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The Misleading Indicators

Tags Calculation and KnowledgePolitical Theory

05/17/2002Frank Shostak

The National Bureau of Economic Research (NBER), the academic panel that dates U.S. business cycles, moved a step closer to declaring an end to the recession that it said began in March 2001. The panel often waits for months before calling the end to a slump, in order to ensure that there is not be a renewal of economic weakness.

The possibility that the economy may have reached the bottom of a slump is also supported by the index of Leading Economic Indicators. According to the Conference Board that compiles the index, this index has been posting strong gains--growing by 2.9 percent from September 2001 to March 2002.

Many economists believe that if the effects of factors that cause economic fluctuations could be ascertained before they start to have an effect on general economic activity, the government and its central bank could devise a suitable policy mix to counter these causes.

Likewise, businessmen, by acting on the information regarding the upcoming impact on general economic activity, could position their businesses in the most advantageous ways for them. The economic-indicators approach, then, is seen as a way of capturing early warnings regarding the upcoming recession or prosperity. What is the rationale behind this approach? Is it valid?

What is a "leading indicator"?

The National Bureau of Economic Research introduced the economic-indicators approach in the 1930s. A research team led by W.C. Mitchell and Arthur F. Burns studied some 487 economic data to see whether the data persistently led, coincided with, or lagged turning points in the U.S. business cycle.

The underlying premise of the NBER is that causes of business cycles are complex and are not properly understood. Furthermore, the bureau contends, these causes tend to vary over time and, consequently, it is much better to focus on the outcome of these causes as manifested through economic data.

In short, the indicators approach is based on the view that it is possible to ascertain the state of an economic business cycle by monitoring economic data, regardless of what the nature of the causes of the business cycle are. The NBER has identified 31 cycles between December 1854 and March 2001, according to their peaks and troughs.

Once the data are classified into leading, coinciding, and lagging peaks and troughs of business cycles, they are combined into leading, coincident, and lagging indices. These indices are seen as economic signposts that are expected to alert analysts and policymakers regarding the state of a business cycle.

When the leading-indicators index starts to display signs of weakening, this is seen as a possible indication of weakness in economic activity in the months ahead. The confirmation that the peak of the cycle might have been reached is ascertained by means of the coincident index, while the lagging index provides the final OK that this might be the case. Hence, by means of these three indicators, it is held, the phase of an economic business cycle can be established.

The Black Box

Despite the simplicity of this approach, it does not always work. Should we regard any fall in the leading index as a precursor for future economic decline? Is there a criterion that will tell us how many months the index must decline before we could be certain of an upcoming turning point in the economic business cycle?

The current method that is employed regards three consecutive declines in the leading index during an expansion as a signal of an upcoming recession. Likewise, three consecutive rises in the index during a recession are seen as a signal of an upcoming recovery.

Why, however, are three consecutive months, and not one or five, required in verifying an upcoming recession, or prosperity? The indicators approach remains silent on this point. Also, if one were to wait for the confirmation of the leading index signal on the signal from the coincident index, what is the point of having the leading index? After all, it supposed to alert policymakers and businessmen before the boom, or a bust, has started.

Furthermore, in order to be able to classify whether particular data lead the business cycle, one must have a definition of what a business cycle is. According to Mitchell and Burns,

Business cycles are a type of fluctuation found in the aggregate economic activity of nations. . . . a cycle consists of expansion occurring at about the same time in many economic activities, followed by similarly general recessions, contractions, and revivals which merge into the expansion phase of the next cycle; this sequence of changes is recurrent but not periodic.1

In other words, business cycles are seen as broad swings in many indicators, which upon their careful inspection allow us to see peaks and troughs in general economic activity. However, stating that business cycles are about swings in the data says nothing about what business cycles are. In order to define what business cycles are, there is the need to establish the driving force that is responsible for the emergence of economic fluctuations.

