Making Sense of the Noise from Economic IndicatorsADS2J

The economic indicator du jour is a higher-than-expected 0.7% increase in industrial production for the month of September, the third-straight monthly increase. So the economy is getting better, right? But the unemployment rate climbed in September, to 9.8%, which seems like a bad sign. On the other hand, new claims for unemployment benefits fell last week by 10,000. What does it all mean?

Frustrated by conflicting economic reports, President Harry S Truman said he wished for a one-armed economist who could express an opinion that was not followed by a sentence beginning with "on the other hand." Today, still, the news is full of economic indicators, often pointing in different directions. So it is difficult for consumers, business leaders and economic policymakers to know the overall state of the economy on any given day.

Now, a Wharton finance professor, Francis X. Diebold, and two colleagues — S. Borağan Aruoba, an economics professor at the University of Maryland, and Chiara Scotti, an economist for the Federal Reserve Board – offer a kind of indicator of indicators that purports to measure the overall state of the economy on just about any given day. Their Aruoba-Diebold-Scotti Business Conditions (ADS) Index  measures the real-time state of the economy by six essential indicators: the quarterly gross domestic product; the monthly figures for industrial production, payroll employment, personal income less transfers, and manufacturing and trade sales; and the weekly measure of initial claims for unemployment compensation. The index is updated whenever one of the indicators is released or adjusted, which typically occurs about three times per week.

Using a complex "dynamic factor model," the index compares the latest figure in each indicator to the number that would be expected when the economy is behaving normally. Normal behavior is represented as a zero in the index. If all six indicators are better than they usually are, the overall index is a positive number. Today, the index, though still in negative territory, took a slightly upward tick thanks to the gain in industrial production. But in an interview this morning, Diebold and Aruoba warned that while the newest number is a good indication of today's business conditions, it will become more accurate as subsequent monthly and quarterly data are updated and factored into the index.

"The latest number is not as useful as the trend line," says Diebold. Using historical data, the trend line has been calculated back to 1960, and it clearly lines up with the eight recessions since then. Had the index been available during those previous recessions, it would have shown the beginning and end of those recessions long before they were declared officially by the National Board of Economic Research, of which Diebold is a member.

"This is not forecasting, it's nowcasting," which is gaining attention currently in economics, according to Diebold. "But you are going to make better forecasts if you start with an accurate measure of current conditions." He says the index is useful also for "business leaders who must make important decisions about increasing or decreasing production."

Absent the ADS index, says Aruoba, the parade of economic indicators provides more noise than information. "We're separating the noise from what we really care about." Still, he adds, the index is not the one-armed economist that President Truman wanted. "It's a six-armed economist."

Research Paper:

Real-Time Measurement of Business Conditions