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August 3, 1c)7c)

Tip-off on Recession
"The most widely heralded recession of
recent times," some analysts are calling it. If
a recession actually did begin this spring as seems likely on the evidence of the
second quarter's 3.3-percent rate of decline
in real GN P - then much of the credit for
calling the turn belongs to the composite
index of leading eCOriomic indicators. This
index. which correctly predicted each of the
preceding five business-cycle peaks, apparently did the same this time, sinceit has
declined in each of the past two quarters and
is now 2 percent below last October's peak.
Many important statistics come out of Washington every month, but the leadingindicators series is rather special. The "big"
numbers - employment, industrial production, personal income, retail sales, and
consumer prices - are all important, of
course, but they simply tell us the current
status of business activity. The leadingindicators series has a more Clmbitious gOClI:
to tell us where the economy is going in the
future. GenerCllly, it does that quite well.

The composite
The index's unique value comes from the
ability of its twelve components to Clnticipate developments in a number of importClnt
economic activities. These Clctivities span
the economic spectrum
IClbormarkets,
product milrkets, business formCltions,
financial markets, Clndconstruction Clctivity.
The composite index is derived by weighting the twelve components in a way which
indicates their cyclicClI importClnce, by such
measures as cycl iCClI
timing, closeness of fit
to the overClI! business cycle, and (bta aVClilability.
.
In the words of the Commerce Departnient's
Handbook of Cvc/ic<illnclicators, the

composite index "serves as a summary
measure designed to indicate changes in the
direction of economic activity." The index
thus captures bClsicchClngesin the underlying structure of the economy while those
chClnges are still in the eClrlystages of
development.
The composite index hClsbeen revised
several times over the years, most notably in
late 1c)76. At thClttime, severClIcomponents
were dropped because they lacked timeliness or behaved erraticCllly at the cycliclli
turning points, and were replaced by more
su itable indicators. Another improvement
was the replacement of several series which
were expressed in nominal dollllr terms, llnd
which thus impClrtedlln upwClrd bias to the
index during infilltionllry periods.

Labor and product marl,ets
The labor markets provide two of the index's
components: the averClgeworkweek and the
layoff rate in mllnutJcturing. When business
activity begins to weaken, employers may
reduce the llmount of labor at their disposdl
by laying off workers - or Cllternlltively, by
shortening the workweek in various WllyS,
either through reducing hours, eliminating
overtime or dropping cl shift. Conversely,
when conditions begin to improve, they
mClYreduce IClyoffsor lengthen the
workweek in various wavs. Through sLlch
tentative adjustments, employers can
respond to the first hints of a ch(1tlge in the
business climate.
Similarly, several leading indicators give
signals of impending slack (or tightness) in
product markets and distribution channels.
One such measure is vendor performance; if
more production capacity becomes llvailable in a weakening economv, then

Opinions

expre::,:;ed in tllis newsletter do lien
u,flect the views of the
Bank of San
nnr of tht' Bo"H'd (Jf Covernors of [h(::,Federal
Rese┬Ěrve
an impending downturn, individuals will
tend to restrain spending if their stocks of
money and liquid assets are below desired
levels, and vice versa.

suppliers can provide faster deliverv, and
vice versa. New orders provide another
important clue to cyclical change, since
business firms will cut back on orders if they
find their stock of inventories rising relative
to sales, or vice versa. Sensitive commodity
prices are yet another measure of easing or
tightness in markets; in particular, they
provide a good indicator of shifts in strongly
competitive international markets.

Other indicators refer to impending developments in household spending, such as
new housing permit activity and manufacturers' orders for consumer goods and
materials. Still, these and other indicators do
not show transactions with the ultimate
owner or consumer. Indeed, that point
reflects the basic purpose of the leading
indicators
to detect underlying trends in
various sectors of the economy before they
show up in final markets. The twelve leading
series generally reflect changes in the early
stages of production, which are affected by
business firms' expectations about the future
as well as the feedback from the present state
of the market.

Other components
Business planning fo-r the future affects the
composite index in other ways as well. If the
outlook is cloudy, business people will have
doubts about the wisdom of starting new
enterprises, and net business formations will
decline. On the eve of recession, firms will
reduce or eliminate their contracts for new
plant and equipment. The stock-market
index is in this category also, because
current stock prices reflect the expected
future flow of earnings from assets.

