A Beginner's Guide to Economic Indicators

What are Economic Indicators?

Q: I'm constantly hearing about economic indicators in the news, but I'm never sure what
they're talking about. What are economic indicators and why are they important?

A: An economic indicator is simply any economic statistic, such as the unemployment rate,
GDP, or the inflation rate, which indicate how well the economy is doing and how well the
economy is going to do in the future. As shown in the article "How Markets Use
Information To Set Prices" investors use all the information at their disposal to make
decisions. If a set of economic indicators suggest that the economy is going to do better or
worse in the future than they had previously expected, they may decide to change their
investing strategy.

To understand economic indicators, we must understand the ways in which economic

indicators differ. There are three major attributes each economic indicator has:

1. Relation to the Business Cycle / Economy

Economic Indicators can have one of three different relationships to the

economy:

1.Procyclic: A procyclic (or procyclical) economic indicator is one

that moves in the same direction as the economy. So if the
economy is doing well, this number is usually increasing,
whereas if we're in a recession this indicator is decreasing. The
Gross Domestic Product (GDP) is an example of a procyclic
economic indicator.
2.Countercyclic: A countercyclic (or countercyclical) economic
indicator is one that moves in the opposite direction as the
economy. The unemployment rate gets larger as the economy
gets worse so it is a countercyclic economic indicator.
3.Acyclic: An acyclic economic indicator is one that has no relation
to the health of the economy and is generally of little use. The
number of home runs the Montreal Expos hit in a year generally
has no relationship to the health of the economy, so we could
say it is an acyclic economic indicator.
2. Frequency of the Data

In most countries GDP figures are released quarterly (every three months)
while the unemployment rate is released monthly. Some economic indicators,
such as the Dow Jones Index, are available immediately and change every
minute.

3. Timing

Economic Indicators can be leading, lagging, or coincident which indicates the

timing of their changes relative to how the economy as a whole changes.

1.Leading: Leading economic indicators are indicators which change

before the economy changes. Stock market returns are a leading
indicator, as the stock market usually begins to decline before
the economy declines and they improve before the economy
begins to pull out of a recession. Leading economic indicators are
 the most important type for investors as they help predict what
the economy will be like in the future.
2.Lagged: A lagged economic indicator is one that does not change
direction until a few quarters after the economy does. The
unemployment rate is a lagged economic indicator as
unemployment tends to increase for 2 or 3 quarters after the
economy starts to improve.
3.Coincident: A coincident economic indicator is one that simply
moves at the same time the economy does. The Gross Domestic
Product is a coincident indicator.

Many different groups collect and publish economic indicators, but the most important
American collection of economic indicators is published by The United States Congress.
Their Economic Indicators are published monthly and are available for download in PDF
and TEXT formats. The indicators fall into seven broad categories:

1. Total Output, Income, and Spending

2. Employment, Unemployment, and Wages
3. Production and Business Activity
4. Prices
5. Money, Credit, and Security Markets
6. Federal Finance
7. International Statistics

Each of the statistics in these categories helps create a picture of the performance of the
economy and how the economy is likely to do in the future.

Total Output, Income, and Spending

These tend to be the most broad measures of economic performance and include such
statistics as:

 Gross Domestic Product (GDP) [quarterly]

 Real GDP [quarterly]
 Implicit Price Deflator for GDP [quarterly]
 Business Output [quarterly]
 National Income [quarterly]
 Consumption Expenditure [quarterly]
 Corporate Profits[quarterly]
 Real Gross Private Domestic Investment[quarterly]

The Gross Domestic Product is used to measure economic activity and thus is both
procyclical and a coincident economic indicator. The Implicit Price Deflator is a measure of
inflation. Inflation is procyclical as it tends to rise during booms and falls during periods of
economic weakness. Measures of inflation are also coincident indicators. Consumption and
consumer spending are also procyclical and coincident.

Employment, Unemployment, and Wages

These statistics cover how strong the labor market is and they include the following:

 The Unemployment Rate [monthly]

 Level of Civilian Employment[monthly]
 Average Weekly Hours, Hourly Earnings, and Weekly Earnings[monthly]
 Labor Productivity [quarterly]
The unemployment rate is a lagged, countercyclical statistic. The level of civilian
employment measures how many people are working so it is procyclic. Unlike the
unemployment rate it is a coincident economic indicator.

