The Three P's

Excerpt from Beating the Business Cycle

Today’s State of the Art

How is it possible to apply the basic leading index approach in forecasting to all these different aspects of the economy? Fortunately, the many cycles we have described exhibit similar key characteristics. First, they share the principle of the durable sequence, meaning that economic events move in a known order at turning points. It is the predictable nature of this sequence of events that allows us to forecast cycle turns in both the entire economy and its many parts.

Second, their turning points can be recognized in the same way. Specifically, at each turning point, regardless of the kind of cycle we are monitoring—the aggregate business cycle, the inflation cycle, or the specialized sectoral cycles—the indexes, in order to signal a genuine turn in the cycle, must change direction in a way that is pronounced, pervasive, and persistent.  We call this “the three P’s.”

Why are the three P’s so important? When a leading index forecasts a change in the direction of the cycle in a pronounced, pervasive, and persistent manner, the likelihood of a turn rises significantly. We will illustrate these concepts with charts showing a three P’s analysis of the Leading Employment Index at the time ECRI made its 2001 recession call.

Pervasiveness measures the extent to which the economy as a whole is affected by the cycle. During a cyclical upswing the improvement in economic activity spreads from one company to another, form industry to another, and from one region to another. These developments multiply throughout as an expansion takes hold. In the case of a contraction, the downturn also spreads out across industries and regions. Pervasive movement is revealed by watching the percentage of components contributing to an index’s rise or fall and comparing that pattern with past cycles.

A cyclical change also needs to be pronounced—of sufficient magnitude—in order to distinguish it from mere fluctuations or “noise.” As a directional change in growth becomes more pervasive, it begins to snowball, gaining momentum and magnitude, becoming more pronounced. Again, in order to get a sense of just how pronounced a movement is, one needs to compare it with past cycles.

Finally, the cyclical movement must be persistent in order to qualify as a cyclical upswing or downswing, because such a move feeds on itself, prolonging the move. A slowdown in sales may cause a production cutback, triggering job losses and lowering incomes, which in turn feeds back again to even lower sales, creating a vicious cycle. Just a month or two of movement may indicate nothing more than an economic hiccup. A move in cyclical indicators that is somewhat pervasive and pronounce does not qualify as a cyclical turn if it lasts only a couple of months. Technically, a cyclical upswing or downswing has to persist for at least five months in order to be labeled as such. Most last much longer.

These two characteristics, the durable sequence and the three P’s, are common to all cycles, whether in overall economic activity, inflation, employment, economic sectors, or foreign trade. These similarities allowed us to develop forecasting tools that share a consistent design while complementing each other.     

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