What exactly do leading indicators forecast?

 

The ZEW economic sentiment indicator, an often-quoted early indicator of German economic growth, improved for the first time since its fall from the peak in January (see chart). ZEW president Wolfgang Franz told the press two days ago that “expectations have passed through the trough and are now on the rise thanks to robust economic perspectives.”

 

This raises the question what exactly do these leading indicators forecast? There is a real concern that expectations might be endogenous in the sense that a dip in sentiment does not only reflect the expectation of the 350 financial experts in the survey but that these expectations itself influence public opinion and economic decision makers through the press. 

 

In order to distinguish the causality we make a simple experiment. We ask whether the sentiment reflects more the current economic situation or whether the expectations are purely exogenous. As a measure for the economy we take the quarter-to quarter growth rate in real GDP. The first indicator is then calculated as a three-month average of the ZEW indicator for each quarter (red line). The second indicator takes the three-months average of the previous quarter and plots it against the current GDP growth rate (green line). Lets call the first a coincident and the second a forecast indicator. We present the data for the Euro area since the chart for Germany looks very similar and the euro area is more in our interest.

 

There are two main observations. First, the ZEW indicator is much more volatile than real GDP growth even if we smooth the indicator by taking three-months averages.  The boom in the second quarter is exaggerated as is the subsequent downfall. The second observation is that the coincident indicator (red line) works much better than the purely forecasting indicator (green line). Even if the December figures indicate an upswing in expectations, this upswing has already been well documented in the GDP forecasts from the European commission, published in October 2006. So it appears in this sense that the ZEW indicator is in fact more of a coincident than leading indicator.

 

 mundschenk(at)eurointelligence.com

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