Economic Indicator: Definition and How to Interpret

What Is an Economic Indicator?

An economic indicator is a piece of economic data, usually of macroeconomic scale, that is used by analysts to interpret current or future investment possibilities. These indicators also help to judge the overall health of an economy. Economic indicators can be anything the investor chooses, but specific pieces of data released by the government and non-profit organizations have become widely followed. Such indicators include but aren't limited to the Consumer Price Index (CPI), gross domestic product (GDP), or unemployment figures.

Key Takeaways

An economic indicator is a macroeconomic measurement used by analysts to understand current and future economic activity and opportunity.
The most widely-used economic indicators come from data released by the government and non-profit organizations or universities.
Indicators can be leading—which tend to precede trends, lagging—which confirm trends, or coincident—that which is happening now.
Indicators can also be lagging, which means they report economic circumstances but only after the circumstance has materialized.
Indicators can give investors insight as to how trades may play out, though unreliability of data and inconsistence of variables may yield indicators less helpful.

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Economic Indicator

Types of Economic Indicators

Economic indicators can be divided into categories or groups. Most of these economic indicators have a specific schedule for release, allowing investors to prepare for and plan on seeing certain information at certain times of the month and year.

Leading Indicators

Leading indicators, such as the yield curve, consumer durables, net business formations, and share prices, are used to predict the future movements of an economy. The numbers or data on these financial guideposts will move or change before the economy, thus their category's name. Consideration of the information from these indicators must be taken with a grain of salt, as they can be incorrect.

Investors are most often interested in leading indicators, as a correctly placed leading indicator means certain measures correctly predicted the future. Leading indicators are prepared making broad economic assumptions. For example, many investors track forward-looking yield curves to project how future interest rates may dictate stock or bond performance. This analysis relies on historical data; based on how investments performed the last time the yield curve was a certain way, some may assume those same investments will repeat their performance.

Coincident Indicators

Coincident indicators, which include such things as GDP, employment levels, and retail sales, are seen with the occurrence of specific economic activities. This class of metrics shows the activity of a particular area or region. Many policymakers and economists follow this real-time data, as it provides the most insight into to what is actually happening. These types of indicators also allow for policymakers to leverage real data without delay to make informed decisions.

Coincident indicators are somewhat less helpful to investors, as the economic situation has already blossomed. As opposed to a forecast or a prediction, a coincident indicator informs investors of what is actually happening in the present. Therefore coincident indicators are only useful to those who can correctly interpret how economic conditions today (i.e. falling GDP) will impact future periods.

Lagging Indicators

Lagging indicators, such as gross national product (GNP), CPI, unemployment rates, and interest rates, are only seen after a specific economic activity occurs. As the name implies, these data sets show information after the event has happened. This trailing indicator is a technical indicator that comes after large economic shifts.

The problem with lagging indicators is the strategy or response to these indicators may be too late. For example, by the time the Federal Reserve interprets CPI data and decides how best to enact monetary policy to stem inflation, the numbers they are observing are slightly outdated. Though lagging indicators are still used by many governments and institutions, they also pose the risk of guiding incorrect decision-making due to incorrect assumptions about present-day economics.

Indicators provide signs along the road, but the best investors utilize many economic indicators, combining them to glean insight into patterns and verifications within multiple sets of data.

Interpreting Economic Indicators

An economic indicator is only useful if one interprets it correctly. History has shown strong correlations between economic growth, as measured by GDP, and corporate profit growth. However, determining whether a specific company may grow its earnings based on one indicator of GDP is nearly impossible.

There is no denying the objective importance of interest rates, gross domestic product, and existing home sales or other indexes. Why objectively important? Because what you're really measuring is the cost of money, spending, investment, and the activity level of a major portion of the overall economy.

Like many other forms of financial or economic metrics, economic indicators hold tremendous value when compared across a period of time. For example, governments may observe how unemployment rates have fluctuated over the past five years. A single instance of unemployment rates doesn't yield much value; however, comparing it to prior periods allows analysts to better gauge a statistic.

In addition, many economic indicators have a benchmark set, whether by a government agency or other entity. Consider how the Federal Reserve's target rate of inflation is usually 2%. The Federal Reserve then enacts policies based on CPI measurements to achieve this target. Without this benchmark, analysts and policymakers wouldn't know what makes a good indicator's value good or poor.

