Can the Leading Economic Index alone predict the future economy? We break down the concept and application of this indicator in simple terms. If you’re curious about how to read economic trends, check it out!
Reading the Future Economy with the Leading Economic Index
You’ve likely often encountered expressions like, “The Leading Economic Index has risen, so the economy is expected to improve,” or “The Leading Economic Index has fallen, so the economy is predicted to worsen.” In this blog post, we’ll cover the basic concept of the Leading Economic Index, which governments, companies, and media use to forecast the economy. The leading economic index has fallen, so the economy is expected to worsen.” In this blog post, we’ll examine the basic concept of the leading economic index used by governments, businesses, and media to forecast economic trends.
People always want to know the future. They constantly wonder what lies ahead: when they’ll find a job, when they’ll get married, or when they’ll start earning a lot of money. This is likely why people visit fortune-tellers, psychics, and fortune-telling cafes. It’s not just individuals who wonder what the future holds. Governments and companies are no different. For governments and companies, a single misjudgment can plunge a nation into crisis or lead to a company’s collapse, making accurate future predictions even more crucial. This is why more advanced countries and global companies invest heavily in future forecasting, often establishing dedicated research organizations.
Economic forecasting is where experts focus their greatest efforts. Knowing how the economy will move ahead allows governments to prepare policies and companies to decide what products to launch and when. To predict future economic shifts, economists and statisticians developed the ‘Composite Leading Indicator’. For example, in Korea, Statistics Korea has been compiling and releasing it monthly since March 1983. The CLI, as the name suggests, is a statistic that precedes the economy. It provides a gauge for the economy roughly 3 to 6 months ahead. The CLI is calculated relative to a baseline of 100, with values above or below this threshold. Like other economic indicators, a higher number generally signals positive economic conditions.
How is the CLI constructed?
Since the CLI is published monthly, the overall trend is more significant than the absolute value. That is, while how much higher it is than 100 matters, whether it is rising compared to the previous month is far more meaningful. Even in economic news, the focus is less on the raw number itself and more on analyzing the overall trend, such as whether it has been rising or falling for several consecutive months.
For reference, news outlets often use the term ‘cyclical fluctuation value of the leading economic index,’ and both the government and businesses consider this cyclical fluctuation value a crucial statistic. South Korea’s GDP has continued to grow. In a developing economy like Korea’s, GDP tends to increase even if a recession hits. However, problems arise if one looks only at the increased GDP and concludes, ‘Isn’t this a recession?’ To solve this issue, the cyclical component is derived from the statistics by removing the trend-like flow, meaning the part where the economy grows inertially. This allows for a clearer view of the current economic situation. Getting into specifics makes it a very complex concept, so I’ll leave it at this general explanation here.
So how exactly can we predict the economic situation six months in advance? The basic statistics comprising the leading economic index consist of eight items. Let’s briefly examine a few selected items to understand which statistics are used for economic forecasting and why. Among the items included in the leading economic index is the ‘job openings-to-job seekers ratio’. The job openings-to-job seekers ratio is the number of people companies want to hire (job openings) divided by the number of people seeking jobs (job seekers).
The number of job seekers looking for work is generally stable. However, the number of jobs companies offer varies significantly depending on the state of the economy. Companies tend to expand their operations when they anticipate the economy will improve, and conversely, they tend to maintain or reduce their business scale when they predict the economy will worsen.
They then adjust the number of new hires accordingly. The job vacancy ratio increases when there are more job openings than job seekers. This statistic reveals whether companies are currently expanding their operations or maintaining/reducing them. Therefore, the job vacancy ratio is used as a key indicator in leading economic indicators.
The KOSPI index, which represents the stock value of companies listed on the Korea Exchange, is also used to forecast the economy. This is because stock prices react more sensitively to expected future profits than to current earnings. A rising KOSPI indicates expectations that companies will earn more money going forward. Conversely, a falling KOSPI index suggests that corporate profits are expected to decline, making it another meaningful indicator.
Construction order volume, which represents the amount of work secured by construction companies, is also a key indicator. When construction firms secure a large volume of projects, they purchase more materials for construction and hire more workers. Conversely, a decrease in orders inevitably leads to reduced material purchases and workforce hiring. Construction order volume is used for economic forecasting because clients typically plan new building projects during economic booms. Building construction requires a vast array of materials, from small nails to cement, rebar, glass, finishing materials, and HVAC systems. Large construction sites often employ tens of thousands of workers for several years. This makes construction a major industry significantly influenced by the economy.
Other indicators include the inventory cycle index, consumer expectations index, domestic machinery sales index, import-export price ratio, and 5-year government bond yield. The common feature of the indicators comprising the Leading Economic Index is that they are figures helpful for forecasting the future in the areas of production, consumption, investment, external economy, employment, and finance. Statistics Korea synthesizes the indicators just described to predict whether the future economy will improve or deteriorate compared to the present. Simultaneously, it also provides insight into the current economic situation; this statistic is called the ‘Coincident Economic Index’. As the name suggests, it is a statistic that moves alongside the economy.
While the Leading Economic Index is composed of items that can predict the future, the Coincident Economic Index focuses on the present. There is also a statistic called the Lagging Economic Index, which is a statistical summary of past economic conditions compiled after a certain period has passed. It is a statistic used to retrospectively confirm the direction in which the economy has moved.
So, what does the current state of the Korean economy look like when viewed through the previously explained Leading and Coincident Economic Indices? The reality of Korea as reflected by these statistical indicators remains far from optimistic. As of October 2023, the cyclical fluctuation value of the Coincident Economic Index fell for the fifth consecutive month, decreasing by 0.1 points compared to the previous month. This can be seen as a signal that the economic slowdown is continuing. The cyclical variation of the Leading Economic Index recorded 99.3 as of July 2023, showing an upward trend for two consecutive months. However, it still remains below 100, indicating lingering uncertainty about economic recovery.
Meanwhile, according to the OECD’s November 2022 Leading Economic Index, major advanced economies including Germany, France, Italy, the Eurozone as a whole, the UK, Canada, and the US continued to see declines in their indices due to the impact of high inflation and rising interest rates. Conversely, Japan was projected to maintain relatively stable growth. Among non-OECD members, China showed signs of recovery, supported by increased automobile production and rising stock prices. However, India and Brazil were expected to experience slowing growth due to declining money supply and weak manufacturing orders, respectively.
These indicators suggest the possibility of continued economic slowdown over the next 6 to 9 months, necessitating ongoing monitoring and response.