By ignoring the essential driving factors behind economic swings, the indicators approach treats boom-bust cycles as something external to the economy. They are seen as being like viruses that arrive from outer space and attack the inhabitants of planet Earth. The role of the indicators in this way of thinking is to provide advanced warning regarding the upcoming attack of this menace. This, in turn, would permit the government and its central bank to introduce necessary measures to counter boom-bust cycles.

If the driving factors of boom-bust cycles are not known, how is it possible to make sense of movements in the leading index? Furthermore, how could the government and the central bank introduce measures to counter something that is unknown?

Contrary to this way of thinking, data do not talk, and they never issue any "signals" by themselves. It is the interpretation of the data, which is guided by a theory, that generates various "signals."

The indicators approach that was created by the NBER was designed to be as impartial as possible in order to be seen as purely scientific. This is what Rothbard had to say about the NBER methodology:

Its numerous books and monographs are very long on statistics, short on text or interpretation. Its proclaimed methodology is Baconian: that is, it trumpets the claim that it has no theories, that it collects myriads of facts and statistics, and that its cautiously worded conclusions arise solely, Phoenix-like, out of the data themselves. Hence, its conclusions are accepted as unquestioned holy "scientific" writ.2

Are we really ignorant?

Contrary to the indicators approach, boom-bust cycles are not about the strength of the data as such. (For instance, for the NBER, a recession is a significant decline in activity spread across the economy, lasting more than a few months.) It is about activities that sprang up on the back of loose monetary policies of the central bank.

Whenever the central bank loosens its monetary stance, it sets in motion an economic boom by means of the diversion of real funding from wealth generators to various false activities that a free unhampered market would not facilitate.

Whenever the central bank reverses its monetary stance, this slows down or puts to an end the diversion of funding toward false activities, and that, in turn, undermines their existence. In short, the trigger to boom-bust cycles is central bank monetary policies--not some other group of mysterious factors.

Consequently, whenever a looser stance is introduced, this should be regarded as the beginning of an economic boom. Conversely, the introduction of a tighter stance sets in motion an economic bust.

Furthermore, whenever the central bank changes its interest-rate stance, the effect of the new stance doesn't assert itself instantaneously; it takes time. The effect starts at a particular point and shifts gradually from one market to another market, from one individual to another individual. In short, the previous monetary stance may dominate the scene for many months to come before the new stance begins to assert itself.

So while an economy could be in the midst of a liquidation process, i.e., an economic bust, on account of the still-powerful influence of the previous boom, this will not be seen in the data. If economists were to proclaim that there was no need to be concerned with the health of the economy since the leading index remains strong, they would be passing on erroneous information to their audience. If in a few months' time the tighter stance began to assert itself, the consequent fall in the leading index would likely catch most economic gurus by surprise.

The Longest-Ever Expansion?

According to the NBER, between March 1991 and March 2001, the U.S. economy experienced its longest economic expansion ever. This conclusion is questionable, however, since during this period the Fed raised interest rates 14 times (see chart). In short, a tighter stance couldn't have been good news for various false activities.

Thus, between February 1994 and February 1995, the Fed raised the federal funds rate target from 3.25 percent to 6 percent, an increase of 2.75 percent.

This tightening was followed by an easier stance that began in July 1995 and ended in January 1996, with the federal funds falling to 5.25 percent.

Then, in March 1997, the central bank raised the federal funds target rate by 0.25 percent, to 5.5 percent. This level was kept until September 1998, when the new cycle of easing was introduced. Between that time and November 1998, the federal funds rate target was lowered to 4.75 percent.

Then, on June 1999, a new cycle of tightening was set in motion, with the federal funds rate rising to 6.50 percent by May 2000. Finally, as of January 2001, a new cycle of easing was set, with the federal funds rate target lowered to 1.75 percent.

During the so-called prosperity phase, the leading index fell for five consecutive months between January and May 1995. According to the accepted rule, this had to be regarded as a valid signal of an upcoming recession, which, according to the NBER, only arrived in March 2001. Also, the capacity and production data of various goods displayed rather surprising weakness for the prosperity phase.

