Economic Indicators – What’s Important to Watch?

You see them on the news, in the newspaper, on the internet.  Not every day, but certainly it seems like a new one every week:  Key Economic Indicators.  There’s the CPI, GDP, and Unemployment.  There’s also the Consumer Confidence Index and Leading Economic Index.  What’s this all about?  What do these numbers mean? And most importantly, which ones should we pay attention to?

Below I’ve listed several of the more important economic indicators and what makes up the indicator, along with my commentary on what the indicator may tell us.  If I’ve left out any of your favorites, let me know!

Key Economic Indicators

Gross Domestic Product (GDP) – this is the value of all goods and services produced in the United States, minus the value of imported goods and services.  This broad measure of economic health shows the quarter-by-quarter growth or shrinkage of the US economic output.  Comparisons are most often made between the current figure and the previous quarter and year.  These numbers are reported quarterly, and are revised in following months as more complete data is gathered.

The main number that you’ll see referenced is the “real” GDP or “real” GDP growth – meaning that the numbers are inflation-adjusted to a reference point (these days the reference is to the year 2005).  In other words, real GDP growth for a year is based upon the GDP figure from the previous year to the most current figure, with inflation factored in.  For the most recent quarter reported, you can go to the website of the Bureau of Economic Analysis.

As you might expect, it’s a positive sign to see the real GDP growing.  In the past year though, GDP has reduced, which is why our current economic cycle has technically been called a recession.  A recession is defined as two quarters of decline in GDP, amounting to less than a 10% decline.  If the decline is 10% or more, the economic cycle is technically a depression.  From the second quarter of 2008 to the second quarter of 2009, we saw four quarters of GDP decline in a row, amounting to a total decline of 9.6% – close to a depression, but no cigar.  Since that point, we’ve seen two quarters of GDP growth through the fourth quarter of 2009 (most recent data as of this writing).

Although this is an important number to understand what has happened in our economy – because it can help explain the real outcome economic activity – it’s usefulness is limited since it is reported so long after the fact.  Knowledge of this index is helpful in your decision-making process, but you need more information to make good decisions about your investments.

Consumer Price Index (CPI) – this index, which is based upon the cost of a basket of consumer goods and services such as housing, transportation, food, energy and clothing, is a good measure of inflation within our economy.  The current figure, reported monthly and adjusted as more data becomes available, is compared to the previous month, quarter, and year (typically) to determine the rate of increase in the costs of these items to the consumer.  This particular index is used to develop cost-of-living adjustments (COLAs) for things like Social Security benefits.

As you might expect, we would always like to see this index increasing at a controlled pace – annually in the 3% to 4% range is considered “normal” – since increasing costs of goods and services presumably indicates that the overall economy is growing.  Put differently, if the consumer is willing and capable of paying an increased cost for a basket of goods and services, then the economy has grown, providing the consumer with additional funds to pay the increased cost.  It’s not a perfect way to measure economic growth, but it’s what we have.

In the past year, for example, we’ve seen an annual inflation increase (as evidenced by CPI) of roughly 1.8% through February of 2010 (most recent data as of this writing).  Annual inflation from 1980 to the present has ranged from 10.3% to -0.37%, and has averaged 3.37%.  You can view the most recent data at the Bureau of Labor Statistics Consumer Price Index site.

As with the GDP growth discussed above, CPI is interesting to understand general overall increases in inflation and very important in determining COLAs, but being a historical piece of data that lags in reporting by months, it really doesn’t help us much as we plan for the future.  CPI does give us indication of what inflation we’ve experienced in the past so that we can estimate future inflation, but as always, the past doesn’t necessarily predict the future.

Consumer Confidence Index – this is a survey of 5000 consumers regarding their attitudes concerning the present economic situation and expectations for the economy going forward.  This report can be helpful to understand how the current economy is affecting the point of view of “everyman” – and it often is an insightful prediction of the direction of the economy.

The Consumer Confidence Index’s month-to-month changes are the most important viewpoint to consider:  any time there is an increase or decrease of 5 points or more, it’s worth noting.  The amount of the change isn’t as important as the direction of the change, as a significant change in either direction often denotes a trend for the overall economy in that particular direction.    You can view the most recent information on the Conference Board’s Consumer Confidence Index website.

Producer Price Index (PPI) – this index is pretty much the same as the CPI, except that the pricing is taken at the wholesale, or producer level, rather than at the retail level.  This index, especially the core PPI (made up of food and energy prices alone) is a useful indicator of future increases in the CPI.  The Bureau of Labor Statistics also maintains the Producer Price Index.

Leading Economic Index (LEI) – while not a perfect prediction of the future, the LEI gives us a forward-looking view of economic activity.  This index is made up of 10 separate components:

• Average weekly hours (manufacturing sector)
• Average weekly jobless claims for unemployment insurance
• Manufacturer’s new orders for consumer goods and materials
• Vendor performance (slow delivery diffusion index)
• Manufacturer’s new orders for non-defense capital goods
• Building permits for new private housing units
• S&P 500 stock index
• Money Supply (M2)
• Interest rate spread (10-year Treasury vs. Federal Funds target)
• Index of consumer expectations

With all of these factors compiled, this index gives a somewhat reliable forecast, especially of recessionary periods, but as I mentioned earlier, it’s not without fault.  The index often gives a false signal of recession just prior to an economic upswing, and so should not be utilized alone as your determinant of future economic activity.  You can see the LEI and its components at the Conference Board’s Leading Economic Index website.

What’s very interesting is to review the LEI’s activity as a composite index, and then take a look at the activity of the underlying components.  If the entire index is indicating a downturn (legend has it that three consecutive months of downturn foretell a recession, but this is the false signal referred to above, as well), then review the data for all of the underlying components.  If there is a broad-based downturn noted by all (or most) of the components, chances are the indication of future economic downturn is real.

Beige Book – anecdotal information on general economic conditions is gathered by each District of the Federal Reserve System and then combined into this report.  The Federal Open Market Committee (FOMC) uses this information, along with other economic indicators, to help make decisions regarding the rate of Federal Funds, which often drives changes to rates across the overall marketplace.

While this data may not make a difference in your own investment decisions, it’s helpful to see the information that the Fed is using to make their decisions – although it’s not always readily apparent why they’ve made one decision or another, even seeing the Beige Book information.  You can view the Beige Book at the Federal Reserve website.

Unemployment Rate – pretty much self-explanatory, the unemployment rate is the percentage of potential workers in our economy who are not currently employed.  This factor is also a useful gauge of the overall health of the economy, as reductions in the unemployment rate indicates that companies are expanding operations (and payrolls) in preparation for growth.  You can see the current Unemployment Rate at the BLS website as well.

Summary

While no single index or economic indicator is the best or most important piece of information, those I’ve presented above are some of the more common and insightful indicators of economic activity.  Paying attention to these indicators and their trends over time can be insightful as you make decisions about your financial life.  Don’t imagine for an instant that there is a cut-and-dried predicter of the future in all of these – there’s no such thing as a crystal ball.  So pay attention, but don’t put all your faith in the numbers…

How about you?  Do you have a particular index or indicator that you follow religiously?  Tell us all about it in the comments below!

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Photo 2 by VinothChandar(AWAY)