They say that hindsight is 20/20. There’s also an old joke that economists have predicted nine of the last five recessions. These two sayings encapsulate, respectively, the concepts of “lagging” and “leading” indicators – the two key categories of data that economists and businesses use to make decisions. A lagging indicator shows how the economy has performed in the past and gives concrete data about its current outcomes. A leading indicator predicts how the economy will perform in the future and is based on data about current outcomes. Here’s what you should know about these two key metrics.
How Lagging and Leading Indicators Are Used
In many ways, whether a piece of data is a lagging or leading indicator depends on how an economist chooses to use it. Data that is strongly associated with future outcomes can be used as a leading indicator to predict events, even while at the same time this data is the outcome of past events for which it is a lagging indicator.
Lagging and leading indicators are common tools for business and financial analysis as well. In fact, virtually any form of quantitative analysis and prediction will rely on this concept. However, for ease of use, in this article, we will refer to how this applies to economic research. Together economists use lagging and leading indicators to understand the state of the economy overall and to anticipate how it will move in the years to come.
What Is a Lagging Indicator?
Lagging indicators are data about actual outcomes. Put another way, lagging indicators measure results after changes have happened, letting economists study how a series of events affected the economy. Per the name a lagging indicator shows up after, or “lags behind,” the changes which caused it.
The employment report is an example of a lagging indicator. Every month the Bureau of Labor Statistics publishes information on how many jobs the U.S. economy created and destroyed over the course of the previous month. While economists can use this data as the basis for future decisions, it is not a prediction of what the market will do going forward. Instead, it is a statement of how the labor market performed previously.
Data in the jobs report tells economists how their efforts affected the labor market overall. If the Federal Reserve changes interest rates, months later the employment effects will show up in the jobs report. These results will lag behind the changes which caused them, and inform economists as to how changing interest rates affected employment.
Lagging indicators measure the results of a system or a series of decisions. This makes them useful, even while they can frustrate analysts. A lagging indicator is a valuable information because economists can compare them with their predictions to test the strength of a theory. However, they can also frustrate economists because they provide data about events that have already taken place. By the time a lagging indicator arrives, it’s already too late to change those results. All economists can do is try and make better decisions the next time.
What Is a Leading Indicator?
Leading indicators are data that indicate a likely or potential future outcome. Put another way, leading indicators suggest likely changes in the market or the possible results of a series of decisions. Per the name, a leading indicator precedes, or “leads,” the changes that it indicates.
Economists use leading indicators to make predictions about the economy. When the Federal Reserve changes its benchmark interest rate, this is because leading indicators suggested that doing so would help stabilize inflation or raise employment. (The Federal Reserve would then look at the measured inflation rate and the reported unemployment rate, two lagging indicators, to determine the results of those changes.)
The quit rate is a good example of a leading indicator. One of the most important, but rarely reported, pieces of labor data is the percentage of workers who voluntarily leave their jobs every month. This quit rate is a strong indicator of consumer confidence at large. People who feel good about their finances and the labor market will be more likely to leave a job in search of a better one, while workers who feel financially insecure or anxious about the labor market may stay in their positions longer.
This makes the quit rate a very good leading indicator for the labor market and consumer economy overall. By measuring how many people quit their jobs every month economists can predict how the economy as a whole is likely to develop in the months ahead. A strong quit rate suggests that the economy may do well, as workers are showing signs of financial strength and confidence. A low quit rate can suggest an economic downturn may be coming as workers show signs of financial uncertainty.
Leading indicators predict the result of a system or a series of decisions, letting economists use them to influence outcomes down the road. They can also be frustrating, however, as they are never precise. Leading indicators can suggest what will happen but can never tell for sure.
The Bottom Line
Lagging indicators are sets of data that follow economic events and tell economists the state of the economy, either as it currently is or as it was at some time in the past. Leading indicators are sets of data that precede economic events and tell economists how the economy is likely to change.
Tips for Understanding Economics
- A financial advisor can consider various economic indicators in building and fine-tuning your portfolio. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- The field of economics can be confusing, especially if you’re not familiar with the terms. There are 12 phrases in economics that are particularly important to know. The unemployment rate is one of those terms, but it’s also a fairly weak one and has several problems that you should be aware of.
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