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Economic
Tea Leaves, Part II
By Victor A. Canto and Christian Carrillo |
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For that reason, in addition to tracking the great real-time indicator of the stock market a variety of economists focus on a number of surveys that try to measure consumer and business sentiment about the future. The argument being that when consumers are feeling confident about the future they are more likely to spend and hence drive the economy. The most widely used index in this category is the Conference Board's Consumer Confidence Index (charted below). It polls 5,000 households and asks them how they feel about current and future economic conditions.
A similar index is computed by the Purchasing Manager's Index (below), which surveys roughly four-hundred manufacturing executives. Other forward-looking indicators include the Help Wanted Ads and the Leading Economic Indicators (also charted below).
Looking at the troughs and peaks of the chart series above, it appears that the forward-looking indicators do indeed lead real GDP. The lead relationship is a major building block in any forecasting relationship. Knowledge of the indicators may in fact help forecast the path of the economy. Hence, the evidence does suggest that the forward-looking indicators may in fact be useful in forecasting real GDP growth. Looking at the previous four charts, however, it is also clear that the forecast would not be very precise. Keynesians, of course, use many of these indices as inflation indicators. According to Keynesian logic, as capacity utilization and employment increase (or unemployment declines), our ability to churn out more products is strained. To increase capacity, companies have to raise prices and that triggers inflation. The data is not too kind to this Keynesian hypothesis. Looking at the relationship described in the figures below, it is fairly apparent that the peaks in one series are associated with troughs in the other series. The data posit a negative relationship between the rate of change in the Capacity Utilization rate and the inflation rate (below, top) as well as a negative relationship between the rate of increase in employment levels and the inflation rate (below, bottom).
The relationship identified in these charts are the opposite of what the Keynesian hypothesis predicts. An increase in the growth rate of the employment level, the capacity utilization rate, or the leading indicators is associated with lower, not higher, inflation. Looking at the data it is also apparent that the amplitude of the fluctuations changes dramatically around the early 1980s, and from that point on, the negative relationship appears to be weaker and almost nonexistent. The story with the unemployment rate (charted below) is quite different. It appears that during the pre-1980s period, inflation leads the unemployment rate. Thus, if one takes the temporal precedence as a causal relation, we end up with inflation causing unemployment, not the other way around. How can we explain this relationship? Bracket creep. Rising inflation pushes people into higher marginal tax rates, destroying incentives to work and produce. The higher tax rate produces lower output and higher inflation, or as we used to call it in the '70s: stagflation (a situation that is close to a theoretical impossibility in the simple Keynesian model — - yet we lived through it!).
A final point to make is that the relationship between inflation and the various indicators weakens significantly from the 1980s onward. The answer to this little puzzle lies in the price rule. Recall the workings of the price rule: Whenever the inflation rate is above the target level there is too much money in the system, so the Fed pulls money out by selling bonds in the open market. On the other hand, when the inflation rate falls below the target rate there is too little money in the system, so the Fed corrects the deficiency by buying bonds in the open market, thereby increasing the quantity of money in the economy. If the Fed adheres to a strict price rule there should be no systematic relationship between the real economy and the inflation rate. In fact, in an idealized case, the inflation rate will remain constant irrespective of the fluctuations in the real economy. However, to the extent that the price rule is not strictly adhered to, or that there are violations of the price rule, a systematic relationship will be observed between the inflation rate and the real economy. Looking at the last three charts, it is apparent that since the 1980s, inflation has steadied around the 2% to 3% range. Furthermore, the relationship between the inflation rate and the real variables is much weaker than it was during the 1970s. These results are consistent with the price-rule hypothesis. Finally, notice that during the price rule period that deviations from the inflation trend are associated with deviations in the real economy indices. These episodes can be interpreted as temporary deviations from the price rule. These are the times when Alan Greenspan has attempted to fine-tune the economy. Inflation is too much money chasing too few goods, and a decline in the real economy signals a rise in the inflation rate and vice versa, hence the negative relationship between the two. What
Do the Tea Leaves Tell Us? More interesting insights are provided by the forward-looking indicators (charted above), as they suggest that the economic slide will continue at least one more quarter. Interestingly, the Leading Economic Indicators and the Purchasing Mangers Index appear to be signaling a trough in the economy. If these indicators are correct, the recession will be a short one. Going forward, the phase-in of the Bush economic package will only delay the incentives to recognize income until next year. Therefore, through the remainder of the fourth quarter, one can expect the economic slowdown to continue. Once the New Year begins and the tax-rate cuts take effect, the economy will pick up. If the markets recognize the effects of the phase-in, they will see through the temporary slowdown and begin to recover. The recent strength of the financial markets remains consistent with this forecast. Return to "Economic Tea Leaves, Part I" |
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conomists
have developed a variety of measures to gauge future economic activity,
and they are largely based on the fact that consumer spending accounts
for about two-thirds of total spending. However, these measures
are at best contemporaneous. To develop a forward-looking indicator,
we need to forecast or obtain estimates of how these variables are
likely to change in the future.
