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Timothy Slaper
Indiana Business Research Center

George Vlahakis
IU Communications

Last modified: Tuesday, November 20, 2012

IU Kelley School's Leading Index for Indiana continues 'steady ascent,' but fiscal cliff looms

Nov. 20, 2012

BLOOMINGTON, Ind. -- The Leading Index for Indiana continued its measured but steady ascent, moving up from a revised reading of 100.1 in October to 100.4 in November.

The component measuring future activity in the auto sector was down slightly, but all other indicators gave the LII lift, including the Purchasing Managers Index, home builders' sentiment and the Dow Jones Transportation Average.

Timothy Slaper, director of economic analysis at the Indiana Business Research Center in Indiana University's Kelley School of Business, continues to be concerned about what he says is a mixed view of the near-term economic picture. While some indexes suggest that consumers may feel more optimistic about their economic prospects, businesses, both large and small, are increasingly downbeat. The Indiana Business Research Center produces the LII.

The Morgan Stanley Business Conditions Index plummeted in September and October. The Conference Board Measure of CEO Confidence declined again in the third quarter. The National Federation of Independent Business' Small Business Optimism Index, while registering a small uptick in October, still remains in solidly pessimistic -- and recessionary -- territory. Small businesses owners are still not eager to hire as the recovery continues its slow and uncertain path.

"It would appear that businesses are concerned about the fiscal cliff. Now that the election is over, consumers may consider the potential economics effects of the fiscal cliff ... and ratchet down their expectations," Slaper said.

"For example, if the tax rate on capital gains increases by at least a third for lower-income earners or increases by a half on higher incomes as either a part of a compromise agreement or 'going off the cliff' as the legislation is currently written, one outcome is assured: There will be a stock sell-off as investors realize their capital gains at a lower tax rate," he said.

Indeed, since mid-October, the market has been in a steady but orderly retreat. While the market rose strongly on Monday, Nov. 19, there is still a lot of ground to recover to reclaim the pre-election highs. The full extent of this higher-tax-rate-induced sell-off is unknown, but a falling stock market could make consumers feel less wealthy and reduce their spending, which would, in turn, reduce economic growth.

Tim Slaper

Timothy Slaper

Print-Quality Photo

"Even if the country goes over the fiscal cliff because both the Congress and the president dig in their heels and cannot come to an agreement, some economists speculate that the economic consequences will be slight. It would be more like a fiscal curb," Slaper said.

"The automatic tax increases and spending cuts would result in a small economic dip and a bump up in unemployment, but the economy would regain its footing by summer. The big worry is that not reaching an amicable agreement on taxes and spending -- resulting in job losses and another short recession -- could put raising the debt ceiling early next year in jeopardy."

Without a raise in the debt ceiling, government programs and expenditures would be curtailed and those creditors holding U.S. securities may fear that the U.S. would default. Such a "double whammy" would be "economically catastrophic," Slaper said.

"All in all, if the fiscal cliff is transformed into the fiscal bunny hill, as most want, economic growth for 2013 would still be subpar, about 2.5 percent, insufficient to make strong progress on lowering unemployment," he concluded.

Drivers of change

The National Association of Home Builders/Wells Fargo Housing Market Index posted a solid 5-point gain to 46. Builder confidence has improved dramatically in recent months, and this marks the seventh consecutive monthly gain. Builders are seeing increased demand for new homes as inventories of foreclosed and distressed properties have begun to shrink. Many potential buyers are now motivated to move forward with a purchase in order to take advantage of today's favorable prices and interest rates.

While the Housing Market Index has yet to break the 50 mark -- at which point an equal number of builders view sales conditions as good versus poor -- the index is the highest it has been since May 2006. All four regions of the country posted gains in their Housing Market Index, with the Midwest posting a 3-point gain.

Giving the LII additional lift, the Institute for Supply Management's Purchasing Managers Index moved out of the "economic contraction" zone last month and increased from 51.5 to 51.7 this month. After several summer months in the economic contraction zone, the PMI has spent the past two months in positive territory. A PMI reading of above 50 signals expanding economic activity in the manufacturing sector.

While October auto sales didn't measure up to September's nearly 15 million units, year-to-date sales are almost 14 percent greater than last year. Unfilled orders for motor vehicle bodies, parts and trailers -- the auto sector component for the LII -- took a downward turn however, falling about 1 percent. This was the only negative component for November's LII.

The transportation and logistics component of the LII -- the Dow Jones Transportation Average -- turned around in October, improving nearly 4 percent. Consistent with the previous months, the October trash index -- a measure that tracks the amount of waste and scrap hauled by railroads and that tracks with current economic output -- was 11.7 percent lower compared to last year, and all rail car loads were down 6.1 percent compared to last year.

In September, the Federal Reserve announced a third phase of quantitative easing, or QE3. The injection of liquidity is intended to help the residential real estate market by reducing the cost of mortgages.

"The degree to which this policy will help those who are truly underwater remains to be seen," Slaper said. "As stated before, the interest rate spread component of the LII is really a story about the behavior of the 10-year Treasury interest rate, given that the Federal Funds rate hovers near zero as part of state Fed policy."

The rate on 10-year Treasuries edged up in October.

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.