The Stock Market As an Indicator

Leading indicators forecast where an economy is headed. One of the top leading indicators is the stock market itself. Though not the most critical leading indicator, it’s the one that most people look at. Because stock prices factor in forward-looking performance, the market can indicate the economy’s direction, if earnings estimates are accurate.

A strong market may suggest that earnings estimates are up, which may suggest overall economic activity is up. Conversely, a down market may indicate that company earnings are expected to suffer. However, there are limitations to the usefulness of the stock market as an indicator because performance to estimates is not guaranteed, so there is a risk.

Also, stocks are subject to price manipulations caused by Wall Street traders and corporations. Manipulations can include inflating stock prices via high-volume trades, complex financial derivative strategies and creative accounting principles—both legal and illegal. The stock market is also vulnerable to the emergence of “bubbles,” which may give a false positive regarding the market’s direction.

If you're particularly interested in a specific economic indicator released monthly by the government, be aware that report is often released on the same day (i.e. second Tuesday) of every month at the same time.

Advantages and Disadvantages of Economic Indicators

Pros of Economic Indicators

Economic indicators rely on data to substantiate predictions of what is to come in the future. When analyzed correctly, investors can capitalize on data to make successful trades or correctly assess future market conditions.

Economic indicators are often free and public, as the United States government prepares many economic indicators. In addition, these economic indicators reported by governments often have a fixed cadence and steady form of measurement. This means you can usually rely on the method of how an indicator was calculated and the timing of when that indicator will be released.

Cons of Economic Indicators

The obvious downside to economic indicators, at least leading or coincident indicators, is that they rely on some degree of forecasting. While leading indicators are projections to the future, even coincident indicators may rely on a bit of assumptions. Therefore, economic indicators do not always predict the future correctly, and the recommended action to take may not play out as expected.

Economic indicators, though boiled down to a single number, can be very complex. For example, consider all of the variables the comprise unemployment. From macroeconomic conditions to weather patterns impacting farming jobs, there may be too many levers that manipulate a given indicator that make it tough to accurately predict what will happen.

Finally, economic indicators are somewhat open to interpretation. Consider an example where inflation has dropped from 4.6% to 4.5%. Is this considered a good change, or should the drop have been larger? Economics and policymakers often debate on the appropriate approach for economic factors. Though data may be concrete, the way to interpret it may lead to various ways evaluating these indicators.

Economic Indicators Pros and Cons

Pros

May accurately forecast what is to come based on prevailing data
Often use publicly available information
May be calculated using the same process over and over (when issued by governments)
May be released on a fixed, predictable cadence

Cons

May not accurately predict the future
Relies on many assumptions, some of which may be unpredictable
Can be open for interpretation, as data may indicate different things
Still requires expertise to interpret and understand the results

What Is the Most Important Economic Indicator?

Every economist may come up with their own favorite economic indicator. For many, a country's GDP usually represents the best overall picture of a country's economic health. It combines the monetary value of every produced in an economy for a certain period, and it considers household consumption, government purchases, and imports/exports.

Is Inflation an Economic Indicator?

Yes, inflation is a lagging indicator that is reported after a rise in prices has occurred. This type of economic indicator is helpful for government agencies to set public policy, as without this type of data, they would not know the direction of the economy. Therefore, while inflation and other lagging indicators are still useful to investors, they are more useful not for the indicator themselves (as they are representative of the past) but for future policy responses.

What Are the Economic Indicators of a Strong Economy?

An economy may be strong if it has a robust amount of economic activity, and job growth. This is measured by low unemployment, steady inflation, increases to construction, positive consumer index readings, and increasing GDP.

Do Traders Use Economic Indicators?

Traders and investment professionals may use economic indicators to predict how broad economic policy will impact their trades or investment strategy. Many trades rely on technical indicators which reflect the detailed movement of specific stocks. Technical indicators are different than economic indicators as economic indicators are much more broad and less security-specific.

The Bottom Line

Economic indicators are leading, coincident, or lagging figures that indicate broad conditions. Economic indicators such as GDP, unemployment, inflation, or certain prices inform economics, companies, and investors of not only where the economy is today but perhaps where the economy may be headed. Economic indicators can be used to guide government policy or set investment strategies.