How to forecast the economy? Economic Indicators could help

November 17, 2023

What are Economic Indicators?

A basket of factors that help forecast how an economy will perform in the future.

Economic forecasting is used by

  • Businesses to plan investments and operations and estimate performance
  • Investors to adjust portfolio allocations and expected returns
  • Govt and regulators to make policies for the public, businesses, and investors
  • Consumers to plan and adjust consumption
  • Economic forecasting may be done using some statistical and quantitative models. These models require vast amounts of data, tools, and knowledge to make complex calculations.

A simpler alternative is using economic indicators to forecast economic performance.

GDP growth, interest rates, inflation, employment levels, level of industrial production, farm output, consumption levels, and fuel prices, among several others, give a perspective on how the economy has performed, is performing, and is likely to perform.

You could also use some second-order derivative indicators such as indirect tax collections, electricity consumption, and aviation traffic.

Indicators that depict

  • past performance are lagging indicators.
  • the current economic state are called coincident indicators.
  • the future economic direction are called leading indicators

Depending on your use case, you could build your own set of leading indicators to forecast economic performance.

Let’s say, as an investor, you fix a set of the following 10 indicators. I have created this list arbitrarily. You may create your own set.

  1. GDP growth
  2. Inflation
  3. Interest rates
  4. Crude prices
  5. Monsoon levels
  6. Farm output
  7. Direct tax collections
  8. Internet connectivity
  9. Aviation travel
  10. Forex rates

This set could be your pseudo-diffusion index. This index could suggest a

  • Positive sentiment, if 7 or more indicators are pointing upwards
  • Neutral sentiment, if 4 to 6 indicators are upward pointing
  • Possible economic stress, if 7 or more indicators are pointing downwards

You can get most of this data on government websites and easy Google searches.

The simplicity of this model makes it easy to use. But it is also a limitation. These indicators could suggest a good likelihood of a future direction, but it cannot be guaranteed.

Also, economic indicators are prone to have a “look ahead bias”.

Picture this: historically, a strong GDP growth is associated with strong equity returns. Therefore, based on the current expected GDP growth number, you make your investment decisions.

But were these GDP numbers available to the decision-makers then? It is possible that the past decisions were based on different GDP estimates. The data you see today may be revised later, and your convictions may not hold.

The key takeaway is that economic indicators may be used to make quick decisions, but some room for error must be accounted for.

Content, Zerodha Varsity

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