Production and Business Activity

These statistics cover how much businesses are producing and the level of new
construction in the economy:

 Industrial Production and Capacity Utilization [monthly]

 New Construction [monthly]
 New Private Housing and Vacancy Rates [monthly]
 Business Sales and Inventories [monthly]
 Manufacturers' Shipments, Inventories, and Orders [monthly]

Changes in business inventories is an important leading economic indicator as they

indicate changes in consumer demand. New construction including new home construction
is another procyclical leading indicator which is watched closely by investors. A slowdown
in the housing market during a boom often indicates that a recession is coming, whereas a
rise in the new housing market during a recession usually means that there are better
times ahead.

Prices

This category includes both the prices consumers pay as well as the prices businesses pay
for raw materials and include:

 Producer Prices [monthly]

 Consumer Prices [monthly]
 Prices Received And Paid By Farmers [monthly]

These measures are all measures of changes in the price level and thus measure inflation.
Inflation is procyclical and a coincident economic indicator.

Money, Credit, and Security Markets

These statistics measure the amount of money in the economy as well as interest rates
and include:

 Money Stock (M1, M2, and M3) [monthly]

 Bank Credit at All Commercial Banks [monthly]
 Consumer Credit [monthly]
 Interest Rates and Bond Yields [weekly and monthly]
 Stock Prices and Yields [weekly and monthly]

Nominal interest rates are influenced by inflation, so like inflation they tend to be
procyclical and a coincident economic indicator. Stock market returns are also procyclical
but they are a leading indicator of economic performance.
Federal Finance

These are measures of government spending and government deficits and debts:

 Federal Receipts (Revenue)[yearly]

 Federal Outlays (Expenses) [yearly]
 Federal Debt [yearly]

Governments generally try to stimulate the economy during recessions and to do so they
increase spending without raising taxes. This causes both government spending and
government debt to rise during a recession, so they are countercyclical economic
indicators. They tend to be coincident to the business cycle.

International Trade

These are measure of how much the country is exporting and how much they are
importing:

 Industrial Production and Consumer Prices of Major Industrial Countries

 U.S. International Trade In Goods and Services
 U.S. International Transactions

When times are good people tend to spend more money on both domestic and imported
goods. The level of exports tends not to change much during the business cycle. So the
balance of trade (or net exports) is countercyclical as imports outweigh exports during
boom periods. Measures of international trade tend to be coincident economic indicators.

While we cannot predict the future perfectly, economic indicators help us understand
where we are and where we are going. In the upcoming weeks I will be looking at
individual economic indicators to show how they interact with the economy and why they
move in the direction they do.

How Markets Use Information To Set Prices

The Use of Contingent Contracts

Markets, when they operate efficiently, can provide a great deal of information on the
beliefs of the people who participate in that market. Prices, and changes in prices, convey
a lot of information on what traders think is currently happening and what they believe will
happen in the future. To see how this works, we'll look the at the pricing of a simple asset
known as a "contingent contract".

A contingent contract in finance generally refers to a contract in which the amount of

money one agent pays to another in the future will differ depending on the realization of
some future event. A simple example of a contingent contract would be a contract which
gave the bearer of that contract nothing if it rains next Thursday but one dollar if it does
not rain. These kinds of contracts are more common than you might believe at first glance.
A farmer's crop may depend rather heavily or whether or not it rains. If it does rain, he
has a healthy crop which he can sell on the market. If it does not rain the crop will be
ruined and the farmer will having nothing. The farmer can minimize this risk by buying
many of these contingent contracts. If the farmer buys the contingent contracts and it
does not rain, his crop will be worthless but he will get $1 for each contract he holds. Of
course, if it does rain his crop will be valuable, but he'll also have paid money for
contingent contracts which are now worthless. If the farmer buys enough of the contracts,
he can insure that he receives the same amount of money no matter what the weather
does. This sort of risk-minimization is known as hedging and is used quite frequently,
particularly in finance.

