What are Economic Indicators and their Importance
Economic
indicators are key stats about the economy that can help you better
understand where the economy is headed. These indicators can help
investors decide when to buy or sell investments. For example, if the
stock market is at its peak, you may want to sell. If the market is low
and on the rise, you may want to buy. Economic indicators can help you
understand the flow of market, as well as other important
financial factors.
Types of Economic Indicators
Leading indicators:
Leading
indicators signal future changes. That means, they usually change
before the economy itself changes. This makes them extremely useful for
short term predictions of economic developments. An example of a leading
indicator is the stock market. Stock market returns usually start to
decline, before the economy as a whole falls into a recession and vice
versa.
Lagging Indicators:
Lagging indicators usually change
after the economy as a whole changes. For that reason, they cannot
directly be used to predict economic changes. They are more useful to
confirm specific patterns (e.g. economic cycles) and make further
predictions from there. Arguably the most popular example of a lagging
indicator is unemployment. Unemployment usually starts to increase a few
quarters after the economy has started to recover from a recession.
Coincident Indicators:
Coincident
indicators occur at about the same time as the changes they signal.
Therefore, they can provide valuable information about the current state
of the economy. An example of a coincident indicator is personal
income. If the economy is strong and business is going well, personal
income rates will increase at about the same time.
Attributes of Economic Indicators:
It may possess one of the three following attributes:
Pro cyclical:
It
is an indicator that moves in a direction similar to the economy. For
example, GDP is pro cyclical because it increases if the economy is
performing well. If the economy is not doing well (i.e., recession), GDP
decreases.
Counter cyclical:
It is an indicator that moves
in the opposite direction of the economy. For example, the unemployment
rate declines if the economy is thriving.
A cyclical:
It is an indicator that bears no relationship to the economy at all.
Few Important Economic Indicators:
Gross Domestic Product (GDP)
GDP
is a lagging indicator. It is one of the first indicators used to gauge
the health of an economy. It represents economic production and growth,
or the size of the economy.
An increase in GDP indicates that
businesses are making more money. It also suggests an increase in the
standard of living for people in that country. If GDP decreases, then it
suggests the reverse.
Balance of Trade
Balance of
trade is a lagging indicator. It’s the net difference between a
country’s value of imports and exports, and shows whether there is a
trade surplus or a trade deficit. A trade surplus is generally
desirable, and shows that there is more money coming into the country
than leaving. A trade deficit shows that there is more money leaving the
country than coming in. Trade deficits can lead to significant domestic
debt. In the long term, a trade deficit can result in a devaluation of
the local currency, since it leads to significant debt. The increase in
debt will reduce the credibility of the local currency. It could also
lead to a major financial burden for future generations, since they will
be forced to pay off that debt.
Inflation
Inflation
measures the cost of goods and services. Inflation has a key effect on
economies and markets. For economies, high inflation discourages savings
and investment, leads to higher interest rates, and ultimately limits
growth. In markets, higher inflation may initially lead to asset price
increases, but ultimately investors will pay lower multiples and real
wealth will decline. The key reports to focus on are the Producer Price
Index (PPI) and Consumer Price Index (CPI). Use a moving average of the
year-over-year change and watch for results that are negative (signaling
deflation) or over four percent.
Housing
In a land of
increasing house prices, banks lend and the economy booms. However, the
housing game has changed. We have lived through the housing collapse, we
expect banks to become more prudent for many years. Weakness in housing
will lead to a drop in lending and economic contraction. Many reports
track housing. New home sales and existing home sales are the most
popular. However, I prefer to look at housing starts and building
permits. Permits are a leading indicator and offer an assessment of
housing demand. When permits are rising, house prices should appreciate
as well.
Spending
We live in a consumption-based society.
As consumers increase their expenditures, the economy grows. While many
surveys attempt to capture people’s feelings about the state of the
economy, behavior is what counts. Look to the monthly retail sales
report for an indication of actual consumer activity.
Consumer Price Index (CPI)
CPI is a lagging indicator, and the U.S. relies on it heavily as one of the best indicators of inflation. This is because changes in inflation can spur the Federal Reserve to make changes to its monetary policy.
CPI measures changes in prices paid for goods and services by urban consumers for a specified month. It’s essentially a measure of the cost of living changes. It offers a gauge of inflation as it relates to purchasing those goods and services.
CPI takes a sampling of several hundred goods and services across 200 categories. CPI does not include Social Security taxes, income, or investments in stocks, bonds or life insurance. However, it does include all sales taxes associated with the purchase of those goods.
Producer Price Index (PPI)
PPI is a coincident indicator that tracks price changes in almost all goods-producing sectors, including mining, manufacturing, agriculture, forestry and fishing. PPI also tracks price changes for an increasing portion of the non-goods-producing sectors of the economy. The report measures prices for finished goods, intermediate goods and crude goods. Prices from thousands of establishments are tracked each month and are recorded on the U.S. Bureau of Labor Statistics website.
PPI is important because it’s the first inflation measure available in the month. It captures price movements on a wholesale level, before price changes show up on the retail level.
Interest Rates
Interest rates are a lagging indicator of economic growth. They are based around the federal funds rate, which is determined by the Federal Open Market Committee (FOMC). When the federal funds rate increases, interest rates increase. The federal funds rate increases or decreases as a result of economic and market events.
When interest rates increase, borrowers are more reluctant to take out loans. This discourages consumers from taking on debt and businesses from expanding, and as a result, GDP growth may become stagnant.
If interest rates are too low, that can lead to an increased demand for money and raise the likelihood of inflation. Raising inflation can distort the economy and the value of its currency. Current interest rates are indicative of the economy’s current condition, and can also suggest where the economy might be headed.
Currency Strength
Currency strength is a lagging indicator. When a country has a strong currency, its purchasing and selling power with other nations is increased. A country with a strong currency can import products at a cheaper rate and sell its products overseas at higher foreign prices. However, when a country has a weaker currency, it can draw in more tourists and encourage other countries to buy its goods since they are cheaper.
Manufacturing Activity
Manufacturing is a leading economic indicator. Durable goods orders are an indicator of manufacturing activity. The term “durable goods” refers to consumer products that usually aren’t replaced for at least a few years, such as refrigerators and cars. Near the end of each month, the Department of Commerce Census Bureau publishes its report on durable goods.
Durable goods orders are a measure of new orders manufacturers receive for those types of goods. An increase in durable goods orders is generally taken as a sign of economic health, while a decline might indicate trouble in the economy. Increases and decreases in durable goods orders may also be associated with increases and decreases in stock indices, respectively.
Income and Wages
Income and wages are a lagging indicator. When the economy is operating properly, earnings should increase to keep up with the average cost of living. However, when incomes decline relative to the average cost of living, it is a sign that employers are either laying off workers, cutting pay rates or reducing employee hours. Declining incomes can also indicate an environment where investments are not performing as well.
Incomes are broken down by different demographics, like age, gender, level of education and ethnicity. These demographics can give insight into how wages change for certain groups. A trend that may affect what seems to be only one smaller group may actually suggest an income problem for the entire country, rather than just the group it initially affects.
There’s no golden rule in investing, but considering these economic indicators one can help themself to make informed investment decisions. The Federal Reserve releases a report known as "the Beige Book" eight times per year. The Beige Book outlines the nation’s economic conditions and it can be a useful resource for investors, economists and analysts. Economic indicators are important to take into account before making any investment decisions. With a little research, you’ll be able to maximize
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