Diffusion index

What Is a Diffusion Index?

A diffusion index is a statistical tool within the broader field of economic indicators that measures the breadth and direction of change in a particular economic or market phenomenon. It summarizes the common tendency of a group of statistical series, indicating whether more series are rising, falling, or remaining unchanged⁴⁰. This type of index provides a snapshot of the underlying trends, offering insights into the prevalence of change rather than the magnitude of that change³⁸, ³⁹. Diffusion indexes are commonly derived from survey data and are widely used to assess the health of various sectors or overall economic activity.

History and Origin

The concept of diffusion indexes emerged as a method to analyze business cycles and identify their turning points. Arthur F. Burns and Wesley C. Mitchell, prominent economists associated with the National Bureau of Economic Research (NBER), were instrumental in developing early approaches to business cycle analysis in the mid-20th century. Geoffrey H. Moore, a protégé of Burns and Mitchell, further developed and popularized diffusion indexes in the 1950s and 1960s as part of his work on business cycle indicators. His 1961 publication, "Business Cycle Indicators," presented diffusion indexes for various economic series, suggesting their use as measures of dispersion and as leading indicators. ³⁶, ³⁷Since their introduction, various institutions, including the Federal Reserve Banks, have adopted and adapted diffusion indexes to summarize responses from their regional business surveys, providing timely assessments of economic conditions. ³⁵For instance, the Federal Reserve Bank of Philadelphia has collected and published data from its Manufacturing Business Outlook Survey, which utilizes a diffusion index, since May 1968.
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Key Takeaways

• A diffusion index measures the breadth of change across a set of economic or market components.
• It is typically derived from surveys where respondents report increases, decreases, or no change.
• A reading above a certain threshold (often 50 or 0, depending on calculation) indicates expansion, while a reading below it suggests contraction.
• Diffusion indexes are valued for their timeliness and simplicity in providing insights into current economic trends.
• While useful for indicating the direction and prevalence of change, they do not inherently quantify the magnitude of that change.

Formula and Calculation

A common method for calculating a diffusion index involves surveying respondents about whether a particular variable has increased, decreased, or remained unchanged. The index is then calculated as the percentage of respondents reporting an "increase" plus half the percentage reporting "no change."

Alternatively, some diffusion indexes, particularly those used by certain Federal Reserve Banks, are calculated as the percentage of respondents reporting an "increase" minus the percentage reporting a "decrease". ³¹, ³²This formula typically yields an index ranging from -100 to +100, where 0 is the neutral point.

For example, the Chicago Fed Survey of Economic Conditions calculates its diffusion indexes as the difference between responses above their average and responses below their average, divided by the total number of respondents, and then multiplied by 100 to range from +100 to -100.
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Interpreting the Diffusion Index

The interpretation of a diffusion index depends on its specific calculation method, but a common characteristic is a central threshold that separates economic expansion from economic contraction. For indexes calculated as (% Increased) + 0.5 * (% Unchanged), a reading above 50 generally indicates expansion, while a reading below 50 suggests contraction. ²⁸, ²⁹A reading of exactly 50 signifies no change or a balance between increasing and decreasing components.

For indexes calculated as (% Increased) - (% Decreased), the neutral point is typically 0. A positive reading indicates expansion, and a negative reading indicates contraction. ²⁶, ²⁷The further the index is from the neutral point, the more widespread the reported change (either positive or negative) is across the surveyed entities. ²⁵Analysts often observe the trend of the diffusion index over time to identify shifts in underlying market sentiment or economic momentum.

Hypothetical Example

Consider a hypothetical survey of 100 manufacturing firms conducted to gauge their production levels compared to the previous month.

• 40 firms report an increase in production.
• 35 firms report no change in production.
• 25 firms report a decrease in production.

Using the formula:

First, convert the numbers to percentages:

• % Increased = (40 / 100) * 100 = 40%
• % Unchanged = (35 / 100) * 100 = 35%
• % Decreased = (25 / 100) * 100 = 25%

Now, calculate the diffusion index:

In this example, the diffusion index of 57.5% indicates that the manufacturing sector is generally expanding, as the reading is above the 50% threshold. This suggests that more firms are experiencing increased production than decreased production, reflecting positive momentum within the manufacturing sector.

Practical Applications

Diffusion indexes are widely used across various domains in finance and economics due to their timeliness and ability to provide a broad snapshot of trends.

