Most economists are of the view that by means of economic indicators it is possible to identify early warning signs regarding an upcoming recession or prosperity. What is the rationale behind this approach?

The National Bureau of Economic Research introduced the economic indicators approach in the 1930’s. A research team led by W.C. Mitchell and Arthur F. Burns studied about 487 economic data to ascertain the mystery of the business cycle. According to Mitchell and Burns,

Business cycles are a type of fluctuation found in the aggregate economic activity of nations….a cycle consists of expansion occurring at about the same time in many economic activities, followed by similarly general recessions, contractions, and revivals which merge into the expansion phase of the next cycle; this sequence of changes is recurrent but not periodic.¹

Business cycles are seen as broad swings in many indicators, which upon their careful inspection permit the establishment of peaks and troughs in general economic activity. Furthermore, the research team had concluded that because the causes of business cycles are complex and not properly understood it is much better to focus on the outcome of these causes as manifested through economic data.

Through data inspection, the experts in the NBER establish the reference points to the beginning and the end of the business cycles. Covering the period between December 1854 and June 2009 the NBER has identified 34 cycles according to their peaks and troughs. (On the NBER the last trough took place in June 2009 and since that period we are in an economic prosperity phase).

The peaks and troughs identified by the NBER serve as a reference point to classify various individual data as leading, coinciding or lagging. Once the data is classified it is combined into leading, coincident, and lagging indices.

These indices are seen as economic signposts that are expected to alert analysts and policy makers regarding the state of a business cycle. When the leading indicators index starts to display the signs of weakening this is seen as a possible indication of weakness in economic activity in the months ahead.

The confirmation that the peak of the cycle might have reached is ascertained by means of the coincident index, while the lagging index provides the final OK that this might be the case. Hence by means of these three indicators, it is held, the phase of an economic business cycle can be ascertained.