Insight Line—January 7, 2008

The frustrating fact about the U.S. economy is that it’s all but impossible to know the current point of the business cycle. You see, no two cycles are alike, so history may not present a sufficient guide. Then again, by definition all business cycles follow an established pattern—expansion, followed by recession, and then contraction, which gives way to a revival of activity, and then expansion again—and therefore it is reasonable to expect some sort of predictability. But this proposition leads to the inevitable question: How can we determine when one phase will end and the next will begin? After all, patterns should be measurable.

Writing for the Philadelphia Federal Reserve Bank publication, Business Review, Theodore M. Crone suggests what I believe is a plausible way to forecast the end of a current business cycle as well as to identify the onset of the next one.¹ If Mr. Crone’s analysis holds forth, the telling information is right in investors’ backyards.

Investors, economists and policymakers have long sought a forward-looking indicator to predict what the economy will do next. Some suggest the slope of the U.S. Treasury yield curve should enjoy leadership status among predictive measures. Others contend the price action of the stock market or the Conference Board’s Index of Leading Economic Indicators is more reliable. And just recently, researchers at the Federal Reserve in Washington postulate that a combination of the yield curve and intermediate-term credit spreads holds great promise.²

Informative and forward-looking as these indicators may appear, however, they still represent a result rather than a work in progress. That’s why Mr. Crone’s work caught my attention.

Recognizing that the trees may be as important as the forest, Mr. Crone and his associates deconstructed the national business cycle into a sum-of-the-parts look at state-specific business cycles. Using state-specific data on non-farm employment, average hours worked in manufacturing, the unemployment rate, and reported wages and salaries adjusted for inflation since 1979, his research team created “the state of the economy” index.

The results are worth noting.³

While acknowledging that no one indicator offers an infallible guidepost to the state of the U.S. business cycle, Mr. Crone’s correlation of state business cycles to national business cycles builds some intriguing hypotheses. The premise I found most interesting was that 12 states (California, Indiana, Massachusetts, Michigan, Missouri, North Carolina, South Carolina, Tennessee, Ohio, Oregon, Pennsylvania and Washington) have consistently fallen into recession prior to the nation as a whole. On the other hand, if one is looking for an indication of economic expansion, look no further than Washington and Arkansas, as their business cycles appear to precede the national trend by two months.

Turning to the question of predictability in the business cycle, Mr. Crone offers a measure that may be pretty darn close to precise, in my opinion. Using a simple diffusion index (that is, comparing the rate of change from one time period to the next,) he notes, “The one-month diffusion index has turned negative before the decline in the national index in all four recessions since 1979,⁴ with lead times of one to four months.”⁵ Furthermore, the same diffusion index appears to signal the end of the recession no later than the first month of recovery.

All of which begs the question, what is the data telling investors now? Through November 2007 (the latest available data), the U.S. economy, as measured by state-specific coincident data, shows no sign of an impending recession (42 expanding, six decreasing, and two unchanged).

While the exact dating of the nation’s business cycles falls to the National Bureau of Economic Research’s Cycle Dating Committee, forecasting the turns in the cycle is of significant importance to investors, economists and policymakers. As such, if Mr. Crone’s state business cycle diffusion index lives up to its past successes, all interested observers stand to gain advance knowledge of what is heretofore only known in hindsight.

¹ Crone, Theodore M., “What a New Set of Indexes Tells Us About State and National Business Cycles,” The Federal Reserve Bank of Philadelphia, Business Review, First Quarter 2006

² King, Thomas B., Andrew T. Levin, and Roberto Perli, “Financial Market Perception of Financial Risk,” Federal Reserve Board Finance and Economic Discussion Series, 2007-57. Available at http://www.federalreserve.gov/pubs/feds/2007/index.html

³ The survey is found at http://www.philadelphiafed.org/econ/stateindexes

⁴ The data set covers all the declared recession dates from the National Bureau of Economic Research’s cycle-dating committee from 1979 to 2004.

⁵ Ibid, Crone, page 19

This material has been prepared using sources of information generally believed to be reliable. No representation can be made as to its accuracy. The forecasts and opinions in this piece are not necessarily those of Van Kampen, and may not actually come to pass. Information in this report does not pertain to any Van Kampen product and is not a solicitation for any product.