Leading and lagging indicators are economic tools a nation uses to determine the state and strength of its economy. Economists review specific financial and nonfinancial data in order to put together these figures. Leading indicators attempt to identify future events that signal economic growth or contraction. Lagging indicators report on data that comes from past activity. The difference between leading and lagging indicators is the latter can indicate whether the nation’s economy is actually growing or contracting.
A few examples of leading indicators may be bond yields or housing starts. Bonds are typically safe investments with little inherent risk. When investors begin to purchase these heavily, it can indicate the lack of risk taking in other investments, possibly due to upcoming economic uncertainty. Housing starts also tell a similar story; contractors and other builders who obtain permits or start projects at a slower pace can indicate slower economic growth. The opposite is true of these and many other leading indicators; decreases in bond purchases or increases in housing starts can signal upcoming economic growth.
Lagging indicators take information already known and compute economic data. Leading and lagging indicators are vastly different in this manner. A key lagging indicator is unemployment in a nation’s private sector; bank loans, interest rates, and inventory values can also be lagging indicators. Low unemployment can signal economic growth, while higher unemployment can signal contraction. In classical economics, two consecutive quarters of negative gross domestic product indicates complete economic contraction.
One item to remember is that lagging indicators cannot predict future trends. For example, if an economist computes lagging indicators for May and June in the month of July, he or she cannot predict trends for August based on the information. In a similarly related issue, users of lagging indicators cannot understand current moves in an economy due to changes that may have already occurred. Using the previous example, if a business owner believes in poor economic times due to lagging indicators from May and June, it may turn out be untrue due to changes not reviewed in July. These are the two most inherent drawbacks with lagging indicators.
The computation of leading and lagging indicators is often a monthly project for economists. This allows for enough time to pass for gathering economic data. Economists often compute the same indicators each time. Doing so creates a trend to study a nation’s economy and learn what factors must affect the economic structure of the environment.