Definition and how to interpret

What is an economic indicator?

An economic indicator is a piece of economic data, usually of macroeconomic scale, used by analysts to interpret current or future investment opportunities. These indicators also help assess the overall health of an economy. Although there are many different economic indicators, specific pieces of data released by government and non-profit organizations are widely followed. Such indicators include, but are not limited to, the Consumer Price Index (CPI), gross domestic product (GDP) or unemployment figures.

Types of economic indicators

Economic indicators can be divided into categories or groups. Most of these have a specific schedule for release, allowing investors to prepare for and plan to see information at certain times of the month and year.

Leading indicators

Leading indicators, such as the yield curve, consumer durables, net business formations and stock prices, are used to predict the future movements of an economy. The numbers or data on these financial guidelines will move or change ahead of the economy, hence their category’s name. Consideration of the information from these indicators should be taken with a grain of salt, as it can be wrong.

Investors are mostly interested in leading indicators, as a correctly placed leading indicator can accurately predict future trends. Leading indicators can make broad economic assumptions. For example, many investors follow forward-looking yield curves to predict how future interest rates may dictate stock or bond performance. This analysis relies on historical data. Based on how investments performed the last time the yield curve was a certain way, some may assume that the same investments can repeat their performance.

Random indicators

Casual indicators, which include measures such as GDP, employment levels, and retail sales, are viewed with the occurrence of specific economic activities. This class of metrics shows the activity of a specific area or region. Many policymakers and economists follow this real-time data, as it provides the most insight into what is happening right now. These types of indicators also allow policy makers to utilize real-time data without delay to make informed decisions.

Coincidental indicators can be somewhat less useful to investors as the economic situation unfolds simultaneously. Unlike a prediction or a forecast, a random indicator informs investors about what is actually happening in the present. Therefore, coincident indicators can only be useful to those who can correctly interpret how economic conditions today (ie falling GDP) will affect future periods.

Lagging indicators

Lagging indicators, such as gross national product (GNP), CPI, unemployment rates and interest rates, are only seen after a specific economic activity takes place. As the name suggests, these datasets show information after events have occurred. Such lagging indicators are technical indicators that come after major economic shifts.

One disadvantage of lagging indicators is that a strategy developed in response to such indicators may become sub-optimal. For example, by the time the Federal Reserve interprets CPI data and decides how best to conduct monetary policy to curb inflation, the numbers it observes may be slightly out of date. Although lagging indicators are still used by many governments and institutions, they also carry the risk of misdirecting decision-making due to faulty assumptions about contemporary economics.

Interpretation of economic indicators

An economic indicator is only useful if one interprets it correctly. History has shown strong correlations between economic growth, as measured by GDP, and corporate profit growth. However, it is almost impossible to determine whether a particular company can grow its earnings based on one indicator of GDP.

The objective importance of interest rates, gross domestic product, existing home sales or other indices is not denied. The indicators reflect the cost of money, spending, investment and the activity level of a large part of the overall economy.

Like many other forms of financial or economic measures, economic indicators hold tremendous value when compared over time. For example, governments can see how unemployment rates have changed over the past five years. A single case of unemployment figures does not yield much value; However, by comparing it to previous periods, analysts can better understand the issue as a whole.

In addition, many economic indicators are benchmarked, either by a government agency or other entity. Consider how the Federal Reserve’s target rate of inflation is usually 2%. The Federal Reserve then sets policies based on CPI readings to achieve this target. Without this measure, analysts and policy makers would not know what makes an indicator’s value good or bad.

The stock market as an indicator

Leading indicators predict where an economy is likely to be headed. One of the leading indicators is the stock market. Because stock prices take into account forward-looking performance, the market can signal the economy’s direction if earnings estimates are accurate.

A strong market may indicate that earnings estimates are higher, which may indicate that overall economic activity is picking up. Conversely, a bear market may indicate that company earnings are expected to suffer. However, there are limitations to the usefulness of the stock market as an indicator because the relationship between performance and estimates is not guaranteed.

Stocks are also subject to price manipulations caused by Wall Street traders and corporations. Manipulations can include inflating stock prices through high-volume trades, complex financial derivative strategies, and creative accounting principles, both legal and illegal. The stock market is also vulnerable to the emergence of “bubbles”, similar to false positives about the market’s direction.

Advantages and disadvantages of economic indicators

Advantages of economic indicators

Economic indicators rely on data to back up predictions of what will come in the future. When analyzed correctly, investors can capitalize on data to make successful trades or correctly assess future market conditions.

Economic indicators are often free and publicly accessible. In addition, economic indicators reported by governments often have a fixed cadence and steady form of measurement. This means that you can usually rely on the method of how an indicator was calculated and the timing of when that indicator will be released.

Disadvantages of economic indicators

A disadvantage of economic indicators, especially leading or coinciding indicators, is that they rely on a degree of forecasting. While leading indicators are projections for the future, even casual indicators rely on some assumptions. Such indicators do not always predict the future correctly, and the actions they recommend may not play out as expected.

Economic indicators, when boiled down to a single number, also fail to capture complex realities. For example, consider all the variables that contribute to the unemployment rate. These can include a wide range of influences, from macroeconomic conditions to minor details such as weather patterns. As an indicator, the unemployment rate cannot fully capture all the factors that contribute to an issue.

Finally, economic indicators are somewhat open to interpretation. Consider an example where inflation has fallen from 4.6% to 4.5%. Is this considered a good change, or should the drop have been greater? Economists and policymakers often debate the appropriate approach to interpreting economic data. Although the numbers may be concrete, different interpretations can lead to drastically different conclusions.

The Bottom Line

Economic indicators are leading, incidental or lagging numbers that indicate broad conditions. Economic indicators such as GDP, unemployment, inflation or certain prices inform policy makers, individuals, companies and investors of not only where the economy is today, but perhaps where the economy may be heading. Economic indicators can be used to guide government policy or set investment strategies.