From an informational standpoint, contingent contracts (also known as "contingent

claims") are very nice because they tell how likely the market thinks some event will
happen. Suppose our $1 if it doesn't rain and $0 if it does rain contingent contract is
selling for 70 cents. This implies that the market believes that there is a 70% chance it will
not rain and a 30% chance that it will. This is because we believe that 70% of the time the
contingent contract will be worth $1 and 30% of the time the contingent contract will be
worth nothing. So on average, we'd expect the contingent contract to be worth 70 cents.
Now suppose a number of people in the "rain" market got a new piece of information (say
satellite photos) and now believed that the chance of it not raining on Thursday is now
90%. This would cause them to value the contract at 90 cents, but the price is currently at
70 cents. So they would buy these contingent contracts as they'd expect to make 20 cents
on average. The increase in demand for the contracts will cause the price to rise and if
enough people in the market believed the chance of a lack of precipitation was 90%, we'd
expect to see the value of the contingent contract to rise to 90 cents.

To see a good example of price changes and contingent contracts, we'll look at the world
of baseball.

While often used for serious purposes, contingent contracts can also be used as a form of
entertainment. An Irish based website named TradeSports.com allows people to gamble on
sports events using contingent contracts as a basis. You can buy contracts on all sorts of
events, from who will win tomorrow's Blue Jays vs. Red Sox game to who will win the next
Superbowl. The contingent contracts work in a similar fashion as the one in the previous
section. If you buy a $1 Blue Jay contingent contract and the Blue Jays win you get $1 but
if they do not win the contract pays nothing. At the time of writing, the last trade price of
the Tiger Woods contract for the 2003 British Open was 22 cents, meaning that the market
believes that Tiger has a 22% chance of winning the tournament.

The 2003 Major League Baseball All-Star Game was expected to be a match between two
equally capable teams. Before the game begin, the price of the American League contract
had been hovering around 50 cents, so the market believed that the American League
seemed equally as likely to win the game as the National League team. When the game
began, the price was still around 50 cents, as investors had not learned any information
which would cause them to change their beliefs about the outcome of the game. After an
uneventful inning and a half, the American League started to make some noise. With two
out in the inning, American Leaguer Edgar Martinez was hit by a pitch, then teammate
Hideki Matsui hit a single, putting 2 men on base for Troy Glaus. Although there were two
out, it looked like the American side had a chance to score some runs, which would
obviously improve their chances of winning the game. During the inning the price of the
American League contract rose from 48 cents to 55 cents as investors felt that having 2
men on base and 2 outs in a tie game in the 2nd inning raised the American League's
chances to win to 55%. Glaus struck out swinging and the price of the contingent contract
fell almost immediately to 50 cents. A piece of new information (the Glaus strikeout)
caused the price of the contingent contract to fall 10%, despite the fact that the game was
nowhere near completion.

The National League side was unable to do much against American league pitcher Roger
Clemens, but a single by Ichiro Suzuki, a wild pitch by National League pitcher Randy Wolf,
and a single by Carlos Delgado put the American League up 1-0 and the price of the
contingent contract up to around 65 cents. With Delgado on first and 2 outs, Alex
Rodriguez grounded out to third base, and the price of the contingent contract slid to 60
cents.

Everything fell apart for the American League during the 5th inning. The first National
League batter of the inning got to first base on a walk, and the second, Todd Helton, made
the score 2-0 on a homerun. After the third batter of the inning, Scott Rolen, hit a single,
the price of the contingent contract was down to 33 cents. The next two batters for the
National League got out sending the price up to 38 cents, but a double by Andrew Jones
and a single by Albert Pujols sent the score to 5-1 and the price to around 16 cents. The
price did not seem to recover any after Barry Bonds struck out.

By the bottom of the 6th inning, the market believed that the American Leauge only had a
10% chance of winning. A two run homerun by Garret Anderson caused the price to double
to twenty cents, but the price hike was short lived as a 7th inning homerun by Andruw
Jones for the National League sent the price back down to 10 cents. Although the score
was only 6-3, Fox, the network carrying the game, said that the American league did not
stand much of a chance of winning since the National League's closers were unbeatable.
Even a homerun by Jason Giambi sending the score to 6-4 only moved up the contingent
contract price to 15 cents.

