Lagging Indicator
A lagging indicator is an observable or measurable economic or financial factor that changes only after a broader economic or market trend has already begun or been established. In the context of economic indicators, lagging indicators serve to confirm existing patterns rather than predict future events. These indicators are crucial in analyzing the stages of a business cycle, providing confirmation that an economic expansion or recession has truly taken hold.
History and Origin
The concept of classifying economic indicators into leading, coincident, and lagging categories gained prominence through the work of the National Bureau of Economic Research (NBER). Founded in 1920, the NBER became the quasi-official arbiter of U.S. business cycle dating. Through extensive research, economists like Arthur F. Burns and Wesley C. Mitchell meticulously studied various economic series to understand their typical behavior around peaks and troughs of economic activity. This classification system evolved over time as new data became available and economic structures changed. For instance, the NBER's Business Cycle Dating Committee formally identifies the months of peaks and troughs in economic activity, often confirming these turning points with a significant time lag to ensure accuracy and avoid revisions.8 This retrospective approach highlights the inherent lagging nature of some of the data they consider, such as the unemployment rate.7
Key Takeaways
- A lagging indicator confirms a trend that has already occurred, providing historical context rather than predictive insight.
- Common examples include the unemployment rate, corporate profits, and average duration of unemployment.
- While not predictive, lagging indicators are vital for policymakers and analysts to confirm the actual state of the economy.
- They help validate the effectiveness of past monetary policy or fiscal policy decisions.
- Over-reliance on lagging indicators for immediate decision-making can lead to delayed responses to changing economic conditions.
Interpreting the Lagging Indicator
Lagging indicators are interpreted as confirmatory signals. For example, a sustained rise in the unemployment rate after several quarters of declining gross domestic product would confirm that the economy is indeed in a recession. Similarly, a prolonged period of declining consumer inflation might indicate that past tightening of interest rates has successfully cooled the economy. Analysts often look for several consecutive readings of a lagging indicator to move in a particular direction before concluding that a trend has been definitively established. This delayed confirmation is their primary characteristic and utility.
Hypothetical Example
Imagine a country that has been experiencing robust economic activity. Suddenly, growth begins to slow, but early signs are ambiguous. Six months later, the government releases data showing that the average duration of unemployment has increased significantly for three consecutive months. Simultaneously, corporate profits for the past two quarters are reported to be notably lower than previous periods. These changes in the average duration of unemployment and corporate profits are lagging indicators. They reflect conditions that have already materialized over the preceding months, confirming that the initial slowdown was not a temporary blip but a more substantial downturn in the economy. This data, while not predicting the slowdown, provides definitive evidence of its severity and confirms the onset of a weaker economic period.
Practical Applications
Lagging indicators are indispensable in several areas of finance and economics:
- Economic Analysis: Government agencies, economists, and central banks, such as the Federal Reserve, use lagging indicators to assess the overall health and performance of the economy post-factum. Data like the gross domestic product and inflation figures inform retrospective policy reviews.6
- Monetary Policy Review: Central banks evaluate the impact of their monetary policy decisions on inflation and employment. For instance, if interest rate hikes were implemented to curb inflation, falling inflation rates and potentially rising unemployment, as lagging indicators, would help assess the policy's effectiveness.
- Business Planning: Businesses often review lagging economic data to confirm market conditions before making long-term strategic decisions, such as expansion plans or significant capital expenditures.
- Investment Strategy (Technical Analysis): In technical analysis, a lagging indicator is sometimes referred to as a "trend-following" indicator. Examples include a moving average. When a security's price crosses above a long-term moving average, it confirms an uptrend, but the actual price movement would have begun earlier.5 The Conference Board, a research organization, publishes a composite "Lagging Economic Index" (LAG) which is designed to confirm broader economic trends.4
Limitations and Criticisms
The primary limitation of a lagging indicator is its inherent delay. By definition, it only signals a trend after it has already occurred, offering little to no foresight. This can be problematic for proactive decision-making, especially in fast-moving markets or during economic crises. For instance, if policymakers rely exclusively on lagging indicators, their responses to a downturn or inflationary surge could be delayed, potentially exacerbating the economic impact. The International Monetary Fund (IMF) emphasizes that timely and appropriate macroeconomic policy is crucial for stability, and delays due to late confirmation from indicators can hinder effective interventions.3
In financial markets, a trader relying solely on lagging indicators in technical analysis might enter a trade late in a trend, missing significant portions of the price movement. While useful for confirmation, their backward-looking nature means they are less suitable for anticipating turning points in stock prices or other market dynamics. For example, by the time the effects of a bear market are fully reflected in corporate earnings (a lagging indicator), the market may already be recovering.
Lagging Indicator vs. Leading Indicator
The key distinction between a lagging indicator and a leading indicator lies in their timing relative to economic or market trends.
A lagging indicator changes after a trend has been established, confirming its existence. Examples include the unemployment rate, corporate profits, and the Consumer Price Index (a measure of inflation). They are useful for understanding the magnitude and duration of a past event.
Conversely, a leading indicator changes before a new economic or market trend begins, offering predictive insights. Examples often include building permits, consumer confidence, and stock prices. The Conference Board's Leading Economic Index (LEI) is a well-known composite leading indicator designed to forecast future economic activity.2 The confusion between the two often arises because both are types of economic indicators used to understand the business cycle, but their application and utility depend entirely on whether one seeks confirmation of past events or foresight into future movements.
FAQs
What are some common examples of lagging indicators?
Common examples include the unemployment rate, average duration of unemployment, corporate profits, the Consumer Price Index (a measure of inflation), interest rates on commercial loans, and labor cost per unit of output. These indicators typically shift after the broader economy has already begun a new trend.
Why are lagging indicators important if they don't predict anything?
While they do not predict future trends, lagging indicators are crucial for confirming the presence and severity of current or past economic and market conditions. They provide historical validation, helping policymakers and analysts confirm whether previous monetary policy or fiscal policy decisions were effective and aiding in the accurate classification of business cycle phases.
Can lagging indicators be used in investment decisions?
Yes, but typically in conjunction with other tools. In technical analysis, a lagging indicator like a moving average can help confirm the strength and direction of an established trend. However, investors and traders rarely rely solely on them for entry and exit points, as this could lead to delayed actions. They are more often used for confirming the overall market environment.
Do central banks use lagging indicators?
Yes, central banks, like the Federal Reserve, use lagging indicators extensively as part of their comprehensive economic analysis. While they also monitor leading indicator and coincident data, lagging indicators are vital for assessing the actual impact of their policy decisions on key economic variables such as inflation and employment. This data-dependent approach helps them understand the historical effectiveness of their interventions.1