Leading Indicator
A second forecasting method, pioneered at the National Bureau of Economic Research, exploits observed historical timing relationships through the use of certain that have in the past given advance warning of economic events.
For example, the stock market is a leading indicator because stock market downturns normally begin several months before downturns in industrial production. Why does this happen? Does the decline in the stock market cause economic downturns by reducing consumer spending? Or are both the stock market and industrial production just reacting to some other influence, with the stock market’s reaction coming sooner? Certainly these are fascinating questions. But the answers may not be crucial to a forecaster if the stock market continues to be as good a leading indicator of industrial production in the future as it has been in the past. In that event, we will be able to make use of the observed relationship between stock prices and industrial production for forecasting even if we do not entirely understand its origins.
As it turns out, however, excessive reliance on any single leading indicator produces an unimpressive forecasting record. An obvious solution is to look at many indicators. But once we start to do this, we will often receive conflicting signals. If one indicator is rising rapidly while another is falling, what are we to do?
One way to resolve this conflict is to form an average of several leading indicators. For example, every month the news media report the latest reading on the Commerce Department’s composite index, which is a weighted average of 11 of their leading indicators. The agreement is usually quite good. The leading indicators occasionally call for a recession that never comes (as in 1966), and occasionally they give clear early warning signals of a downturn (as in 1973 and 1979). But often movements of the leading indicators are followed so closely by movements in real gross national product that the advance warning they provide comes too late to be of much use to policymakers.
