Leading Economic Indicator: What is it and Why Should You Care?

The Conference Board released the most recent data on the U.S. Leading Economic Indicator. This is probably one of those economic indicators that you may see the headline or read the news story but not truly understand what the index is, how it is constructed or what it is intended to accomplish. More importantly, you may wonder if it is even something you should care about. So, let’s go behind the headlines and take a little deeper look at the U.S. Leading Economic Indicator.

First, the financial world loves acronyms since many of the economic indicators are a mouthful to articulate. In this case, the common reference to the U.S. Leading Economic Indicator is simply the LEI.

What is the LEI?

The LEI is produced by the Conference Board and composed of 10 economic data points:

Index	Weighting   in the LEI
Average weekly hours in manufacturing	27.13%
ISM new orders index	16.06%
Average consumer expectations for business conditions	14.68%
Interest rate spread (10-year Treasury bonds minus Fed Funds)	11.02%
Leading Credit Index	8.32%
Manufacturers’ new order for consumer goods and materials	8.30%
Manufacturers’ new orders for nondefense capital goods, excluding   aircraft	4.09%
Stock prices, S&P 500	3.92%
Average weekly initial claims for unemployment insurance	3.36%
Building permits for new private housing units	3.12%

 

What is the purpose or intent of the LEI?

The purpose or intent of the LEI is to identify changes in the economy before a big change (i.e. recession or recovery) occurs. Think of it as the economy’s “early warning system”. Many of you probably have a weather app on your cell phone that gives you alerts when the weather is about to change (I just got a severe thunderstorm alert on mine). The LEI is intended to alert us to changes in economic conditions that precede a recession or a recovery. The difference is they don’t have an app for the LEI and you only get the updates monthly rather than instantly!

Why should you care?

Let’s use the weather analogy and relate it to the economy. If you know in advance that the weather is going to change for the worse (i.e. recession) or the better (i.e. recovery) then you have an ability to prepare in advance. If the LEI provides an effective early warning system regarding the health of the economy, then individuals and businesses can prepare for what may be coming.

How accurate has the LEI been as an “early warning system”?

Here is how the LEI has performed since the 1980’s:

Date	LEI	Date	Economy
June 1979	LEI peaked	January 1980	Recession started
May 1980	LEI bottomed	July 1980	Recovery started
November 1980	LEI peaked	July 1981	Recession started
August 1982	LEI bottomed	November 1982	Recovery started
February 1989	LEI peaked	July 1990	Recession started
March 1991	LEI bottomed	March 1991	Recovery started
April 2000	LEI peaked	March 2001	Recession started
October 2001	LEI bottomed	November 2002	Recovery started
March 2006	LEI peaked	December 2007	Recession started
March 2009	LEI bottomed	June 2009	Recovery started

 

As you can see, from a macro perspective, the LEI has provided early warning regarding changes in the economy. As you can also see, there is not a clear pattern of reliability since the early warning time frame has ranged from zero months warning (i.e. the start of the recovery in March 1991) to as long as 21 months advanced warning (i.e. peak in March 2006 until the start of the recession in December 2007).

What is the LEI telling us right now?

Plain and simply, the LEI is telling us that a peak has not yet occurred and thus a recession is not impending.

Remember, the LEI is intended to alert us to changes in the economy; it was not intended to forecast the growth of the economy. Yet, many news stories treat it as an economic forecast and will probably conclude that since the LEI rose faster in August than in July that the forecast is for faster economic growth. The reality is that the LEI rose each consecutive month from March 2013 through December 2013. If the LEI was designed to be a growth forecaster, then that would have led to the conclusion that first quarter economic growth in 2014 would be solid; and yet the U.S. economic growth in the first quarter was negative!

What should be your take-away regarding the LEI?

I believe that the LEI can be a useful “tool” in your “toolbox” for those of you who are trying to gain a better understanding of what is happening with the economy. The key point though is that it is only a tool and not a crystal ball or perfect solution. Two problems exist with the LEI in its current state.

1. Over 55% of the weighting is towards manufacturing and yet the U.S. economy has evolved into a more heavily dominant service economy.
2. Two of the components (almost 15% of the weighting) are being distorted by Federal Reserve intervention in the financial markets. The interest spread and stock prices are both being impacted by actions of the Federal Reserve (i.e. Quantitative Easing and the suppression of short term interest rates).

There are many economic indicators that are released on a monthly basis. Before relying on any of them, you need to understand what the indicator is and what it means. The first step in deciding if an economic indicator is useful for you or your business is gaining an understanding of the index. Now that you know what the LEI is and what it was designed to accomplish, you can decide if it is a useful tool for you or your business.

 

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