What it means
Economies do not grow in a straight line; they run through repeated cycles of expansion and contraction. Because official measures such as gross domestic product arrive months late and are then revised, businesses look at faster-moving statistics to sense the direction of travel.
Those statistics are the indicators. Leading indicators turn before the wider economy does.
Building permits, new orders for durable goods, average weekly hours worked, consumer expectations and the yield curve all tend to move first, because they capture decisions made now that produce activity later. They are the most useful for planning and also the most likely to give a false signal.
Coincident indicators move roughly in step with the economy and confirm where it actually is. Payroll employment, industrial production, personal income and retail sales fall into this group.
Lagging indicators, such as the average duration of unemployment, business lending volumes and the prime interest rate, only turn after the change is well established, and their value is in confirming that a turning point genuinely happened. Practitioners rarely rely on a single series.
Composite indexes bundle several components into one number, and a diffusion index counts what proportion of components are rising, which gives a sense of how broad a movement is. A reading above 50 on a diffusion index means more components are improving than deteriorating.
For a business the point is not to forecast the economy precisely but to buy a few months of warning. If the indicators most connected to your own demand start weakening, you can slow hiring, tighten credit terms and delay discretionary spending before revenue falls.
Choosing three or four indicators specific to your industry beats watching a generic national index.
In practice
Real-world examples.
Example
A building products supplier tracks residential building permits as its main leading indicator. When permits fell roughly 6% over three consecutive months, the company postponed a $2,000,000 capacity expansion and avoided adding fixed cost into a softening market.
Example
A staffing agency watches weekly initial jobless claims because its own placement volumes move a few weeks behind them. A steady rise in claims prompted management to shift the sales team from new client acquisition towards retention of existing accounts.
Example
A regional bank monitors the average prime rate charged, a classic lagging indicator, to confirm that a recovery it suspected six months earlier had genuinely taken hold before it loosened its lending criteria.
Formula
Calculation
Diffusion index = (number of components rising + 0.5 x number unchanged) / total components x 100. Percentage change in a composite index = (current level - prior level) / prior level x 100.
A composite leading index has 10 components. This month 7 are rising, 1 is unchanged and 2 are falling. The diffusion index = (7 + 0.5 x 1) / 10 x 100 = 7.5 / 10 x 100 = 75, meaning the improvement is broad rather than driven by one or two series.
The same composite index level fell from 112.5 last month to 111.6 this month. The change is 111.6 - 112.5 = -0.9 points, and the percentage change is -0.9 / 112.5 x 100 = -0.8%. A broad diffusion reading alongside a falling headline level is a signal to look closely at which components are dragging.Case study
Seen in the real world.
Cobalt Ridge Components is an illustrative parts manufacturer that supplies the vehicle aftermarket. Its planning team chose four indicators tied to its own demand: new durable goods orders, average weekly hours in manufacturing, consumer expectations and its own order backlog.
Over one autumn the composite of those four fell in three consecutive months by 0.5%, 0.6% and 0.7%, a cumulative decline of 1.8%. None of the falls was dramatic alone, but the consistency and the breadth of the decline persuaded the team that this was a trend rather than noise. They cut planned hiring from 40 roles to 25, deferred a tooling upgrade and held an extra $1,200,000 of cash.
Revenue did fall the following two quarters in this fictional example, and Cobalt Ridge entered the downturn with capacity roughly matched to demand rather than carrying a payroll built for a boom that had already ended.
Watch out
Common mistakes.
- Reacting to a single month's move in one indicator, when the accepted convention is to look for three consecutive months of movement in the same direction before treating it as a signal.
- Using national indicators for a business whose demand is regional or sector-specific, so the numbers move for reasons that have nothing to do with its customers.
- Treating leading indicators as forecasts rather than probabilities, which leads managers to cut hard on a signal that turns out to be a false alarm.
Questions
People also ask.
What is the difference between leading and lagging indicators?
Leading indicators change before the wider economy turns and help with planning, while lagging indicators change afterwards and help confirm that a turn really occurred.
How far ahead do leading indicators actually point?
Typically somewhere between three and twelve months, with the lead time varying by cycle and by indicator, so they give a direction rather than a date.
Which indicators should a small business watch?
Usually three or four tied directly to its own demand chain, such as permits for a builder or freight volumes for a haulier, plus one broad measure of consumer or business confidence.
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