Viewpoints

A research paper by the staff at the Federal Reserve Bank of Dallas (1993) claims that the composite index of leading economic indicators does not provide "reliable advance information on the direction of the economy." Other studies have found that nearly half of the cyclical peak predictions in composite indexes of leading indicators were false signals.

The key takeaway from these studies, and others, is that the forecasting record of the composite index of cyclical indicators is not 100% accurate because the group of leading indicators that accurately predicted one cycle might not work in the next. In other words, as the economy moves from one business cycle to the next, the economy changes, as does the policy structure, and some indicators become obsolete and less reliable while others gain more predictive power.

Forty percent of the economic series that comprised the leading index in the 1980s and 1990s, when the Dallas Fed paper was researched, are no longer included. Change is a recurring feature of the leading economic indicators. In the 2000s, a new way of measuring the Treasury yield curve became part of the index. After the financial crisis of 2007-09, the redesigned leading economic index included a leading credit series and the ISM new orders series, removing broad money and vendor performance.

It's too early to conclude confidently that the current composite index of leading indicators sends accurate or false signals. But the performance of several indicators needs to be examined to avoid a wrong prediction.

For example, the current leading indicators index includes three new manufacturing order series. That construction is not ideal as it is best to have indicators covering a wide range of activities and sectors to avoid the intercorrelation between economic indicators.

Also, the current economic cycle has had unique features for the goods sector. Once the economy re-opened following the closures of businesses during the pandemic, there was a record surge in demand, especially for goods, driven by pent-up demand and unprecedented fiscal and monetary stimulus. Yet, firms could only respond slowly due to part shortages and supply chain bottlenecks. That forced firms to double and even triple ordering, resulting in the most significant (record) gains for manufactured consumer goods and capital goods (excluding aircraft). Now that the "ordering binge" has ended, the new orders series have reversed, especially for consumer goods posting monthly declines in five out of the past six months. That has contributed to the leading index's monthly decreases.

Yet, is removing "double-ordering" a sign of economic weakness or a technical adjustment in the orders series? New orders for consumer goods are off their record highs but remain elevated and stand 25% above pre-pandemic levels. Meanwhile, new orders for capital goods (ex-aircraft) were at record highs in April. It's worth noting that unfilled orders, an indicator in an earlier version of the composite index of leading indicators, stands at a record high. New and unfilled orders raise questions about whether the economy is transitioning to a slower growth environment or an outright recession.

Another questionable component of the current leading index is the yield curve, or the spread between the yield on the 10-year Treasury and the federal funds rate. The yield curve series was included in the leading index in the mid-2000s. But that was before the Fed embarked on quantitative easing (QE) or the purchase of long-date securities with the primary intent of keeping long bond yields lower than what otherwise would be the case.

The current inversion of the yield curve is the widest on record, negatively impacting the composite index of leading indicators. It defies logic to think that the yield curve offers similar (leading) signals when the Fed buys securities and when the Fed does not. The Fed doubled its balance sheet to over $ 8 trillion during the past three years. The yield curve was added to the composite leading index in the mid-2000s, and the Fed balance was pretty steady at $750 billion, less than one-tenth of its current size.

With QE as a new policy tool, comparing long bond yields to inflation makes more sense as it is a proxy for real interest rates and captures the intent of QE (i.e., keeping the long-term borrowing cost low). Replacing the yield curve with a proxy for real interest rates would dramatically alter the pattern of the composite of leading indicators.

One cannot use Paul Samuleson's comparison of the stock market in predicting "nine out of the past five recessions" with the track record of the composite index of leading indicators because if the current composition of the index does not accurately predict business cyclical turning points, it will be refitted or redesigned with a group of indicators that does. Unfortunately, that does not offer any hope for investors because people make decisions in "real-time" and can't wait for data revisions or a new index. History painfully shows that using one set of cyclical indicators to predict the future is fraught with failure. That's not a criticism of using leading indicators to help predict cyclical turning points. Still, things are constantly changing in the economy, requiring more than a small set of indicators to predict the future.

As was the case in the April report, only 5 states saw statistically significant increases in payrolls in May, with Texas gaining 51,000 jobs. Utah has the largest percentage increase: .5. A fair number of states report insignificant decreases.

11 states had statistically significant drops in unemployment from April to May, none larger than .3 percentage point. Nevada’s unemployment rate stayed the highest in the nation at an unchanged 5.4 percent. No other state had a rate more than a point higher than the national 3.7 percent, though DC’s was 5.1 percent. Alabama, Florida, Idaho, Maine, Maryland, Missouri, Montana, Nebraska, New Hampshire, North Dakota, South Dakota, Utah, Vermont, and Wisconsin all have rates more than a point lower than the nation, with New Hampshire and South Dakota both at 1.9 percent. California, Texas, Illinois, Oregon, Washington, and Delaware (along with DC) are the states other than Nevada with rates at or above 4 percent. While the seasonally adjusted state rates are not strictly comparable to the national rate, the relatively high rates in the two largest states help explain why so many states can have rates far below the national average, and only handful somewhat higher.

