" Chapter 5 Demand Forecasting Barometric Methods , | 203 Until now we have examined secular trends, seasonal variations, and random influ- \e4] aces in time-series data. Little has been said about forecasting cyclical swings in the level of economic activity or business cycles. One way to forecast or anticipate short- - term changes in economic activity or turning points in business cycles is to use the index of leading economic indicators. These are time series that tend to precede (ead) changes in the level of general economic activity, much as changes in the mer- cury in a barometer precede changes in weather conditions (hence the name baro- metric methods). Barometric forecasting, as conducted today, is primarily the result of the work conducted at the National Bureau of Economic Research (NBER) and the Conference Board. A rise in leading economic indicators is used to forecast an increase in general business activity, and vice versa. For example, an increase in building permits can be used to forecast an increase in housing construction. Less obvious—but very impor: tant—an increase in stock prices, in general, precedes (i.¢., it is a leading indicator for) an uptumn in general business activity, since Tising stock prices reflect expecta- tions by business managers and others that profits will rise. On the other hand, a de- cline in contracts for plant and equipment usually precedes a slowdown in general economic activity. Thus, leading indicators are used to forecast turning points in the business cycle. Although we are primarily interested in leading indicators, some time series move in step or coincide with ents in general economic activity and are therefore called coincident indi¢ators. Still others follow or lag movements in economic ac- fvity and are called lagging indicators. The relative positions of leading, coincident, and lagging indicators in the business cycle are shown graphically in Figure 5-3. The figure shows that leading indicators precede business cycles’ turning points (i.e., peaks and troughs), coincident indicators move in step with business cycles, while lagging indicators follow or lag turning points in business cycles. ‘Time-series data on more than 300 leading, coincident, and lagging indicators are provided in Business Cycle Indicators, a monthly publication of the Conference Board. A shorter list of the 21 best indicators (10 leading, 4 coincident, and 7 lag- ging) are given in Table 5-8. Our interest is primarily in the leading indicators. Table 5-8 also gives the lead (-) and lag (+) times for the composite indexes of the 10 lead- ing, the 4 coincident, and the 7 lagging indicators, These ae a Weighted average of the individual indicators in each group, with the indicators that do a better job of forecasting given bigger weights. As such, composite indexes smooth out random variations and provide more reliabte-forecasts-amt fewer wrong-signalsthan individ- ual indicators, . Another method for overcoming the difficulty some of the 10 lead- ing indicators move up and some move down is Ar aitedan inte deed of com- ‘bining the 10 leading indicators into a composite index, the diffusion index gives the é .Leading indicator Coincident indicator ee a | | | | Peak date Trough date Time Business cycle Indicator level (value) ° Leading indicators precede (lead) business cycles" tuming points (i.e., peaks and troughs), coincident indicators move in step with business cycles, while lagging indicators follow or lag turning points in business cycles. percentage of the 10 leading indicators moving upward. If all 10 move up, the diffu- sion index is 100. If all move down, its value is 0. If only 7 move up, the diffusion index is 70, We usually forecast an improvement in economic activity when the dif- fusion index is above 50, and we have greater confidence in our forecast the closer the index is to Tn general, barornetric forecasting employs composite and diffu- sion indexes rather than individual indicators, except when a firm seeks information about anticipated changes in the market for specific goods and services. Each month the Conference Board reports changes in the individual and composite indexes. Although not much significance can be attached to individual monthly swings, three or four successive one-month declines in the composite index and a difusion index of less than 50 percent are usually a prelude to recession (popularly defined as a decline in gross national product for three or more consecutive quarters). This can be seen from Figure 5-4. The