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JEb11\\ (0\, IN JI ((2) dof @\jI)l if 0 CO) 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·rve 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 p t p t 1967:1 00 1 60 150 140 130 1 20 110 1 00 90 3 a 4eln .. !!eMeH '" e!UJoJ!le:) CD) 4I\illWJC@1 J:JU1! 'J!I1! 'O:>SPU1! S J ZSL 'ON GI Vd 's'n 11\1 SS'VD 1SMB W 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.