Things were looking pretty dire for the American League as they had to face Eric Gagne in
the 8th inning and John Smoltz in the 9th inning while they had a 2 run deficit. With one
out in the 8th, Garret Anderson hit a double, sending the contingent contract price up to
22 cents. Earlier in the game a hit that did not score a run would not have had much effect
on the price, but since it was late in the game and the score was close, investors knew
that even a small change in circumstances could change the outcome. As a result, the
price changes became more dramatic near the end of the game. A ground-out by Carl
Everett sent the price down to 19 cents, but a run-scoring double by Vernon Wells sent the
game to 6-5, and caused the price to rise to 52 cents. Although the American League was
still losing, investors believed that with a runner on 2nd and 2 outs, they were slightly
more likely to win the game than the National League side. Hank Blalock, the next hitter,
hit a towering homerun which caused the American league to take a 7-6 lead very late in
the game, and caused the price to escalate all the way to 85 cents. In a matter of 10
minutes, the value of the contingent contract had increased 8-fold, and investors who
bought at 10 cents suddenly had a very valuable asset. With the 8th inning over, the
American League needed just three more outs to win the game. They would get those
three outs and not score any runs. During the 9th inning the price of the contract rose
from 85 cents to 1 dollar, the price it eventually paid to the holder.

The effect of the All-Star game was seen in other contracts. A day before the All-Star
game, the contract which paid $1 if the Yankees won the World Series was selling for 20
cents. The league that won the All-Star Game would win home field advantage in the
World Series. Teams win more often than not when they have the homefield advantage, so
the outcome of the game was important. The Yankees, seen as the most likely American
League team to make it to the World Series, were seen as slightly more likely to win the
World Series by investors. A contract which pays $1 if the Yankees win the series was
selling for 20 cents the day before the All-Star Game, but had climed in price to 21 cents
the day after. Investors took their new knowledge about homefield advantage in the World
Series, and slightly upgraded the value of all the contingent contracts for American League
teams and slightly downgraded the value of the National League teams.

Next we'll look at some more practical applications of how information causes prices
changes and how we can extract information from price changes.

The effect of new information and changed beliefs are apparent in contingent contracts,
but they also show up in the price of any asset. In quite a few articles, such as Canadian
Dollar Slides Following Surprise Bank of Canada Interest Rate Cut I discuss the link
between the differences in the interest rates in two countries and the exchange rate. In
short, if the interest rate in country A falls and the rate in country B stays the same, we'd
expect to see A's currency become less valuable relative to B's, all else being equal. As an
investor, if I know that country A will be lowering its interest rate, I would expect that the
A's currency would soon become less valuable than B's. So I'd do well for myself if I sold
A's currencies and bought B's on the open market. Of course, if everyone believes the
interest rate drop is coming, they'll sell currency A and buy currency B, until the price of
currency A falls to the level at which it would be after the interest rate drop was
announced. So if we all expect that the central bank of country A will drop rates by 25
points, then they do, we should not expect to see any changes in the exchange rate at the
time of the annoucement. However, if they announce they're not going to cause the
interest rate to decline, we should see currency A rise back up to it's former value, despite
the fact that nothing tangible has changed. To the naive observer, it may even look like
the drop in the exchange rate is causing the central bank of country A to lower its interest
rate a few days later, an idea I look at in length in "Do changes in stock prices cause
recessions?"

By looking closely at these price changes we can also learn a great deal about what the
market expects. Suppose we know that Alan Greenspan is going to make an annoucement
next Tuesday. This situation is not unusual, as it is usually known weeks in advance when
the Federal Reserve Chairman is going to give a speech or make an annoucement. We can
tell what investors' best predictions on the content of the annoucement is going to be by
looking at exchange rates. If the exchange rate drops or rises, we should expect to see a
change in the interest rate, while if the exchange rate stays the same, it's likely that no
change will be made. Of course this is an oversimplification as annoucements by the
Federal Reserve influence all sorts of variables, not just the exchange rate. However it is
apparent that if we watch how prices change we can determine what the investment
community feels will happen in the future.

In a country with a free-market economy, prices are not set by a central planning bureau:
they are set by supply and demand. Because supply and demand reflect the information
and beliefs of investors in those markets, they contain the sum total of all the information
and beliefs the investors have in a market. While we might not have the power to change
people's actions or beliefs, the price mechanism gives us the power to observe those
actions and beliefs. Prices are far more than just what you have to pay for something, they
are also a source of great knowledge if intepreted correctly.