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July 9,1 982

The RecessionIs Over?
The Commerce Department's index of leading economic indicators increased for the
third straight month in May, and to many
analysts that suggeststhat the recession is just
about over. The index,generally is a reliable
cyclical indicator, normally turning up three
months or so before each trough in business
activity, and turning downward for a considerably longer period before each businesscycle peak is reached. Given the index's
importance as a forecasting tool, it would be
worthwhile to review the components of this
measure and to evaluate its success in leading
cyclical turning points throughout all the ups
and downs of the past generation.
I
The Commerce Department selects the
twelve components of the overall series for
their consistency of behavior at businesscycle peaks and troughs, and for their economic significance and statistical adequacy
and availability. An increase or decrease in
the composite index does not mean that the
individual series are all moving in the same
direction simultaneously. Rather it means
that most of the 12 series, adjusted for their
relative importance, are moving in the same
direction. All ofthe individual indicators are
highly accurate forecasters of coming trends.
As individual series, however, they someti mes generate false signals because of random data fluctuations, so we gain a certain
safety in numbers by combining them into a
larger index.
The Commerce Department does not choose
the components of this series for their importance as overall economic indicators. Sales
and employment data, which are far more
comprehensive in scope, are listed as coincidental series, while the closely-watched unemployment rate considerably lags the turns
in business activity. For the leading series, in
contrast, Commerce chooses statistics on the
basis of their consistency in leading the turning points of the business cycle.ltthen groups
the series into four major categories-Iabor-

market trends, capital investment, inventory
investment, and financial flows-as shown
below with relative weights.

labor market (17.5%)
Two series labeled "marginal employment
adjustment" afford an early clue to changes
taking place in the utilization of the labor
force. The two series -the average work
week in manufacturing and new unemployment-compensation claims-provide a foretaste of a declining economy prior to a peak
in business-cycle activity. Conversely, as
the economic climate starts to improve, the
average factory work week lengthens as the
demand for labor increases, while the number of new claims for jobless compensation
declines.
Capitalinvestment23.7%)
(
Two series in this category deal with brickand-mortar capital projects and capital
equipment-the number of new building
permits for private housing and the real value
of contracts and orders for plant and equipment. There are substantial lags involved in
both cases. The lag between permits for new
homes and their actual construction generally runs about three months or so. In the
industrial field, the lag between purchase
commitment and actual delivery may vary
from several months for off-the-shelf items of
equipmentto several years for large structures.
New business incorporations represent a
third major capital-investment commitment.
Founders of new businesses organize those
enterprises when they expect an improvement in the general tone of business activity,
although their actual capital expenditures
may be far in the future. Current feelings of
optimism (or pessimism) thus lead to decisions to create new business firms, which
then in turn lead to capital commitments at
some future date.

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Opinions expressed in this newsletter do not
necessarily reflect the views of the management
of the Federal Reserve Bank of San Francisco,
or of the Board of Governors of the Federal
Reserve System.
public devotes first attention to rebuilding its
stock of financial assets.

Inventory investment (32.0%)
New orders for consumer goods represent
one important indicator, since they reflect the
state of futu re demand by retai lers. (Most consumption goods are produced for stock rather
than for special order.) A second indicatorvendor performance-indicates the slowness or rapidity of deliveries and, hence,
pressures on supply. Deliveries generally
become slower as business activity expands
and as production bottlenecks and materials
shortages begin to appear. A third indicator,
measuring changes in inventories, again
reflects the state of business confidence. If
sales are brisk, for example, business firms
wi II try to stock a fu II range of goods and
reorder as necessary to avoid losing sales for
lack of stock, so that stocks wi II expand at an
accelerated pace.

Also crucial is the behavior of the money
supply, since changes in this aggregate work
with a variable lag upon the major economic
indicators. Money-supply changes generally
precede shifts in output and employment by
two to four quarters, but generally precede
change in prices and interest rates by six to
eight quarters.
A third series, the Standard and Poor stock
price index, represents a measure of changes
incorporate profitability. Stock prices represent the present or discounted value of a
stream offuture income. Changes in expectations regarding the value of this future-income
stream will be reflected in the present value
(price) of stock shares. Increases or decreases
in the stock index therefore will indicate expectations of greater or less profitabi Iity.

A fourth indicator measures changes in sensitive prices-that is, wholesale prices of crude
materials which have undergone no processing and thus are entering organized markets
for the first time. The prices of such materials
generally are quite sensitive to changes in
demand, given a relatively fixed supply comi ng on to the market. The prospect of an
expanding business trend thus will lead to
rising prices, while the prospect of declining
activity normally will lead to a fall in such
prices.