Puerto Rico’s unemployment rate edged up to 6.1 percent. The job count on the island moved above 950,000 (the initial April count was also above 950,00, but there has been a downward revision). Private employment set a new all-time peak, surpassing the old March 2006 record.

Yes, but energy prices fell by 3.6% month-to-month and food prices were up only 0.2%. Used motor vehicle prices account for only 2.75% of the CPI while food and energy prices account for 20.30% of the CPI. Typically each month some consumer prices rise and some prices fall. That is why when we try to measure the overall change in consumer prices we use a weighted price index, the weights being determined by the estimated relative importance of the different items purchased by a representative household.

Let’s look at the annualized percent changes in the All-Items CPI over one month, 3 months, six months and 12 months, which are plotted in Chart 1. As of May 2023, the annualized percent change in the CPI was 4.13%, 3.17%, 2.20% and 1.50% over 12 months, six months, three months and one month, respectively. In May 2022, these changes were 8.50%, 9.21%, 9.69% and 11.62%.

The budget/debt ceiling negotiation ended like several others; a lot of drama but no fundamental change. The irony is that the primary goal of these negotiations, at the least from House negotiators, was to reduce the staggering debt load of the federal government. Yet, in the end, Congress again decided to vote for more debt, a lot of it, to pay for spending.

The Congressional Budget Office (CBO) projects that the US will run budget deficits between $1.5 to 2.0 trillion per year for the next decade, adding nearly $20 trillion to the federal government's outstanding debt.

Nearly two decades ago, CBO projected the US would run budget deficits in the $200 to $300 billion range, which alarmed former Fed Chairman Alan Greenspan. Back then, Mr. Greenspan stated, "When you begin to do the arithmetic of what the rising debt level implied by the deficits tells you, and you add interest costs to that ever-rising debt, at ever-higher interest rates, the system becomes fiscally destabilizing," he told lawmakers. " What would he say today?

The impact of budget deficits on interest rates varies depending on economic conditions. Yet, huge budget deficits for the foreseeable future will occur as the Federal Reserve reduces its balance sheet, removing the non-interest rate-sensitive buyer that has held down interest rates in the past several years. Market interest rates will have to go much higher to attract private sector buyers, and it would not be surprising if ten-year yields rise 100 to 200 basis points over current levels in coming years.

To balance the federal budget requires two things; first, cutting the entitlement programs, and second, raising taxes. Critics would argue against higher taxes, but balancing the budget with tax receipts equaling less than 20%-plus % of GDP (currently running at 18%) is impossible. And since individual tax payments represent a record 50%-plus of total taxes, while corporate tax payments are near a record low of 8%, business taxes are at risk of increasing.

In the past decade, investors have benefitted doubly from Congress's decision to use debt instead of taxes to pay for record spending and the Fed's record purchases of debt securities. Yet, that era is over. The debt deal maintains record federal borrowing, but now without the Fed as a (buying) partner. Investors should expect higher interest rates as a result. And once the higher debt costs become fiscally destabilizing, as Greenspan noted, Congress must move on taxes, with business taxes the target.

The Federal Reserve Bank of Philadelphia’s state coincident indexes in April report gains in all states from March. Vermont had the largest increase (1.27 percent) while neighboring Massachusetts was the other state with a rise of more than 1 percent. West Virginia was, once again, the leading state at the three-month horizon, up a bit more than 3 percent, while Vermont—perhaps the second hilliest Eastern state, after West Virginia—was second. The majority of states again had increases of at least 1 percent since January; Alaska was again the only state with a decline over this horizon. Over the past 12 months, Massachusetts was the leader, with an increase of almost 4 ½ percent, barely edging Texas and New Mexico. Kansas was the only state with an increase of less than 1 percent since April 2022.

The independently estimated national figures of growth over the last 3 months (.74 percent) appears to be short of what the state figures suggest, while the corresponding 12-month result (3.72 percent) looks more or less in line with the state numbers.

Marked changes in state payrolls were limited in April. 5 states saw statistically significant increases, with California up by 67,000 and Indiana seeing a .5 percent increase. Rhode Island had a sharp .8 percent decline, and a few other states (and DC) had insignificant decreases.

A full 14 states had statistically significant drops in unemployment from March to April. Oregon’s .4 percentage point decline (coming on the heels of a .3 percentage point drop in March) was the largest. Nevada continues to have the highest unemployment rate in the nation, at 5.4 percent. California and DC are the only other places with unemployment more than a point higher than the national averages of 3.4 percent. Alabama, Montana, Nebraska, New Hampshire, both Dakotas, and Utah are more than point under the national figures, with South Dakota remaining at 1.9 percent. Indeed, 17 states, including Florida have unemployment rates below 3 percent. On the flip side, along with California’s 4.5 percent rate, New York and Texas both have jobless figures of 4 percent.

