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A Framework That Provides Clarity

During periods of “low visibility,” confusion reigns: for every indication of one trend, there seems to be a countertrend. The key is to glean from the collective wisdom of reliable leading indicators a clear signal that the economy is headed for a turn.

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Success in Timing Cycles


Usually economists try to estimate magnitudes of economic variables at a point in time. But the Economic Cycle Research Institute thinks they should be trying to do the reverse. Its complex analytical models seek to gauge the timing of particular economic magnitudes, all as part of an effort to predict key turning points in the economy, such as the start and ends of recessions.

It's a model that has served the organization well in recent years. ECRI claims to be the first major institution of its kind to call the 2001 recession. In September 2000, an ECRI report declared that "never in this expansion has the risk of recession been higher" and in March 2001, the group concluded that "recession is unavoidable." For its part, the National Bureau of Economic Research, the body that officially dates U.S. business cycles, didn't declare that a recession had begun until November of last year. It said the recession began in March 2001.

Lately, ECRI's forecasts have been more encouraging. It has been insistent that its leading indicator charts are not signaling the so-called "double dip" recession that some economists fear.

Explaining the rationale behind ECRI's approach, research director Anirvan Banerji said: "There are patterns in an economy over time that drive and explain the business cycle. We refer to them as durable sequences that are vital to explaining the way the economy behaves. These are certain reliable leading economic indicators that turn down before a downturn (in economic activity) and then are followed by coincident and lagging indicators."

Those terms - leading, coincident, and lagging indicators - refer to a method of classifying economic indicators according to whether the indicator reaches a peak prior to (leading), at the same time as (coincident), or after (lagging) overall economic activity - for instance, as measured by gross domestic product.

This approach was developed by Wesley Clair Mitchell and Arthur Burns in the 1920s - who later became Federal Reserve Chairman - when they founded the NBER. Geoffrey H. Moore was an early associate of Burns and Mitchell at the NBER and was the founder of ECRI.

Moore developed the art of business cycle analysis in the 1950s and 1960s, performing important empirical work that is continuing to bear fruit in the current cycle.

In a poignant series of coincidences, Banerji said, ECRI's September 2000 report on the risk of recession came six months after Moore's death, while the March 2001 prediction occurred on the first anniversary of his passing.

The Method Has Been Tested

There is nothing astrological about ECRI's approach, however, it's based on rigid empirical research.

Banerji explains that Moore's original research, done in 1950, identified eight economic indicators from 1870 through 1938 that proved to be robust predictors of business cycles. "These indicators proved to be accurate predictors out-of-sample both with respect to time and for other countries," Banerji said.

ECRI performed its out-of-sample test - a validation approach that applies the model to data collected in a period or place outside that upon which the model is based - using the same eight indicators it tracked in the U.S. in the 1948-through-1991 period. This out-of-sample testing has been applied across economies as diverse as Canada, Germany, and India, which has made the method available to measure cyclical indicators in 18 countries.

The crucial similarities found in these tests, according to Lakshman Achuthan, Managing Director at ECRI, is that "the post-civil war U.S. economy is similar to other economies abroad despite huge structural shifts, because of the existence of the free market mechanism in the economy."

That's right, post-civil war. That's how far back ECRI's analysis goes. That makes the shift from a smokestack economy to a high tech economy minor. "It goes from buggy whips to computers, it's the market that's important," Banerji says.

Putting Shocks In Perspective

Many critics of the cyclical approach to forecasting cite various so-called "shocks" to the economic system - such as the 1973 OPEC oil embargo, the 1980 credit crunch, or the 1990 Iraqi invasion of Kuwait - as the cause of the recessions that followed each event.

But ECRI's approach, though cyclical in its focus, acknowledges the influence of these so-called "exogenous" shocks and incorporates them into the model.

"In looking for recessions, we monitor the basic endogenous forces and take into account exogenous shocks to look at the timing of the cycle," explained Achuthan. The behavior of the basic cyclical economic indicators - the endogenous forces - is examined every month in a meeting of the entire ECRI staff. Exogenous shocks are constantly discussed.

This method is superior to standard regression-based methods, explains Achuthan, "because the linear method simply extends the past average behavior in a long expansion and misses the signals of a turning point."

But the method doesn't work equally well in all situations. "It doesn't work for centrally planned economies and it doesn't work for an economy that is overwhelmed by violent political unrest," said Banerji.

ECRI's next challenge is to try to apply the method to China as it goes through an adjustment to a market-based economy.

Domestically, the organization also faces challenges. "This is the first cycle being dated and analyzed in the U.S. without Geoffrey Moore," said Achuthan, who pointed out that before 1979 "Moore was the business cycle dating committee" at the NBER. Indeed, that committee was a one-man show until that time, when it became a six-member group. Moore remained a NBER committee member until he died in March 2000.
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