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Timothy Slaper
Indiana Business Research Center

George Vlahakis
IU Communications

Last modified: Tuesday, December 18, 2012

IU Kelley School's Leading Index for Indiana reflects uncertainty over 'fiscal cliff'

Dec. 19, 2012

BLOOMINGTON, Ind. -- While the nation waits for President Barack Obama and congressional Republicans to reach a deal on the so-called fiscal cliff, the Leading Index for Indiana reflects the sentiment of many Hoosiers who are holding their collective breath economically, anticipating what will come next.

After having edged up for the past five months, the LII stalled in December, remaining at November's revised reading of 100.3. The components measuring future activity in the auto sector were down slightly, and the Purchasing Manager's Index also tumbled into the economic contraction zone.

"To balance the negative pressure, the Dow Jones Transportation Average increased marginally and home builders' pessimism about their future prospects is dissipating. Last month we highlighted that consumers and businesses held two drastically different views of the near-term economic future -- consumers positive and businesses negative. Lately, consumers seem to be moving toward the business sentiment," said Timothy Slaper, director of economic analysis at the Indiana Business Research Center in Indiana University's Kelley School of Business.

The Indiana Business Research Center produces the LII.

While the Conference Board's measure of consumer confidence rose in late November, the preliminary Thomson Reuters/University of Michigan's Consumer Sentiment Index fell a jaw-dropping 7.9 points from November's final read of 82.4.

Meanwhile, Small Business Optimism -- already in recessionary territory -- plunged over a cliff. The National Federation of Independent Business' Small Business Optimism Index dropped 5.6 points in one of the lowest readings in survey history.

"Not only are small business owners concerned about the fiscal cliff, but the advent of higher health care costs and the endless onslaught of new regulations have eviscerated any confidence that Washington considers the needs of small businesses," Slaper said. "Based on the NFIB survey, nearly half of owners are now certain that things will be worse next year than they are now. The survey results had the NFIB chief economist wondering if this is the new normal.

"As Washington edges ever closer to the fiscal precipice, one might be forgiven to think that the potential of falling off the cliff would focus the minds of congressional leaders and the president. It appears that some progress is being made, but the fiscal clock is moving rapidly toward midnight," he added.

"It is something of a relief that the discussions are past the phase in which Republicans consider the Democratic proposal ridiculous and Democrats reciprocate the sentiment. There may be reason for some optimism that an agreement that would do little harm to the fragile economy and make headway in controlling the exploding deficit is in view. That said, recall that in previous negotiations over the debt ceiling in the summer of 2011, Congress and the president were close to a deal, but it collapsed in the final hours.

"There are, in effect, 535 little presidents in Congress who need to be convinced that the fiscal cliff deal is in their individual interest. In other words, it may not be over even when it is over," he said. "It's not the fall that kills you. It is the sudden deceleration at the end."

Slaper notes that views about the potential impact of the cliff vary. For example, Morgan Stanley said it could affect gross domestic product by as much as 5 percent. The Congressional Budget Office projected that first-quarter growth in 2013 would drop 0.5 percent and recover later in the year.

The IU Center for Econometric Modeling Research is more in line with the CBO numbers. The differences may reflect how the timing of the austerity shocks, namely the government spending cuts and reductions in disposable personal income, play out. But they may also reflect how the models incorporate the policy uncertainty shocks.

"Many corporations have likely made their hiring, investment and earnings distribution plans based on their expectations of how, and when, the fiscal cliff will be resolved. Given the state of CEO sentiment -- last gauged as more pessimistic according to the Conference Board -- it is doubtful that those plans include hiring more workers or investing in expanding production," Slaper said.

"Many expect a protracted tug-of-war in early 2013 with fiscal cliff mini-fixes, for example, a temporary extension of middle-class tax cuts. In such a case, the deceleration at the end won't be as sudden, but it may be more drawn out," he added.

Slaper quipped that in addition to taxes and death, another thing is certain: uncertainty.

"Even if politicians can talk themselves off the fiscal cliff, policy and economic uncertainty may be sufficient to sap the economy of any momentum," he said.

Drivers of change

The National Association of Home Builders/Wells Fargo Housing Market Index posted a two-point gain to 47, the highest level the index has attained since April 2006. Builder confidence has improved dramatically in recent months, and this marks the eighth consecutive monthly gain. Builders are seeing increased demand for new homes as inventories of foreclosed and distressed properties have begun to shrink.

The national HMI has yet to break the 50 mark -- the point where an equal number of builders view sales conditions as good versus poor -- but the Midwest index now stands at 53.

The Institute for Supply Management's Purchasing Managers Index, after a brief stint in the economic expansion zone, dropped to 49.5 from 51.5.

November auto sales exceeded the 15 million units mark, almost reaching 15.5 million units, and was almost 15 percent higher than sales last year. Year-to-date sales are up almost 14 percent.

While the sales numbers may be robust, the auto sector component for the LII is not. Unfilled orders for motor vehicle bodies, parts and trailers fell about 1 percent, putting downward pressure on the LII.

The transportation and logistics component of the LII -- the Dow Jones Transportation Average -- after dipping in early November, recuperated later in the month, improving less than 1 percent.

The Federal Reserve recently announced a fourth phase of quantitative easing -- like QE3 but with a larger spigot -- and precise thresholds that will guide policy. The Fed will continue to pursue its current course of expansionary monetary policy until inflation resurfaces or when unemployment dips below 6.5 percent (6.5 percent is not a goal, but an indicator of an economy healthy enough to absorb restrictive monetary policy).

"All this to say that the interest rate spread is something of a zombie component of the LII. Under continuing Fed policy, the spread does little to indicate the direction or strength of future economic activity in the state," Slaper said.

About the Leading Index for Indiana
The LII, developed by the Indiana Business Research Center, is designed to reflect the unique structure of the Indiana economy. It is a predictive tool that signals changes in the direction of the economy several months before the economy has changed. In contrast to economic forecasts, which use sophisticated statistical models to foretell particular levels for a wide variety of economic activities and outcomes in the future, a leading index is a simple construct that indicates a general direction of future economic activity expected in the next five to six months.