Looking at the Leading Index

While it sometimes sends out false alarms, the index has never failed to predict a business-cycle peak.
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Through the Looking Glass

JACKSON HOLE, Wyo. -- The

index of leading economic indicators

is just plain cool.

Get this. Using a three-of-seven rule -- three declines over the course of seven months -- the leading index has never failed to predict a business-cycle peak. (Click

here for a history of the leading index and

here for a history of recessions.)

It does send out plenty of false signals. It

fell during each of the first five months of 1995. It fell three times between February and July in 1994. It fell five times between January and July in 1993. It fell four times between April and September in 1992.

In short, it predicted a recession that never came to pass every year between 1992 and 1995.

Yet certainly a false alarm is better than no alarm at all, and the fact remains that the three-of-seven rule has never failed to predict a business-cycle peak.

One wonders whether the economic forecasters who got riled up last autumn don't know this. Russia begat the

Long Term Capital Management

implosion that begat a pancaked yield curve, remember, and a pancaked yield curve always represents the shortest distance between reasonableness and (predictions of) Apocalypse now.

The curve did flatten markedly. The difference between the yield on a 10-year Treasury note and a three-month Treasury bill dropped to just 7 basis points for the month of September from 30 basis points in August; not since December 1989 had the market seen such a flat curve.

It's somewhat understandable that some forecasters were so spooked as to immediately revise their forecasts to incorporate (a) the expectation that

gross domestic product

growth would plunge to 1% during the first quarter and (b) the very likely possibility of full-blown recession. (The

New York Fed

piece is a must-read.) But for at least three reasons, the fact that they were still doing so more than a month later is not so understandable.

First, the curve had steepened notably come November. The 10-three spread bounced to 46 basis points in October; that went down as its biggest level since May. Given that economists were quick to impose doom forecasts on the basis of a one-month flattening, why did they not remove them on an even bigger one-month steepening?

Second, forecasters failed to put the pancaked curve in proper perspective. Namely, they jumped to the conclusion that it was sending a strong signal about underlying weakness in the economy. (Note that the people who would not shut up about this were the same people who had been predicting slowdowns for three straight years. It is also more than a bit interesting that some of those same people have since found religion and now boast some of the biggest forecasts on the Street.)

But that was an absolutely ridiculous assertion from the start. In fact, the economy could not possibly have been more solid when Russia (and then its fallout) hit. Nothing about what happened last autumn ever had anything to do with the economy. And for that matter, neither did the

Fed's

reaction. The curve action reflected heightened risk aversion; the Fed's reaction reflected an attempt to keep shares from crashing (yes, there is a

Plunge Protection

team). Neither had anything to do with economic weakness -- present or future.

And third, forecasters failed to look to the leading index for guidance.

It wasn't showing three declines in seven months back then, and it's still

not doing so now.

Side Dish

Real teams play on grass.

The best thing about the

Journal

is

Holman Jenkins

on the editorial page every Wednesday.

Early this morning, I had an exceptionally horrific nightmare in which some suit on television said the bond would rally on a

Fed

tightening.