While we closely follow economic news, few of us, if we really admit it, actually know how to gauge the economy’s current and future status. Find out how to read economic indicators and forecast business cycles.

The state of the economy concerns most of us. But how can we predict if the economy will go up or down? The answer—economic indicators—those figures that clue us in.

There are many economic indicators, such as real gross domestic product (GDP) and the consumer price index (CPI). The GDP is the total of all goods produced in the country in real terms—so that inflation doesn’t compromise the accuracy of figures—while CPI reflects the price change for a given set of merchandise and services, corresponding to what an average consumer might buy over a certain period.

Some economic indicators fall under one of three categories—leading, lagging or coincident. Leading indicators provide insight into the economy’s future state while coincident indicators reveal the economy’s current status. In comparison, lagging indicators change months after the start of a downturn or upturn so they give us an idea of how long the economic downturn or upturn will last.

The Federal Reserve—the U.S. economy’s gatekeeper—studies these economic indicators and uses them to determine the nation’s monetary policy. Remember that the Fed oversees financial institutions, handles the country’s money and influences the economy.

Aside from economic indicators, the Fed also reviews The Beige Book, a report that sums up comments from businesses and other contacts. During a calm economy, the Federal Reserve chairman checks data about the economy every half hour or so, and when things are not tranquil, he accesses the information every 15 minutes. By doing so, the Fed can keep abreast of the economy’s current status and future direction.

By looking at economic indicators, the Fed can tell what business cycle phase the economy is in at the time. There are four phases of the business cycle of increasing and declining economic growth, and they are 1) expansion or recovery, 2) peak, 3) contraction or recession, and 4) trough. As the economy goes from one phase to the next, the economic indicators change. While leading indicators tend to change before the economy enters a new phase, coincident indicators change when it does and lagging indicators change afterwards.

Our system relies on the theory that expectations of future profits propel the economy through the different phases. When business executives anticipate increasing sales and profits, companies generally boost production of goods and services and investment in new structures and equipment. On the flipside, if they think profits are headed south, they cut back on production and investment. Indeed, firms’ actions trigger the four phases of the business cycle.

Below, we give you examples of indicators that tell us what phase the economy is approaching, currently at or has already entered:

Leading Indicators

1) Average weekly hours, manufacturing: This is the weekly average number of hours worked by production personnel in manufacturing industries. Because employers typically make adjustments to work hours before expanding or reducing their workforce, this indicator leads the business cycle.

2) Average weekly initial claims for unemployment insurance: This figure is usually more responsive than either total employment or unemployment to general business conditions. When conditions deteriorate (for example, layoffs increase and new hirings decrease), initial claims go up, preceding the business cycle.

3) Building permits, new private housing units: The number of residential building permits issued signifies the level of construction activity, which usually precedes most other types of economic production.

4) Stock prices, 500 common stocks: The Standard & Poor’s 500 stock index, which is compiled daily, signals the price movements of a wide selection of common stocks traded on the New York Stock Exchange. The stock index’s rising and falling can mirror both investors’ attitudes and interest rate changes, which is usually another reliable gauge for upcoming economic activity.

5) Index of consumer expectations: This is the only leading indicator that is totally based on expectations, signifying shifts in consumer attitudes about future economic conditions. In a monthly survey, consumers answer questions about various economic conditions, and their responses are categorized as positive, negative or unchanged.

6) Manufacturers’ new orders, consumer goods and materials: This refers to goods mainly used by consumers. Because new orders of such goods directly impact the level of both unfilled orders and inventories, which are influential in firms’ production decisions, the new orders’ inflation-adjusted value leads actual production.

7) Manufacturers’ new orders, non-defense capital goods: This is the inflation-adjusted value of new orders received by manufacturers in non-defense capital goods industries. It’s the producers’ equivalent to manufacturers’ new orders for consumer goods.

8) Vendor performance, slower deliveries diffusion index: This index gauges how fast industrial companies receive deliveries from their suppliers. It goes up as slowdowns in deliveries become more substantial—a change that usually precedes the business cycle and is generally related to demand increases for manufacturing supplies.

9) M2: This refers to the money supply, in inflation-adjusted dollars, including currency, demand deposits, other checkable deposits, traveler’s checks, savings deposits, small denomination time deposits and balances in money market mutual funds. When the money supply lags behind inflation, bank lending may decrease, making economic expansion tougher.

10) Interest rate spread, 10-year Treasury bonds minus federal funds: Also called the yield curve, this is the spread or difference between long and short rates. It is calculated using the 10-year Treasury bond rate and the federal funds rate, an overnight borrowing rate between banks. It goes up when short rates are relatively low and down when they’re high, signifying monetary policy outlook and general economic conditions. When it has been a negative number (i.e. short rates top long rates), it has reliably signified an upcoming recession.

Coincident Indicators

1) Employees on non-agricultural payrolls: Including both full-time and part-time employees, this figure does not differentiate between permanent and temporary workers. It is one of the most closely monitored measures because it indicates the actual net hiring and firing by all employers, except agricultural establishments and the smallest businesses.

2) Personal income minus transfer payments: By calculating the value of income received from all sources in inflation-adjusted dollars, this figure measures the real salaries and other earnings of all individuals. Income levels are valuable because they affect both aggregate spending and the economy’s overall health.

3) Index of industrial production: This index measures the physical output of all production phases in the manufacturing, mining and gas and electric utility industries. It is based on several sources that calculate physical product counts, shipment values and employment levels.

4) Manufacturing and trade sales: This index takes into account sales at the manufacturing, wholesale and retail levels. It is adjusted for inflation to indicate real total spending.

Lagging Indicators

1) Average duration of unemployment: This series calculates the average number of weeks that persons considered unemployed have been jobless. The average duration always dips after an economic expansion has taken hold. On the flipside, it tends to increase dramatically after a recession has started.

2) Average prime rate charged by banks: Although the prime rate is regarded as the benchmark that banks use to set their interest rates for various types of loans, changes tend to occur following shifts in general economic activities.

3) Ratio of manufacturing and trade inventories to sales: This is a dependable measure of business conditions for individual companies, whole industries and the entire economy. Because inventories tend to pile up when the economy slows and sales disappoint, the ratio usually peaks in mid-recession. It also tends to go down at the start of an expansion as firms satisfy their sales demand from excess inventories.

4) Consumer installment credit outstanding to personal income: This assesses the connection between consumer debt and income. Because consumers tend to delay personal borrowing until months after the end of a recession, this ratio reveals a trough after personal income has increased for a year or more.

5) Change in labor cost per unit of output, manufacturing: This calculates the rate of change in labor costs over a six-month period. The index goes up when labor costs for manufacturing firms outpace their production and vice versa. The rate of change typically peaks during recessions, as output decreases faster than labor costs despite layoffs of production personnel.

6) Outstanding commercial and industrial loans: This series calculates the volume of business loans held by banks and commercial paper issued by non-financial firms. It usually peaks after an expansion hits its highest point because decreasing profits typically boost the demand for loans.

7) Change in consumer price index for services: Gathered by the Bureau of Labor Statistics, it calculates the rates of change in the services part of the consumer price index. Inflation in the service sector usually goes up in the beginning months of a recession and goes down in the early months of an expansion.

Sources: How the Fed Works
Lee Ann Obringer
How Stuff Works
http://money.howstuffworks.com/fed.htm/printable

Economic Indicators
Federal Reserve Bank of Kansas City
http://www.kc.frb.org/fed101html/Monetary/indicators.htm