YOU DECIDE: How can we forecast the economic future?

Media Contact: Dr. Mike Walden, 919.515.4671 or michael_walden@ncsu.edu

By Dr. Mike Walden
North Carolina Cooperative Extension

We’d all like to predict the future. I am often asked to predict the economic future, as are many of my colleagues. Our half-joking response is two-fold: Our crystal ball is cloudy, and we’re much better at predicting the economic past!

However, economists do take the job of trying to assess where the economy might be going seriously. We have developed several ways of meeting this task. One is to construct “models” of how the economy works, then to use those models to draw a picture of the future economy. By necessity, the model is an abstraction, or simplification, of the economy, since it’s impossible to replicate all the decisions involved in generating $14 trillion of annual income.

Part of the job of an economic model is to identify key factors driving the economy. Once these key factors are highlighted, economic forecasting is fairly straightforward. The model builder inputs future values for the key factors, allows the factors to interact in the model and then reads the results for measures like jobs, incomes, production and revenues.

Yet notice the economic model doesn’t do all the work; the user still has to predict values for the key factors. This is one reason economists and others have searched for another way of predicting the economic future. One of these is to find measures that tend to lead the economy –which tend to change before the economy changes.

Perhaps the best known of these “leading indicators” is the stock market. Because stock investors are necessarily focused on the future, the thought is that people who have their money in the stock market will be the first to spot economic change. So if investors think the economy will improve in the future, they will put more money in the stock market and send stock values higher. Conversely, if investors believe the economy is headed down, they’ll take money out of the market and cause stock values to drop.

These expected actions of stock investors lead to a simple rule. Gains in the stock market lead gains in the overall economy, and declines in the stock market foretell deterioration — perhaps a recession — in the economy.

The stock market actually did fairly well in the most recent business cycle, leading both the onset of the recession as well as the beginning of an economic recovery by about four months. But there have also been several examples where a change in the stock market gave a false signal; that is, it was not followed by a major change in the economy.

Another commonly used tool for predicting turning points in the economy is the relationship between short-term and long-term interest rates. Typically, long-term interest rates are higher than short-term rates. This is because there is more uncertainty — or risk — in investing money over a longer period of time.

But sometimes the reverse happens, and short rates are higher than long rates. Financial folks call this an “inverted yield curve,” and when it occurs, it has a very good track record of warning of an upcoming recession. For example, the yield curve became inverted about a year before the most recent recession began. Currently the yield curve has resumed its typical pattern.

One of the most closely watched predictors of future business activity is the “index of leading economic indicators” published by the Conference Board. Rather than relying on one measure, this predictor is a combination of 10 individual factors. The factors are weighted by their relative importance and then averaged to give a single number. The index has been rising, on trend, for over a year, therefore signaling an improving economy.

Because I am often asked to make forecasts about the course of North Carolina’s economy, I recently developed an index of leading indicators specifically for our state. It’s called the N.C. State University Index of North Carolina Leading Economic Indicators. It is composed of five individual components that are thought to change prior to broad changes in the state’s economy — new claims for unemployment compensation, building permits, weekly hours and weekly earnings in manufacturing, plus a national leading index.

The North Carolina leading index began improving in February 2009, signaling an improvement in the state economy, which we saw beginning in late 2009. Recently the index has dropped slightly, suggesting a slowing, but not declining, North Carolina economy. The current index report can be found at my website, http://www.ag-econ.ncsu.edu/faculty/walden/walden.htm.

There are many ways to try to gauge where our economy is going. You decide which has the clearest crystal ball!

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Dr. Mike Walden is a William Neal Reynolds Professor and North Carolina Cooperative Extension economist in the Department of Agricultural and Resource Economics of N.C. State University’s College of Agriculture and Life Sciences. He teaches and writes on personal finance, economic outlook and public policy. The Department of Communication Services provides his You Decide column every two weeks. Previous columns are available at http://www.cals.ncsu.edu/agcomm/news-center/tag/you-decide

Related audio files are at http://www.ncsu.edu/waldenradio/