Do leadersreally lead?
The composite index of leading economic
indicators led the turn at every businesscycle change in the past quarter-century.
The index turned down anywhere from one

The composite index includes two financial
series - changes in the real (M2) money
supply, and changes in total liquid assets. In

Components of Index

1. Average

workweek of
workers in manufacturing

production

8. Net change in inventories, on hand and
on order (constant dollars)

2. Index of net business formations

9. Percent change in wholesale prices of
crude non-food materials

1. Index of stock prices (500 stocks)

10. Percent of companies reporting slower
del iveries from vendors

4. Index of new private housing permits

5. Layoff rate in manufacturing (inverted)

11. Money supply, M2 (constant dollars)
12. Percent change in total liquid assets

6. New orders for consumer goods and
Illaterials (constant dollars)

7. New plant-equipment

contracts and

orders (constant dollars)

2

to eight months before the cyclical peak,
and it turned up anywhere from one to six
months before the cyclical trough. On the
average, it led the peak by four months, and
led the trough by three months. Those
figures were computed by using the rule-ofthumb that three months' movement in a
new direction constitutes a new trend - a
rule violated in the present instance, where
the composite index dropped for two
.
quarters in a row, but not for any three consecutive months.

cycl ical upturns, without this tenclencv for
making false predictions.
'
False signals of recession generally have
developed about midway in economic
expansions, on those occasions when the
economy tends to become sluggish for a
period of months. The most obvious case
occurred in 1 966, when the composite
index declined 5 percent from February to
December, as a number of incipient weaknesses developed in the economy. (Actually, 1 966 may not have been much of an
exception, because that sluggish year just
missed being declared a recession year.)
Since the index gives off such frequent
signals of impending recession, perhaps the
net is drawn too fine. But if the statistical net
were coarser, the leading series might miss
the warnings of slowdown and might create
some unpleasant surprises for us.
Herbert Runyon

Unfortunately, the composite index not only
predicted the last six recessions but also
predicted six recessions that didn't happen.
The index seems to share that characteristic
with the stock market, of which it has been
said that it predicted "nine of the last five
postwar recessions." The composite has had
a much better performance anticipating

l eadi n g Indicators
t

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1967:1 00
1 60
150
140
130
1 20
110
1 00

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BANKING DATA-TWELfTH FEDERAL
RESERVE
DISTRICT
(Dollar amounts in millionsl

Selected
Assets
anl::lliabilities
LargeCommercialBanles
Loans (gross, adjusted) and investments*
Loans (gross, adjusted) - total#
Commercial and industrial
Real estate
Loans to individuals
Securities loans
U.S. Treasury securities*
Other securities*
Demand deposits - total#
Demand deposits - adjusted
Savings deposits - total
Time deposits
total#
Individuals, part. & corp.
(Large negotiable CD's)

WeeldyAverages
of Daily figures
MemberBani,Reserve
Position

Amount
Outstanding
7(18/79

128,823
106,349
30,762
38,832
22,104
1,742
7,593
14,881
43,454
31,434
30,578
49,909
41,471
17,150

Change
from

Change from
year ago@
Dollar
Percent

7/11/79

-

'-

-

-

-

175
124
69
237
64
88
11
80
662
635
38
99
42
298

+ 17,661
+ 16,659
+ 3,434
+ 8,234

15.89
18.57
+ 12.57
26.91

NA
NA
-

+
+
+
+
+
+
-

Weekended

Weekended

7/18/79

7/11/79

Excess Reserves (+ )/Deficiency (- )
Borrowings
Net free reserves ( + l/Net borrowed( - )

NA
NA

372
1,374
2,837
1,954
59
4,532
5,434
513

4.67
10.17
6.98
6.63
l.93
9.99
15.08
2.90

-

Comparable
year-ago period

4
281
285

6

84
78

93
57
36

federal funds- Seven
LargeBanks
Net interbank transactions
[Purchases (+ l/Sales (-)1
Net, U.5. Securities dealer transactions
[Loans (+ )/Borrowings (- II

'" epeAaNa o4ePI
euozpV
e)lselV

+ 1,634
+

113

+ 2,063
+

388

+

80

+ 647

* Excludes trading account securities.
# Includes items not shown separately.

@ Historicaldataare not strictly comparable to changes the reportingpanel;however,
due
in
adjustments
havebeenappliedto 1978 datato remove muchaspossible effectsof the changes coverage.
as
the
in
In

addition,for someitems,historicaldataarenot available to definitionalchanges.
due
Editorialcomments
maybe addressed theeditor (William Burke) to the author.... Free
to
or
copies this
of
andother Federal
Reserve
publications beobtained callingor writing the PublicInformation
can
by
Section,
Federal
Reserve
Bani,of Sanfrancisco,P.O.Box7702, SanFrancisco
94120. Phone
(415) 544-2184.