© 2011 The Conference Board, Inc. | 1 Using a Composite Index of Financial Conditions Indicators to Predict Turning Points in the U.S. Business Cycle COPAFS Quarterly Meeting -- September 9, 2011 (Work in progress please do not cite without permission) U.S. and Global Indicators Program

© 2011 The Conference Board, Inc. | 2 Overview  What is The Conference Board and what does it do?  Economic indicator programs  Business cycle programs: LEI and CEI  LEI and financial indicators  Concluding comments and questions

© 2011 The Conference Board, Inc. | 3 What is The Conference Board?  Global independent business membership and research organization  Provides the world's leading organizations with the practical knowledge they need to improve their performance and better serve society  Founded 1916  Non-advocacy, not-for-profit

© 2011 The Conference Board, Inc. | 4 What Does The Conference Board Do?  Research and education  Conferences  Councils  Research reports and executive action memos  Periodicals  Briefings  Data products

© 2011 The Conference Board, Inc. | 5 Economic Indicators  Long tradition of economic measurement work  Wide-range of indicators Help-wanted and now Help-wanted Online Consumer confidence U.S. and Global composite coincident and leading indexes Productivity and per capita income levels and growth rates globally Business confidence

© 2011 The Conference Board, Inc. | 6 Business Cycle Indicators Program  Transfer from BEA 1996  Advisory board  Evaluation and updating composite indicators, 1996  “Real” time analytic and production goals  Introduction of statistical imputation in 2001  Introduction of indexes for other countries

© 2011 The Conference Board, Inc. | 7 Indicator Approach to Business Cycles  Recessions versus slowdowns  Monthly frequency  Use of composite indexes  Coincident index provides gauge of “current conditions ” Key to developing new indexes Determining turning points  Leading index anticipates peaks and troughs

© 2011 The Conference Board, Inc. | 8 Construction of Indexes  Seasonal adjustments  Deflation  Volatility adjustments  Equal weights  “Real time”

© 2011 The Conference Board, Inc. | 9 Global Indicators  Introduced indexes for ten new countries  Australia, China, Euro Area, France, Germany, Japan, Mexico, South Korea, Spain, United Kingdom  Consistent methodology  A note on dating business cycles  Asian Economic Symposium in Singapore in 2005  Hosted 30 th bi-annual CIRET Conference in New York in 2010  Euro Area LEI in 2009  China Center and LEI for China in 2010

© 2011 The Conference Board, Inc. | 10  Last comprehensive review of components was in 1996  Introduced the interest rate spread component (10 year Treasury bonds less Federal Funds rate)  Omitted sensitive materials prices  Omitted unfilled orders for durable goods  Manf. New orders, nondefense cap goods, replaced contracts and orders for plant and equipment  Change in deflator for some real series (pce deflator)  2001 TCB introduced more timely LEI, pulling release schedule up by two weeks  2005 TCB (re-)introduced trend adjustment and a new calculation method for contribution of interest rate spread component LEI Review

© 2011 The Conference Board, Inc. | 11 Employees on Non-Agricultural Payrolls Index of Industrial Production Personal Income less Transfer Payments Manufacturing and Trade Sales Composition of Coincident Index

© 2011 The Conference Board, Inc. | 12 U.S. Business Cycles and the Leading and Coincident Economic Indexes

© 2011 The Conference Board, Inc. | 13 Coincident Economic Index mirrors real GDP and LEI leads both

© 2011 The Conference Board, Inc. | 14 The Conference Board Leading Economic Index ® (LEI) for the U.S. Yield Spread (10-Year minus Federal Funds), Federal Reserve Money Supply (M2), Federal Reserve (PCE deflator) Stock Prices (S & P 500), Standard & Poors Average Weekly Hours for Manufacturing, BLS Building Permits, Private Housing, Census Average Weekly Initial Claims for Unemployment Insurance, BLS Vendor Performance, (manufacturing) ISM Manufacturer’s New Orders for Non-Defense Capital Goods, deflated, Census, BLS Manufacturer’s New Orders for Consumer Goods and Materials, deflated, Census, BLS Index of Consumer Expectations, University of Michigan Index methodology is based on equally weighted average of standardized contributions of 10 components