Capacity use of fabricated metal products, after peaking at 85.2 percent in December 1994, fell to 73.5 percent by March 2001. The capacity use of industrial machinery and equipment, which topped at around 85 percent between 1995 to 1997, fell to 76.2 percent by March 2001 (see charts).


The following charts reveal that the capacity use of iron and steel and nondurable goods had been in a steep downtrend between 1995 and March 2001. Moreover, the production of both electrical equipment and iron and steel was stagnant during this period. Also, in 1998, during the supposed prosperity, corporate profits after tax plunged by 13 percent.



It would appear that as long as the NBER does not officially declare the economy has reached a peak, no recession can take place. On this Murray Rothbard wrote:

Everyone waits for the National Bureau to speak; when the oracle finally makes its pronouncement, it is accepted without question. Thus, in 1966, the economy slowed down and receded to such an extent that I, for one, concluded that we were in a recession. But no, GNP had not declined quite long enough to meet the Bureau's definition of a recession, and that, unfortunately, was that. And since we were not in what the Bureau called a "recession," we by definition continued to be in a "boom."3

What is the true leading indicator?

Since central bank monetary policies are responsible for boom-bust cycles, changes in these policies obviously are leading indicators of things to come. In other words, the data that meet the criteria of a leading indicator are the instruments of central bank monetary policy, i.e., the federal funds rate and monetary injections.

If, on a particular date, the central bank announced a looser monetary stance by lowering interest rates, the date of the announcement must be regarded as the proper beginning of an economic boom.

Conversely, when the central bank announces a tighter stance, this implies that the process of an economic bust was set in motion. This type of information is very useful, for it tells us that various false activities that sprang up on the back of the previous loose monetary policy are likely to be in trouble in the months ahead.

What, then, is one to make of the peaks and troughs of economic fluctuations as established by the NBER? How important is this information? By officially proclaiming that an economy is either in a recession or in a recovery phase, the NBER adds very little to the obvious. In fact, the NBER announces its verdicts long after peaks or troughs have been reached.

Thus, the March 2001 peak was announced on November 26, 2001. The March 1991 trough was announced on December 22, 1992. The July 1990 peak was announced on April 25, 1991.

Most economists, however, are of the view that the information about past boom-bust cycles in terms of their average duration is very valuable, for it provides a possible clue as to how long an upcoming cycle might last.

But on this, most economists contradict themselves, since by their own admission the causes of cycles are variable. That implies that cycles are not homogeneous and, therefore, that no meaningful average can be established. According to Rothbard:

 [H]istory means change, and it is absurd to assume that the underlying population of all this data remains constant and unchanging, and therefore can be averaged meaningfully.4

Rather than classifying data in terms of leading, coincident, and lagging the business cycle, it is more useful to classify the data in terms of their sensitivity to changes in the central bank’s monetary stance. For instance, a loose monetary stance tends to benefit activities that are involved in the production of intermediate goods in relation to activities that are involved in the production of consumer goods. The converse takes place when the central bank tightens its stance.


Contrary to the accepted way of thinking, the indicators approach adds very little to our understanding of what business cycles are all about. Economists' various pronouncements regarding the state of the economy--pronouncements which are based on the leading indicators index--are downright arbitrary. Furthermore, it is questionable whether the NBER’s official pronouncements regarding peaks and troughs of business cycles are of much help to businessmen and policymakers.


  • 1. Quoted in Allan P. Layton and Anirvan Banerji, "What is a Recession," Applied Economics Vol. 35, Issue 16, 2003.
  • 2. Murray N. Rothbard, Making Economic Sense (Ludwig von Mises Institute, Auburn, Ala.), p. 232.
  • 3. Ibid., p. 231.
  • 4. Ibid., p. 233.

Contact Frank Shostak

Frank Shostak's consulting firm, Applied Austrian School Economics, provides in-depth assessments of financial markets and global economies. Contact: email.

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