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December 07, 2022 | Report
The Conference Board Leading Economic Index® (LEI) for the United States has long been lauded as a reliable leading indicator of recessions, and recent data suggest that the LEI is signaling an approaching recession. Indeed, given the LEI’s recent performance, The Conference Board projects that economic weakness will intensify and spread more broadly throughout the US economy over the coming months with a recession to begin around the end of 2022 or early 2023.
Here's a look at why and how the LEI provides such valuable information.
The LEI is comprised of 10 indicators that cover a wide range of economic activity, including job growth, housing construction, and stock prices. The index is designed to provide a broad-based look at the health of the economy and can be used to predict turning points in the business cycle. The LEI acts as a predictor of turning points because as a composite index it summarizes the consensus of forward-looking indicators from different areas of economic activity.
On average, the LEI level peaks 11-12 months ahead of a peak in the business cycle (Chart 1). This means that by tracking the LEI, we can get an early indication of when a recession might occur. The most recent data show that the LEI peaked in February 2022 and has been trending downward since then. However, it can take some time to recognize when the LEI is peaking. For example, if the LEI reached its most recent maximum in February 2022, the peak would not be recognized clearly as such until later in the year. This recognition lag could take as long as six months.
Chart 1: LEI turns down ahead of recessions, and the most recent LEI peak was in February 2022
Note: Recession periods are shaded and peak and trough dates are indicated at the top of the graph. The negative numbers in the chart denote the lead time of the index ahead of the corresponding peak.
When the US LEI falls more than 4 percent over a span of six months, it enters recessionary territory. One way to track the LEI is by looking at the six-month change in the index (Chart 2). This measure tells us whether the economy is gaining or losing momentum and can be used to predict changes in direction. The six-month growth rate of the index is a measure of the duration and depth of a recent decline in the index and shows whether the economy might change direction and tip into a recession. For example, the LEI’s six-month growth rate dipped below zero in May 2022 (-1.5 percent, annualized) and it has continued to deteriorate since then. According to the latest available data shown in Chart 2, this rate of change is at -6.3 percent, signaling an increasing likelihood of a recession. This large six-month drop in the LEI cannot be due to a fluke in the data because this negative rate of change is already larger than the average declines that were observed in the past (i.e., the median negative six-month change is about -4.0 percent). This is significant because it suggests that the economy is losing momentum, and the loss of momentum is large enough to tip the economy into a recession.
Chart 2: The six-month growth rate dips into negative territory before slowdowns and recessions
While tracking the six-month change in the LEI is a good way to assess whether a recession is on the horizon, it’s not perfect. Such negative rates have occurred seven times since 1959 without a recession starting shortly afterwards (Chart 2). Historically, these declines, ranging from -0.5 to -2.4 percent, were in October 1966, January 1996, November 1998, December 2002, and three times in the 2010s, and they may be associated with significant growth slowdowns in the economy. This just goes to show that just looking at the index growth rate alone could give false signals and predictions that may not always be accurate.
The signal provided by the LEI can be refined by considering a metric known as “diffusion.” Diffusion indexes measure how widespread economic activity is across different sectors and types of economic activity (e.g., consumers, housing, financial markets, etc.). Diffusion tells us whether an economy is truly weakening or if there are just isolated pockets of weakness that do not translate into a broad downturn in overall economic activity across the board.
Chart 3 shows the diffusion index of the LEI over a span of six months. When all components of the LEI are rising over the past six months, this index registers 100 percent. When none of the components are rising, it registers 0. Readings above (below) 50 percent indicate that a majority of the LEI components rose (fell) over the previous six months. As with the six-month growth rate, the LEI’s diffusion index is sensitive to slowdowns as well as recessions and it shows several periods when a majority of the index components were pointing to weaknesses that didn’t develop into recessions.
Chart 3: The LEI six-month diffusion index falls below the 50 threshold when the economy gives a growth slowdown warning
The LEI and its diffusion index work together to give us a more complete picture of where the economy is headed. And when we consider all of these indicators together, it’s clear that the US economy is facing an imminent recession around the beginning of 2023.
Chart 4 illustrates the so-called 3Ds rule which is a reliable rule of thumb to interpret the duration, depth, and diffusion—the 3Ds—of a downward movement in the LEI. Duration refers to how long-lasting a decline in the index is, and depth denotes how large the decline is. Duration and depth are measured by the rate of change of the index over the last six months. Diffusion is a measure of how widespread the decline is (i.e., the diffusion index of the LEI ranges from 0 to 100 and numbers below 50 indicate most of the components are weakening). The 3Ds rule provides signals of impending recessions 1) when the diffusion index falls below the threshold of 50 (the index is not shown but the months are denoted by the black dotted line in the chart) and simultaneously 2) when the decline in the index over the most recent six months falls below the threshold of -4.0 percent. The red dotted line is drawn at the threshold value (measured by the median, -4.0 percent) on the months when both criteria are met simultaneously. Thus, the red dots signal a recession.
While the LEI started flashing a recession earlier in 2022, other indicators may be giving mixed signals. This is especially so for employment and unemployment rates, which are still showing strength. However, even in this area, a leading indicator of employment, temporary help jobs, has now declined for four consecutive months, pointing to weakening labor markets in the months ahead. The Conference Board Employment Trends Index™ (ETI), a composite index of leading indicators of employment, akin to the LEI, signals slowing employment growth in the near term.
The LEI provides valuable information about impending recessions. By tracking the index and considering how widespread the risks to economic activity are, we can get a clearer picture of where the economy is headed and plan accordingly.
The Conference Board’s indicator program relies on the LEI’s companion index, the coincident economic index or CEI, together with real GDP to tell whether an economy is currently in recession or not. We will take a deeper dive on what the coincident indicators are saying in our next article.
Chart 4: The LEI diffusion index continues to show a strong recession signal
Related references:
Business Cycle Indicators Handbook
Understanding Business Cycles: The Indicators Approach to Forecasting for Agility
