Author: Derek Ramirez
Every month the Federal Reserve Bank of Philadelphia (the “Philly Fed”) uses their crystal ball to predict where each state’s economy will be in the next six months. To measure state progress, the Philly Fed produces two measures of each state’s economy: the Leading Index, tracking the economy six months ahead, and the Coincident Index, which tracks the current state of the economy. The leading index, charted below, shows that North Carolina has seen positive expected growth since January 2010. However, after peaking in September 2013, the index has seen a sharp decline in July and August of this year, indicating that economic growth may slow down during the beginning of 2015. There is, typically, some decline in the leading index in May, but the current August downturn in the series is not a part of that pattern. We will keep an eye on the economy in the coming year for any evidence of a slowdown after the holiday season.
The Philly Fed has noted, “Business persons, investors, and policymakers tend to be more interested in where the economy is going than in where it has been, so composite indexes of leading indicators often get more attention than indexes of coincident indicators.” There are other entities that also produce leading indices for various geographies, including the U.S., but the Philly Fed product is unique because it’s produced for every state in the U.S. on a monthly basis. The questions we will explore are:
- What makes the coincident and leading indices tick?
- How closely does the leading index track our regional economy?
The Philly Fed is open about the methodology behind the development of their indices. The coincident index uses nonfarm payroll employment, the unemployment rate, average hours worked in manufacturing, and the consumer price index to measure the current state of the economy. The trend for the coincident index is matched to the wage and salary disbursements (a component of personal income) and gross domestic product by state from the Bureau of Economic Analysis, which allows the index to match state GDP growth. The leading index is designed to be a six-month forecast of the coincident index. In addition to the coincident index, the models include other variables that lead the economy: state-level housing permits (one to four units), state initial unemployment insurance claims, delivery times from the Institute for Supply Management (ISM) manufacturing survey, and the interest rate spread between the 10-year Treasury bond and the three-month Treasury bill. The math is complex, but the basic idea is that they use past values of these variables to predict the six-month ahead values.
The value of a leading index lies in its ability to help us see shifts in the economy before they happen. Primarily we’re interested in knowing if the economy, whether local, regional, or national, is headed for a recession. To see how well the leading index performs, we graphed the leading index against the three-month average change in the coincident index. Above, the leading index appears to lead the coincident index for North Carolina. With this in mind, we will continue to track the leading recession to see if the economy continues to change as predicted.
In a follow up post we'll look at the coincident and leading indicators for our neighboring states to determine if there are any connections between their growth and our economy.
Reader's Note: The Federal Reserve Bank of Philadelphia released revised data for the states on Oct. 29, 2014. This article uses previous data.