Puerto Rico’s unemployment rate remained at 6.0 percent, but its job count moved above 950,000 for the first time since 2009. Payrolls on the island had (excepting the Maria and COVID shocks) been under 900,000, but have been on a steady increase in this expansion. The record high was October 2004’s 1,059,200. However, Puerto Rico’s job markets has shifted dramatically since then: private payrolls are now only 400 shy of their peak.

The wage cycle is a critical factor in the scale and length of the Fed tightening cycle. Based on the current wage data, history says the tightening cycle has yet to reach its peak rate, and the duration of the higher official rate cycle could extend much farther than the markets expect.

The thinking behind the Fed hiking rates to break the inflation cycle is straightforward: lift rates to a prohibitive high enough level that curtails or breaks the willingness to borrow and spend. Each tightening cycle is different, and the scale and length often depend on wage and income growth.

One traditional way to determine if higher rates are prohibitively high is to compare them to inflation. That helps determine the real borrowing costs for businesses since the price is what firms get for their products and services. Yet, to measure the real borrowing costs for consumers, one needs to compare interest rates to wages since the latter is the worker's price.

In April, and for the first time since the Fed started to raise official rates in March 2022, the gap between Fed funds and wage growth was closed. That's the good news. The bad news is that the tightening cycles of the late 80s, 90s, and mid-2000s ended when official rates were several hundred basis points over the wage growth. So history would say the Fed tightening cycle is far from over, and the April wage and jobs data lends credence to that view.

Still, policymakers may pause and gauge the lagged effects from the scale of the tightening to date. Lagged effects from monetary tightening are adverse and build over time. Still, the overall stance of monetary policy must be tight or restrictive for them to generate the negative economic and financial results policymakers want to achieve.

Up to this point, the policy stance shifted from less accommodative to neutral. That helps to explain why cyclical sectors (motor vehicle sales in April were the highest in nearly two years, and housing activity has perked up) showed renewed momentum. More rate hikes will be needed to break the momentum in cyclical industries.

In Q1, the combined output of the cyclically sensitive motor vehicles and residential housing sectors expanded by 1.3% annualized, slightly better than the 1.1% growth for the overall economy and the first quarterly gain since late 2021. Also, the Q1 data shows that operating profits gained sequentially quarter over quarter and year over year. The rebound in cyclically sensitive sectors and profit data run counter to the recession forecasts. All economic recessions have standard features; declines in cyclically-sensitive sectors and drops in operating profits. Those features are missing at this time.

S&P purchasing managers manufacturing index rose over one percentage point to 50.2 in April. That’s the highest level in six months, driven by new orders, production, and employment gains. Thus, the rebound in cyclically sensitive sectors has continued into Q2.

Recessions forecasts are linked primarily to the inverted yield curve and the decline in the leading indicators. Questions over the accuracy of the signal from the inverted curve stem from the Fed's new policy tool, quantitative easing (QE). Since the Fed now actively purchases substantial quantities of long-duration fixed assets to keep a lid, or even depressing, on long-term interest rates, how can the yield curve signal be as reliable as in prior periods?

History shows that lower long-term borrowing costs often lead to faster growth in cyclically-sensitive sectors. The yield on the 10-year Treasury has declined 75 basis points in the past six months, and cyclically sensitive sectors have rebounded. Is that a coincidence, or are they interrelated? If the latter, the recessionary signal from the inverted yield curve is wrong. It’s the latter.

The leading economic index, which has declined sharply over the past year, triggering fears of recession, includes the yield curve. Yield curve inversion has been a significant factor in the decline of the aggregate index over the past year. Yet, is the yield curve still a reliable leading indicator with the creation of QE?

It’s common for the index composition to change from one cycle to the next because economic, financial, or policy changes make some indicators less reliable or obsolete. Broad money failed as an indicator before the Great Financial Recession. A new credit series replaced it in 2012. It will not be surprising if the leading index includes a QE series and removes the yield curve indicator at some point.

It’s worth noting the 2020 recession was unique from the standpoint non-economic factors triggered it. Yet, the monetary and fiscal policymakers viewed it as a vast economic disaster, rightly so, and responded with the most significant monetary and fiscal stimulus ever seen. Doubling the Fed's balance sheet from $4 trillion to over $8 trillion in 18 months was never done before, and we still need to learn all the economic and financial consequences. At the very least, the aggregate stimulus and new ways of interjecting liquidity in the system raise questions over long-trusted indicators such as the yield curve and broad money.

Investors should keep it simple; the economy is growing if companies generate profits and hire.