top panel shows that the composite index of leading indica- tors tumed down prior to the recessions of 1969 to 1970, 1973 to 1975, 1980, 1981 to 1982, and 1990 to 1991, and 2001 (the shaded regions in the figure). Similarly; the bot- tom panel shows that the diffusion index for the 10 leading indicators was generally below 50 percent in the months preceding recessions (the shaded areas).A CE ATC TSE TT LETS sl Rs Chapter $ Demand Forecasting © 20", Short List of Leading, Coincident, and Lagging Indicators Meee LEADING INDICATORS (10 SERIES) Average weekly hours, manufacturing Initial claims for unemployment insurance, thousands (inverted) MaRufacturers’ new orders, consumer goods and materials, Vendor performance, slower deliveries diffusion index ‘Manufacturers’ new orders, nondefense capital goods Building permits, new private housing units Stack prices, 500 common stocks ‘Money supply, M2 lncerest rate spread, 10-year Treasury bonds less federal funds Index of consumer expectations COINCIDENT INDICATORS (4 SERIES) Employees on nonagricultural payrolls Personal income less transfer payments Industrial production Manufacturing and trade sales LAGGING INDICATORS (7 SERIES) | Average duration of unemployment, weeks (inverted) Ratio, manufacturing and trade inventories tb sales ‘Change in labor cost per unit of output, manufacturing ‘Average prime rate charged by banks ‘Commercial and industrial loans outstanding Ratio, consumer installment credit co personal income ‘Change in consumer price index for services, Leads (-) and Lags (+) COMPOSITE INDEXES. in months) SOMPOSTEINDEXES OO dinmonths) Composite index of 10 leading 6 Composite index of 4 coincident indicators 1 Composite index of 7 lagging indicators 3 Source: The Conference Board, Busnes Cle Indcstr (New Yor, various issues). Although the composite and diffusion indexes of leading indicators are reasonably good toals for predicting tuning points in business cycles, they face a number of shortcomings. One is that on several occasions they forecasted a recession that failed ~ to occur.0 The variability in lead time can alsq be considerable. More importantly, barometric forecasting gives little or no indication of the magnitude of the forecast *d change in the level of economic activity (ie., it provides only a qualitative for -cast of turning points). Thus, while barometric forecasting is certainly superior tc time- series analysis and smoothing techniques (naive inethods) in forecasting short-term 'eThe best, barometric forecasting is only 80 to 90 percent accurate ia forecasting tuning points.206 | Part 2 Demand Anal) Figure 5-47 Composite and Diffusion Indices of the 10 Leading Indicators Composite index for the 10 leading indicators (1968-2002) 10+ —|10 04 ° “10 10 68 10 72 74 76 78 80 82 8% 86 88 90 92 % 96 98 00 O2 Diffusion index for the 10 leading indicators (1968-2002) 100 + fi Fi 100 50 W 50 ° ° 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 OO 02 ‘The top pane! shows that the composite index of 10 leading indicators turned dowa prior to (Le. they lead) the recessions of 1969 to 1970, 1973 to 1975, 1980, 1981 to 1982, 1990 to 1991, and 2001 (the shaded regions in the figure), The bottom panel shows that the diffusion index for the 10 leading indicators was generally below 50, percent in the months preceding recessions (the shaded areas). Source: The Conference Board, Business Cycle Indicators (New York, May 2002, p. 10). tuning points in economic activity, it must be used in conjunction with other meth- ods (such as econometric forecasting—discussed in Section 5-5) to forecast the mag- nitude of change in the level of economic activity. Case Application 5-4 shows the use of the composite and the diffusion indexes in forecasting the level of economic activity in May 2002 (the reader can check whether the forecast was correct). Case ‘Application 5-5 shows that the index of leading indicators has now gone global. Econometric Models” [5:57 The firm’s demand and sales of a commodity, as well as many other economic vari- abies, are increasingly being forecasted with econometric models. The characteristic that distinguishes econometric models from other forecasting methods is that they seek fo identify and measure the relative importance (elasticity) 8F the varidus deter- -: minants of démand or other economic variables to be forecasted. By attempting to explain the relationship being forecasted, econometric forecasting allows the man- ~- t> determine the optimal policies for the firm. This is to be contrasted with the