• Economic Analysis: Central banks, such as the Federal Reserve, use diffusion indexes from their regional business surveys to inform their understanding of current economic conditions. These surveys often cover aspects like new orders, production, employment trends, supplier deliveries, and inventories. ²³, ²⁴For example, the Federal Reserve Bank of Philadelphia's Manufacturing Business Outlook Survey provides monthly diffusion indexes that reflect the sentiments of manufacturers in its district. ²²The Federal Reserve Bank of Chicago's Survey of Economic Conditions also utilizes diffusion indexes to gauge various aspects of economic activity.
  ²¹* Purchasing Managers' Indexes (PMIs): One of the most prominent applications is in the calculation of Purchasing Managers' Indexes (PMI), such as the ISM Manufacturing PMI. This index is a composite diffusion index that aggregates survey responses from purchasing managers regarding economic activity in the manufacturing sector. A PMI reading above 50 percent generally indicates an expansion of the manufacturing economy, while a reading below 50 percent suggests contraction. ²⁰The ISM Manufacturing PMI is closely watched by analysts and policymakers as a forecasting tool for overall economic performance. ¹⁹The latest Manufacturing ISM® Report On Business® in July 2025 indicated a manufacturing PMI of 48.0%, signifying contraction for the fifth straight month.
• ¹⁷, ¹⁸ Labor Markets: Diffusion indexes are also applied to labor market data. The Bureau of Labor Statistics (BLS) historically published an employment diffusion index to measure the breadth of employment change across different industries. Wh¹⁵, ¹⁶ile the BLS currently focuses on it as a measure of dispersion, it can still offer insights into the widespread nature of job gains or losses.
• Consumer Confidence: Surveys of consumer sentiment often employ diffusion indexes to gauge attitudes toward current and expected economic conditions, including household financial health and spending intentions. These insights can influence expectations about future consumer spending and overall Gross Domestic Product growth.

These applications provide policymakers, investors, and businesses with real-time insights into economic shifts, aiding in decision-making related to monetary policy, investment strategies, and business operations within financial markets.

Limitations and Criticisms

While diffusion indexes offer timely and easily digestible insights into economic trends, they have certain limitations. One primary criticism is that they capture the breadth of change (i.e., how many components are expanding or contracting) but not necessarily the intensity or magnitude of those changes. Fo¹², ¹³, ¹⁴r instance, a diffusion index might show broad expansion, but if the magnitude of increases is small, the overall economic growth could still be modest. Conversely, a large contraction in a few heavily weighted sectors might be masked if many smaller sectors show slight expansion, leading to a misleadingly neutral diffusion index.

A¹¹nother criticism relates to their construction, where components are often assigned equal weights, which may not accurately reflect their economic significance. Th¹⁰is can be problematic if the components represent sectors of vastly different sizes or contributions to the overall economy. Furthermore, survey-based diffusion indexes can be subject to "respondent bias" and the challenge of consistently measuring qualitative responses over time. Wh⁹ile useful for signaling turning points, their predictive power can vary, and they are best used in conjunction with other quantitative economic activity data. The reliability of diffusion indexes can also be influenced by factors like survey sample size and the overall level of uncertainty in the economy, which can affect the polarization of responses.

#⁷, ⁸# Diffusion Index vs. Purchasing Managers' Index (PMI)

The diffusion index is a statistical method, whereas the Purchasing Managers' Index (PMI) is a specific and widely recognized economic indicator that uses a diffusion index in its calculation. The relationship is that the PMI is a type of diffusion index, not a separate, opposing concept.

Confusion often arises because the PMI is so frequently cited that it can sometimes be implicitly referred to as the diffusion index, overshadowing the broader statistical concept. However, many other economic surveys, including those from various Federal Reserve Banks, also produce and rely on diffusion indexes to gauge economic conditions.

FAQs

What does a diffusion index measure?

A diffusion index primarily measures the breadth or prevalence of change across a group of components, such as industries, firms, or economic indicators. It tells you whether more components are improving, deteriorating, or staying the same.

#⁶## How is a diffusion index interpreted?
Typically, a diffusion index will have a neutral threshold, often 50 or 0, depending on its specific formula. A reading above this threshold generally suggests that a majority of the components are expanding or improving, indicating positive momentum. A reading below the threshold implies that more components are contracting or worsening, signaling negative momentum.

#⁴, ⁵## What are some common examples of diffusion indexes in use?
The most widely known example is the Purchasing Managers' Index (PMI), which assesses the manufacturing and services sectors. Various Federal Reserve Banks also publish diffusion indexes from their regional business surveys, covering indicators like new orders, production, and business cycles.

#², ³## Is a diffusion index a leading, lagging, or coincident indicator?
Diffusion indexes are often considered leading indicators, meaning they tend to signal changes in the broader economy before those changes become apparent in aggregate data. Th¹is is particularly true for survey-based indexes like the PMI, which provide timely insights into future economic activity.