New Forecasting Gauge Predicts Economy, Stock Market Will Decline
Posted by: Administrator in Business & Economy
Economists have long sought an effective financial indicator that gives us an accurate forecast on where the economy is going. Results have been mixed. Examples here are plentiful. One is to look at the term structure of interest rates and gauge the spread between short and long term bond yields.
Another is to look at stock prices and yield spreads as in the Conference Board’s Index of Leading Economic Indicators. Bloomberg also has its Financial Conditions Index and others have similar indices. Many prefer to look at the spread between riskier yields and safer yields to estimate where the economy is headed.
The more technically minded have looked at measures of financial stress as a leading economic indicator, such as the difference between actual and predicted yields from various interest rate models or, more simply, the LIBOR-OIS spread.
However, rarely are these measures very successful when applied retroactively against actual historical data, especially in predicting amounts of future change. That is the rub.
Recently, however, a team of economists -- Jan Hatzius, from Goldman Sachs, Peter Hooper, from Deutsche Bank, Rick Mishkin, from Columbia, Kermit Schoenholtz from New York University and Mark Watson, from Princeton – have worked hard to develop a financial conditions index which does just that and it does it pretty well, too. The work behind it and the index itself have recently been presented with explanations to top Fed officials who are said to have listened with considerable interest.
The goal was to develop not only a good gauge to show us where we stand in regard to our financial sector, but also one which tells us in which direction the economy is headed. They have done so by a major effort to isolate the relevant data from the general underlying business cycle, with the goal being to predict real GDP growth from the financial index they have developed.
Applied against historical data, the formulation does better in some periods than others. But that is more in predicting actual GDP than it is in gauging the direction of GDP movement relative to the present, where the index fairs much better and exceptionally well compared to most.
So what does the new index show us for the here and now? The results are not as encouraging as we would like. The indication is, as I have been arguing, that we are having a contraction in the financial sector that portends the possibility of a double dip recession at worst and a mild mid-recovery dip, at best. Chartists will undoubtedly notice the trend of lower highs since about 1992 or indeed, with some slippage, all the way back to 1970.
Source: Hatzius, et. al. (.pdf)
This result obtains, notwithstanding an expanding stock market, a steep yield curve and other favorable variables. But contrary indicators include declining M2 and M3, a falling monetary multiplier, a decline of issued and outstanding commercial paper and a decline in the issuance of mortgage backed securities. All signs of contraction in the latter category.
Although we seem to be fine for now, this is a forward looking, predictive indicator. In part, it is based on the deviation of various financial indicators from what is predicted for those indicators from recent economic conditions. Some indicators have not improved much, in light of our recent GDP growth. That is a bad sign. Secondly, the index uses not only flow variables, but also underlying stock variables and many of the latter are relatively stagnant, too.
It is clear that we are not out of the woods, by any means.