Importance of index
The leading-indicators series derives its
importance, of course, from the fact that it
generally precedes turning points in the overall national economy, as designated by the
National Bureau of Economic Research (see
chart). Over seven business cycles from the
July 1953 peak through the July 1981 peak,
the leading indicator series generally led the
cycl ical peak by some eightto fifteen months,
with an average lead of about ten months. In
contrast, the leading-indicator series ied the
lower turning point by from one month to six
months, with an average of less than four
months. The difference reflects the fact that
cyclical expansions normally last much
longer than contractions; specifically, expansions have averaged 39 months over the past
generation compared with the 11-months
average for cyclical contractions.

Financial flows (26.9%)
The Commerce statisticians have given
heavier weights to each of the financial indicators than to any of the other leading indicator series. (Only one other series-new
unemployment claims (8.9%) -can match
the importance of any of these financial series.) The highest weight goes to changes in
total liquid assets,which is a comprehensive
series including the monetary aggregates and
most short-term market instruments ranging
fmm Treasury bills to commercial paper. The
importance of this series stems from the fact
that as the stock of liquid assets rises, the
public feels more confident about boosting
spending, and as asset holdings decline, the

Does a one-month change in the leadingindicators index portend a shift in cyclical
activity? Not necessarily; the composite
index picks up a certain amount of statistical
"noise" from the component series, reflect-

2

ing short-run random movements which do
not represent basic changes in the direction
of the national economy. The composite index thus should show several consecutive
months of sign change (positive or negative)
as the minimum indication of a change in the
direction of economic activity. In a recession
period, for example, signs shifting from the
minus to the plus column should indicate a
shift from cyclical recession to expansionwhich describes the present situation quite
closely.

1966 and December 1966, the composite
index declined consistently for a number of
months. The decline was not followed by an
official recession in either case. However, the
series could be considered vindicated by the
fact that real GN P weakened substantially
throughout all of 1955 and again throughout
all of 1 966.
There is no such ambiguity in the present
situation. May's third consecutive plus sign in
the leading-indicator series suggeststhat the
bottom of the recession, given the lags involved, may have been reached just around
mid year. This squares with the predictions of
most business forecasters, who see the second half as a period of recovery and expansion. Continued plus signs in the composite
series shou Id add more statistical weight to
thei r forecast.
Herbert Runyon

Reliability of signals
Does the leading-indicators series ever forecast cyclical-turning points which never arrive? Only two false signals can be detected
in the cyclical record of the past generation,
and there was a reason for the shift in each of
those two cases. Between September 1955
and June 1 956 and again between March

Index of Leading Indicators
1 967=1 00
1 50
130
110
90
70

50

1955

1 960

1965

u.s.

Source:
Department of Commerce
Shaded areasindicate recessions

3

1970

1975

1 980

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BANKING DATA-TWELFTH
FEDERAL
RESERVE
DISTRICT
(Dollar amounts in millions)

Selected
Assets liabilities
and
large Commercial
Banks
Loans (gross,adjusted)and investments*
Loans (gross,adjusted)- total #
Commercial and industrial
Real estate
Loansto individuals
Securitiesloans
U.s. Treasurysecurities*
Other securities*
Demand deposits - total#
Demand deposits - adjusted
Savingsdeposits - total
Time deposits - total#
Individuals, part. & corp.
(Largenegotiable CD's)

WeeklyAverages
of Daily Figures
MemberBankReserve
Position
ExcessReserves+ )/Deficiency (- )
(
Borrowings
Net free reserves(+)/Net borrowed(- )

Amount
Outstanding
6/23/82

159,422
138,813
43,467
56,981
23,349
2,265
6,559
14,050
37,174
26,117
30,227
94,696
84,999
34,432
Weekended
6/23/82
108
25
83

Changefrom
year ago
Dollar
Percent

Change
from
6/16/82

-

143
116
12
58
22

107
38
11
-2,836
-1,241
559
339
340
692
Weekended
6/16/82

-

21
8
13

8,964
10,115
5,029
4,219
291
604
212
1,363
2,625
1,883
301
13,444
12,942
3,880

6.0
7.9
13.1
8.0
1.3
36.4
3.3
8.9
6.6
6.7
1.0
16.5
18.0
12.7

Comparable
year-agoperiod

-

50
359
309

* Excludestrading account securities.
# Includes items not shown separately.

Editorial
comments beaddressed theeditor(WilliamBurke) to theauthor.... Free
may
to
or
copies this
of
andotherFederal
Reserve
publications beobtained calling writingthePublic
can
by
or
Information
Section,
Federal
Reserve of SanFrancisco, Box7702,SanFrancisco
Bank
P.O.
94120.
Phone
(415)544-2184.