Watch The Weekly Leading Index For Clues About The Fed’s Next Move

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May 24, 2011 9:59am NYSE:TBT NYSE:TIP

Jon D. Markman:  There’s no shortage of economic indicators economists count on to make predictions. But one of the most reliable measures I’ve found is the Weekly Leading Index

 (WLI) developed by the Economic Cycle Research Institute (ECRI).

The WLI is helpful for predicting recessions, and in this particular case, could offer some insight into whether or not the U.S. Federal Reserve will go for a third round of quantitative easing (QE3).

So let’s take a closer look.

The WLI has more than a dozen weighted inputs, such as mortgage applications, housing starts, stock index prices and obscure commodity prices, such as cardboard and tallow. While most economic models are linear in nature, extrapolating from the recent past into the near future, the WLI model is cyclical and intended to help us look around the corner rather than straight ahead.

As you can see in the accompanying chart, the WLI began to flatten out in March and is just barely tipping over now.

This flat spot does not mean anything special in isolation. Moves in the WLI must be persistent, pervasive and profound – the “three Ps” as explained to me many times by ECRI Founder and Managing Director Lakshman Achuthan – before they start to tell a persuasive story.

The WLI is always early, so if it starts to turn down in a persistent, pervasive manner over the next month or two, it would be forecasting a contraction in U.S. gross domestic product – and a possible recession – four to six months down the road.

But don’t jump the gun in making that connection now. The WLI often pauses like this before resuming its direction.To indicate a recession, the WLI’s monthly growth rate would first have to go negative. And even then, the decline might not be pervasive enough to lead Achuthan to forecast a contraction.

You can see in the second chart that the WLI monthly growth rate went negative in the middle of last year before turning up – just a slow spot, which turned out to be the May-August unpleasantness that was known in polite circles as a “growth scare.”

That period ended with the U.S. Federal Reserve announcing its second round of quantitative easing. Some have made the case that the economy was headed for a contraction, and that the Fed saved the day. We will never know, but it makes sense.

If the WLI goes negative again over the summer, after QE2 ends, it’s possible the Fed will announce a third round of large-scale asset buying. That, more than anything, makes the WLI worth watching.

So keep an eye on it.

Another indicator you may want to keep an eye on is the Long Leading Index of global industrial growth, which has been trending downward since last year.

“It is not country specific, but imagine if you could add up all the activity in factories around the world and see if it was accelerating or decelerating, that is what this indicator is focused on,” Achuthan, told Yahoo! Finance‘s “The Daily Ticker.” “And it has been telling us very clearly, unambiguously, that we have a peak in global industrial growth this summer.”

“The U.S. economy will not escape” the downturn, Achuthan said.

Achuthan certainly deserves our attention. As The Economist noted in 2005, “ECRI is perhaps the only organization to give advance warning of each of the past three recessions; just as impressive, it has never issued a false alarm.”

Written By Jon D. Markman From Money Morning

Jon D. Markman brings a unique perspective and unparalleled insights to his role as a Money Morning contributor. And with good reason: During the past two decades, Markman has worked as both a journalist/commentator and as an actual portfolio manager. In addition to his contributions to Money Morning, Markman manages The Markman Portfolios, and is the editor of two premium investment research services: Strategic Advantage and Trader’s Advantage.

 From 1982 to 1997, Markman was an editor, reporter and investments columnist at the Los Angeles Times. In 1992 and 1994 he was a news editor on staffs that won Pulitzer Prizes, the top award a journalist can receive. From 1997 to 2002, Markman was managing editor of CNBC on MSN Money. Markman is the author of four books, including the bestsellers Online Investing (1999) and Swing Trading (2003). His fourth book – an annotated version of the widely read investment classic, Reminiscences of a Stock Operator – debuted in late 2009. Markman is also the co-inventor on two investment-software patents. A graduate of both Duke University and Columbia University, Markman is a regular guest on radio and television, and at investment conferences – sought out for his insights on stocks, credit and the global economy. Markman lives with his family in Seattle.

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