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New Concident, Leading and Recession Indexes for the Canadian Economy: An Application of the Stock and Watson Methodology

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Author Info
Yanjun Liu
Carl Gaudreault
Robert Lamy

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Abstract

Using modern econometric techniques, Stock and Watson (1989) developed a new system of composite indexes of coincident and leading economic indicators, as well as a recession index for the United States. We apply this approach to build coincident and leading economic indexes for the Canadian economy. The composite coincident economic index (CEI) is based on an econometric model in which the "state of the economy" is an unobserved variable, which is common to several macroeconomic variables. The model is based on the fact that the fluctuations in these variables share a common element, which can be estimated. The approach to the construction of the composite leading economic index (LEI) is also different from the traditional approach. Rather than constructing a composite index on the basis of a weighted average of leading indicators, we use past changes in the CEI, as well as other variables that have historically led the business cycle, to forecast the change in the CEI over the coming three or six months. If the coincident index truly reflects the state of the economy, then a good forecast of this coincident index should make a good leading index. We also build a recession index for the Canadian economy. Unlike Stock and Watson, who used a rather complicated and tedious procedure, our recession index is the forecast probability that the economy will be in a recession in the coming three or six months based on logit models, using data available through the month of its construction and the constructed LEI.

Stock et Watson (1989) ont développé un nouvel ensemble d’indices composites coïncident et avancé, ainsi qu’un indice de récession pour les États-Unis en utilisant des techniques économétriques modernes. Nous appliquons cette approche pour construire des indices coïncident et avancé pour l’économie canadienne. L’indice économique coïncident (CEI) est basé sur un modèle économétrique dans lequel « l’état de l’économie » est une variable non observable commune a plusieurs variables macro-économiques. Le modèle est basé sur le fait que les fluctuations de ces variables partagent un élément commun qui peut être estimé. L’approche pour la construction de l’indice économique avancé (LEI) est également différente de la méthode traditionnelle. Plutôt que de construire un indice composite sur la base d’une moyenne pondérée de plusieurs indicateurs avancés, nous utilisons les variations passées du CEI ainsi que d’autres variables qui ont historiquement devancé le cycle économique pour prévoir les variations du CEI pour les trois ou six mois à venir. Si l’indice économique coïncident reflète réellement l’état de l’économie, alors une bonne prévision de cet indice devrait produire un bon indice économique avancé. Nous construisons également un indice de récession pour l’économie canadienne. Contrairement à Stock et Watson qui utilisent une procédure relativement lourde et complexe, notre indice de récession est une prévision de la probabilité que l’économie se retrouve en récession pour les trois ou six mois à venir, estimée à partir de modèles logit et en utilisant les données disponibles jusqu’au mois de sa construction.

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Paper provided by Department of Finance Canada in its series Working Papers-Department of Finance Canada with number 2003-12.

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