in turn will affect their profits and they will decrease. This is the mainstream interpretation of economic processes, but this omits the extremely important condition that for the producer it does not matter so much what the price level is, and a far more important indicator is the profit margin, i.e. the difference between revenues and costs.

5. Interest rate

The interest rate is another important indicator of economic growth. You can read more about it here. The base interest rate in an economy these days is determined centrally by an institution called the central bank and is adjusted according to the phase of the economic cycle.

When interest rates rise, as they did in the US in 2018, banks and other lenders have to pay higher interest rates to get money. They, in turn, lend money to borrowers at higher rates, thus encouraging borrowers to borrow less. On the other hand, when interest rates are held at sub-market levels (such as in the years immediately following the Great Recession), it can lead to an increase in the demand for money, inflation, speculative decisions by individuals, and ultimately malinvestment (i.e., "bad" unsustainable investments).

6. Corporate profits

Corporate profits are associated with increases in GDP because they reflect growth in sales or optimization of the production process of companies. They also increase the level of the stock market, as investors look for places to invest their income. What exactly are profits? A reward for those entrepreneurs who have managed to use scarce economic resources in the most efficient way possible and the market, which is the collection of all individuals, has rewarded them for this endeavor.

Profit is achieved when the entrepreneur discovers that the prices of certain factors are undervalued relative to the potential value of the products that these factors, once used, could produce. The reality, however, is that profits are never guaranteed in the free market, and every entrepreneur is prone to making mistakes that must be covered by his own resources.

7. Investment Assets Havens

Gold and silver are often seen as assets that store value and protect owners from currency depreciation or economic downturns. When the economy is in a bad period, the value of these assets increases because people seek them out to protect themselves from negative economic conditions. They are considered to have intrinsic value because they are used in industry, especially silver, while currencies, for example, have no collateral. Furthermore, since these metals are valued in US dollars, any decline in the value of the currency leads to an increase in the price of the metals. Thus, the prices of precious metals can be seen as a reflection of consumer sentiment towards the US dollar and its future.

As for the finale

Since the state of the economy is closely related to consumer sentiment, as can be seen from the indicators listed above, politicians prefer to turn the data into a positive light or manipulate it so that everything looks rosy. Of course, no matter how much some economic analysts claim that there is no bubble in a given market, there are bubbles, and not in one and not in one country thanks to the actions of banking institutions. For this reason, in order to accurately characterize the state of the economy, you should rely on your own critical analysis, and not on some analyst from an "elite" educational institution.

Keep in mind that you should not rely on just one indicator and not draw hasty conclusions before you have seen the big picture.

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The article was originally published on the author's personal blog.