The composite leading index of the Canadian economy sums up the performance of 10 components that track the short-term course of the economy. A leading indicator signals changes in the business cycle (notably, the approach of turning points that see the economy move into recession or recovery) and periods of faster and slower economic growth.
Leading indicators are necessary for governments and businesses, whose fortunes are tied to the course of the overall economy. Furthermore, they are useful for individuals confronted with questions about what to do in everyday life.
The new leading index extends Statistics Canada's recently discontinued work in this area, increasing the lead times while maintaining a low error rate. The composite leading index retains 6 of the 10 components from the Statistics Canada index:
- the housing index;
- the U.S. leading indicator;
- the money supply;
- the stock market;
- the average workweek in manufacturing;
- new orders for durable goods.
The four new components added to the composite index are:
- The Conference Board of Canada's Index of Consumer Confidence;
- commodity prices;
- claims received for Employment Insurance;
- the spread between the interest rate for private versus government short-term borrowing.
They replace four components that no longer displayed significant lead times (retail sales of furniture and appliances, retail sales of other durable goods, services employment, and the ratio of sales to inventory in manufacturing).
Together, the 10 components in the current index cover all the major cyclical parts of the economy, including financial markets, the labour market, exports, housing, and the manufacturing sector.
As a result of these changes to the components, the average lead time in signalling recessions increased from 4.9 months in 1952 under the old Statistics Canada index to 7.4 months in the new index.
To minimize the risk of error, we combine the components into a composite index. The virtue of the composite index is that it markedly reduces the risk of false signals when one particular indicator erroneously signals a recession or a recovery. On average, the individual components have an error rate of 21.2 per cent in signalling a recession, while the error rate for the overall composite index is only 5.1 per cent.
Leading indicators are able to signal changes in the business cycle because they reflect the behaviours of economic agents acting in the market place that anticipate the future direction of the economy. Besides signalling turning points in the business cycle, the leading indicator also signals periods of faster and slower growth.
The Ten Components of the Composite Leading Index
These ten components track developments in key sectors of the economy, such as financial markets, labour demand, housing, and manufacturing. They are a useful guide since the short-term course of the economy is often hard to track, given the inevitable contradictory signals coming from the wide range of data available.
The Money Supply (M1) This component is the real money supply, or gross M1 deflated by the all-items consumer price index. There are many possible definitions of money, so we have kept the simplest version with good leading indicator properties. Changes in the money supply are impacted by the Bank of Canada's monetary policy and lead future changes in production. Changes in the M1 have an above-average lead time and a below-average error rate.
The Stock Market The stock market is one of the best-known leading indicators, and probably the one the public associates most with the future of the economy. It is one of the four components that retains a significant lead time of more than a month in signalling recoveries.
Interest Rate Differential The differential is the difference between the prime lending rate charged by chartered banks and the yield on three-month Treasury bills issued by the Government of Canada. As such, it is one measure of the risk financial markets perceive when lending to the private sector relative to lending to the public sector. The lead time of the interest rate differential in signalling each of the last four recessions was more than a year.
Commodity Prices This is the Bank of Canada commodity price index, measured in U.S. dollars so that it reflects only the ebb and flow of global demand and supply, and not gyrations in the value of the Canadian dollar. This index has the shortest track record, with data going back only to January 1972.
Claims for Employment Insurance This is one of the new components we have added, with seasonally adjusted data on claims received (both new and renewals) back to 1952. Claims for Employment Insurance are a sensitive index of changes in labour market conditions, rising when demand slows and falling as the economy improves. Not only does labour demand reflect changes in the business cycle, it reinforces the cycle, since consumers will adjust their spending as employment conditions change.
The Housing Index This component is itself a composite of two housing variables: the number of existing home sales (from the Canadian Real Estate Association) and housing starts (from the Canada Mortgage and Housing Corporation). Housing demand is one of the most sensitive indicators of consumers' willingness to commit to buying a big-ticket item. The housing index has the longest lead time in signalling turning points, an average of 7.5 months at peaks and troughs.
New Orders for Durable Manufactured Goods New orders for durable goods are measured in constant 1992 dollars. They are a leading indicator because producers alter production schedules based on the inflow of new orders from customers. The lead time for this indicator has increased over the last two recessions, after lagging slightly in the 1981 downturn.
Average Workweek in Manufacturing The workweek indicator has one of the best combinations of lead times and reliability, ranking as the second-best component on both. Its superior performance has not faltered in recent decades.
The U.S. Leading Indicator This indicator, now produced by The Conference Board, Inc., is one of the more reliable indicators of the business cycle in Canada—a reflection of how intertwined our economy is with that of the United States. The indicator has the fourth longest lead time of the nine components, and the lowest error rate of all.
The Index of Consumer Confidence This index is constructed from responses to four attitudinal questions posed to a random sample of Canadian households. Those surveyed are asked to give their views about their households' current and expected financial positions and the short-term employment outlook. They are also asked to assess whether now is a good or a bad time to make a major purchase such as a house, a car, or other big-ticket items. The consumer confidence survey has been ongoing since 1960. It is conducted monthly by The Conference Board of Canada.
Some of the components (such as the average workweek or the interest rate gap between private and public borrowers) measure small changes in variables. Others (such as the stock market, new orders, and housing) measure variables that vary widely from month to month. To prevent the latter components from dominating short-term movements in the overall composite index, we use a well-known statistical technique known as "standardization."
Essentially, standardization factors compare the percentage change in a component with the typical monthly change in that component. This corrects for the average variability of each component over time and prevents "noisy" series (such as the stock market or new orders) from dominating changes in the index.