Using a Leading Credit Index to Predict Turning Points in the U.S. Business Cycle

Financial indicators such as yield curves and stock prices have been extensively used as leading indicators of economic activity due to their forward looking content. Indeed, the Leading Economic Index (LEI) for the United States, a widely used forecasting tool for business cycle turning points, includes several financial components. However, we argue that the coverage of financial and credit market activity in the LEI can be improved to account for some of the structural changes in the U.S. economy (especially in financial markets) and we present evidence that at least one of the existing components, namely real money supply does not perform as well as it used to as a leading indicator in the past several decades. Over the past three decades, many new financial indicators, such as interest rate swaps, credit default swaps, certain corporate-treasury spreads, the Federal Reserve’s senior loan officer survey, etc. have become available, but, since most of these new indicators have not been available for a long enough period, very little research has been conducted to evaluate their utility as leading indicators. In this paper we evaluate the usefulness of a large number of financial indicators according to their ability to predict recessions (i.e. peaks in the business cycle). First, we establish the criteria which are helpful for assessing whether and when such financial indicators generate signals of recessions. We then choose the best ones and aggregate them into a single composite index of financial indicators which we name the Leading Credit Index (LCI). Our approach differs from others in the literature in that we focus on a small, carefully selected set of indicators as index components and, additionally, in our selection criteria we target business cycle turning points rather than financial stability. We argue that this leading credit index can be helpful to estimate recession probabilities better than individual indicators, including some of the existing components of the LEI, especially real money supply. As opposed to other recent financial indexes created to measure financial instability or volatility, the purpose of ours is to signal recessions in the US economy, and as such it could serve as an appropriate new component for the U.S. LEI.