© 2011 The Conference Board, Inc. | 15 Financial/Non-financial LEI - levels

© 2011 The Conference Board, Inc. | 16 Close up on Index Levels

© 2011 The Conference Board, Inc. | 17 6-month growth rate of M2 & CEI

© 2011 The Conference Board, Inc. | 18  Address structural changes in the U.S. economy and financial markets  Improve coverage of financial conditions and activity indicators  Omit real money supply component (M2)  Substitute a better indicator of financial conditions for M2  But also other areas of improvement:  Improve coverage of new orders  Improve measurement and coverage of consumer expectations of business and economic conditions  Methodological improvement to use diffusion indexes in levels rather than changes  Improve measurement of current economic conditions (i.e., CEI) Areas of possible improvement in the U.S. LEI and proposals for changes in the composition

© 2011 The Conference Board, Inc. | 19 Deciding whether or not to include a leading indicator in the composite index:  The indicator is economically significant.  The indicator measurement is statistically sound.  The index has fewer false signals (extra cycles) historically when a new component is included.  The inclusion of a component enables an index to track a cycle that might be missed otherwise.  A significant improvement in the cyclical timing pattern, in terms of its consistency and conformity, of the new index after the inclusion of the new component.  The index is smoother with better articulated turning points.  There is an improvement in the cyclical behavior of the new index to the cyclical behavior of aggregate economic activity after the inclusion of the new component.

© 2011 The Conference Board, Inc. | 20 Creating an evaluation score to assess candidate indicators Source: The Conference Board

© 2011 The Conference Board, Inc. | 21 Selected components of the Financial Conditions Index  Two-year Swap Spreads (monthly)  Libor 3 month Less Treasury 3-month yield (monthly)  Debit balances at margin accounts at broker dealers (PCE deflated) DLOG (monthly)  Senior Loan Officer C&I Loan Survey -Banks Tightening Credit to Large & Medium Firms (quarterly)  AAII Investor Sentiment: Bullish (%) Less Bearish (%) (monthly)  Total Finance: Liabilities - Security Repurchases (PCE Deflated) DLOG (quarterly)

© 2011 The Conference Board, Inc. | 22 Financial Conditions Index leads peaks and troughs in the business cycle

© 2011 The Conference Board, Inc. | 23 LEI including the Financial Conditions Index Real M2 remains a component until April After May 1990 the FCI replaces M2.

© 2011 The Conference Board, Inc. | 24 History of the new and old LEI’s very similar but improved recession signals from Depth, Diffusion, Duration (3D’s) with new LEI New LEI Current LEI

© 2011 The Conference Board, Inc. | 25  Benchmark model of CEI growth with lagged dependent variable and lags of current LEI (all variables are detrended first)  Alternative models replace current LEI with alternative versions  Estimate a regression and create sequence of out of sample forecasts  Look at relative RMSE and Diebold-Mariano statistic to evaluate improvement due to alternative LEI  Forecasting exercise:  initial estimation period: 1959 – 1979  out of sample period: Forecasting with the new LEI

© 2011 The Conference Board, Inc. | 26 Replacing M2 with the FCI improves the out of sample forecasting ability of the LEI

© 2011 The Conference Board, Inc. | 27 Summary  Given the growing importance and complexity of the financial sector there is a need to review the financial indicators in the LEI  M2 ceased to be a useful leading indicator and should be replaced  We want to replace M2 with an index, rather than with a single indicator, for the following reasons:  One indicator is more likely than an index to lose its predictive ability  An aggregation of several indicators averages out the “noise” The aim of the financial index is predicting turning points in business cycle and not measuring financial stress or instability

© 2011 The Conference Board, Inc. | 28 New Approach  A composite index as a component of the LEI  Use quarterly components as part of the FCI (and LEI)  Using M2 up to 1990 and FCI afterwards

© 2011 The Conference Board, Inc. | 29 New Composition of The Conference Board Leading Economic Index ® (LEI) for the U.S.  Addresses structural changes in the economy and financial markets  Improved coverage of financial and credit conditions and activity  Better measurement of contraction  Better forecasting performance of growth in CEI  Cons:  FCI only extends back to 1990  FCI contains quarterly variables that have to be interpolated and imputed

© 2011 The Conference Board, Inc. | 30 APPENDIX

© 2011 The Conference Board, Inc. | 31 Charts of the Selected FCI Components - I

© 2011 The Conference Board, Inc. | 32 Charts of the Selected FCI Components - II

© 2011 The Conference Board, Inc. | 33 Charts of the Selected FCI Components - III

© 2011 The Conference Board, Inc. | 34 Turning points of the LEI

© 2011 The Conference Board, Inc. | 35 Selecting the Components of the Financial Conditions Index