What is a Lagging Economic Indicator?
With all the talk in the last year of will there or won't there be a recession, last week I covered the 4 leading major economic indicators to watch that help predict a recession before it comes. And as I anticipated, lots of you wanted to know whether they were predicting a recession or not. And here's the thing: reading leading indicators are a little like reading tea leaves. You have to look at the long-term trends, not just individual data points, and all of them together to get a full picture. And you don't really know for sure until a lagging economic indicator confirms it.
A Lagging Economic Indicator
A leading economic indicator is predictive. It starts to change ahead of the broader economy. A lagging economic indicator is confirmatory. Once reported, they confirm what leading indicators may have predicted was already happening, eliminating any uncertainty.
Lagging indicators are slower to respond and serve to confirm long-term trends. While leading indicators predict where the economy is going, they can also be more volatile, moving up and down frequently, seasonally, and for many different reasons beyond just the long-term economic trend.
Case and point: the stock market, a leading indicator, got skittish and took a nosedive in December 2018... but then rallied and had a huge recovery in 2019 with no recession. A lagging economic indicator is more reliable than a leading indicator, albeit often late with the news.
4 Major Lagging Economic Indicators
Real GDP Growth
Gross Domestic Product, also known as GDP. This is the big one. It is the most comprehensive measure of U.S. economic activity. The very definition of an economic recession revolves around what happens to GDP: two consecutive quarters of declining GDP.
The Bureau of Economic Analysis reports GDP quarterly, releasing a first estimate on a one-month lag, and a more fully-baked second estimate two months after the quarter ends. So for Q4 ending in December, they will announce an estimate at the end of January, which may or may not be revised at the end of February.
The National Bureau of Economic Research's Business Cycle Dating Committee officially declares a recession (and recoveries). And since a recession is typically declared after two consecutive quarters of declining GDP, a recession is often not officially announced, until we have already been in it for 7-8 months, at which point, it may nearly be over. Hence, the lagging indicator.
So what exactly is GDP? That could be an entire post in itself, but anyone remember this formula from high school economics?
GDP = C + I + G + (X – M)
GDP is composed of
- Personal consumption (C), all the stuff and services you and I spend money on every day
- Investment (I), all the money businesses invest in equipment, buildings, technology, inventories and residential investment too
- Government spending (G), everything the federal, state and local government spends
- Net exports (X-M), or all the goods we export less all the goods we import.
Here's how GDP brokedown in 2019 - remember how consumer spending drives the bulk of it???
One last thing... what does it mean when it's "real"? Real GDP adjusts for inflation. It picks a year and assumes constant prices, to see what economic growth is without inflation, or price increases.
Unemployment Rate
While the Bureau of Labor Statistics publishes a monthly Current Employment Summary on just a one week lag, unemployment is still a lagging indicator. This is because employer's are typically making employment decisions in response to leading indicators - like slower sales. It takes time for hiring (and firing / laying off) decisions to play out.
Unemployment Rate =
Unemployed Workers ÷
Total Labor Force
Some say this metric understates true unemployment, because people outside of the labor force (those not actively looking for work) and anyone who may be under-employed are not accounted for in the unemployment rate.
Unemployment typically reaches its lowest point just before a recession begins, then rapidly increases during a recession, as employers work to cut costs quickly in response to declines in sales. It takes a long time for employment to recover post-recession.
Historically, many economists considered 4% to be "full employment" to account for job switching and people newly entering the workforce. In 2020, we are currently experiencing 50-year lows in the unemployment rate, with many employers indicating they can't find qualified employees for job postings.
Income and Wages
With employment, follows income and wages. A week after the monthly Current Employment Statistics report, the Bureau of Labor Statistics puts out its Real Earnings Summary. It breaks out the average weekly earnings, hours and hourly earnings of all employees.
While hourly wages historically have risen relatively consistently over time, during a recession overall income is impacted in two ways. First, by unemployment. And second, for those who remain employed, by a reduction in hours.
So even if you remain employed, you may still experience a decline in income from working fewer hours. Those two factors - employment levels and weekly hours - both take the longest to recover post-recession as well.
CPI
The Consumer Price Index, aka CPI, is the most cited lagging economic indicator for measuring periods of inflation (or deflation). CPI is tracked by the Bureau of Labor Statistics, reported monthly on roughly a two-week lag, and measures the actual prices paid by consumers for a set basket of goods.
They are literally surveying Americans across the country to see what they pay for everything from food and utilities, to medicine and gas. CPI is reported for all items, for food, for energy, and excluding food and energy, as these drive the most variability. CPI is also available for different regions as well.
CPI is calculated as the change in that basket of good from period to period. Historically, prices have declined in a recession, as wages and employment decline.
In the late 1970s, there were also recessions caused by excessive inflation due to volatile energy prices. The Federal Reserve works to use monetary policy, primarily the overnight lending rate, to keep inflation in check. They target 2% inflation as a healthy, growing, but stable, economy.
Generally speaking, when interest rates are low, the economy grows and inflation increases. When interest rates are too high, the economy slows and inflation decreases. The Fed can make changes to the overnight lending rate to increase or decrease interest rates, and thus achieve their 2% target inflation rate, while also keeping an eye on other goals for a healthy economy: unemployment (3.5-4.0% natural level) and GDP growth (2-3%).
So Where Are We Now?
While some of the major leading economic indicators have given warning signs of a pending recession, none of the lagging economic indicators have confirmed it yet. Q4 2019 GDP growth was 2.1%; the January 2019 current employment statistics show continued job growth and 3.6% unemployment; real earnings continue to increase and annual CPI growth for January was 2.5% so a little ahead of the inflation target.
We are beginning to see the global impacts of the coronavirus and the nearly entire economic shutdown of China this month having some spillover effects, and the Fed is watching it too. So, we keep watching these leading and lagging economic indicators to see what they tell us, and in the meantime preserve your financial flexibility to whether the cycle. Shore up your emergency fund, and keep living within your means and investing for the long-term.
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