Why Industrial Production Mattered This Week

On Thursday, the consensus (whatever that means) for Industrial Production ("IP") was an increase of 0.3%, however, the numbers disappointed with no growth at all. That was the biggest piece of information that came out all week -- bigger than Europe coming out of recession or Japan posting another quarter of growth (see below for those two stories), and following is my explanation of why.

You call that Growth?

When GDP numbers were initially released on the 31st of August, so too was Marcelle Chauvet and James Hamilton's GDP Based Recession Indicator. Without getting too engrained in the calculation of the index, they provide a clever way to estimate whether the U.S. economy is in recession using real time data (i.e. at the time of release). This contrasts the considerably lagged methodology currently employed by the National Bureau of Economic Research ("NBER"), which actually comes to a consensus decision as to when the Business Cycle began and ended, post facto (with the track record of this country coming to consensus at all, it's a wonder they actually finalize a date). Below is a graphic I created that illustrates:

  1. The actual points of recession as declared by the NBER (shaded grey)
  2. The GDP Based Recession Indicator including the most recent GDP Release from July 31st
  3. The threshold at which the GDP Indicator declares recession (dotted red line)


The reader can see that the GDP Based Recession Indicator has done a very good job of estimating recessions since its first reading in 1968, and likewise hasn't exhibited a single false positive (type I error, where a recession occurs but the indicator so fails to indicate). So the current reading of 30.5 seems curious, especially because there have only been two other times when reading has gone above 30 and not continued to recession (1985 and 1996).

Specifically for that reason, I closely watched the Industrial Production ("IP") numbers on Thursday. Why? Industrial Production serves as a good bellwether for national output, and can also provide indication of when the economy is falling into decline -- and most importantly, the releases are monthly instead of quarterly.

Real GDP versus Industrial Production

The Real GDP numbers just released were a first estimate for the 2nd quarter; in other words, they are a best first guess (of two, where the third is the "actual number") of the real growth that occurred during the months of April, May, & June. For the next three months, the Real GDP number will be revised, but the revision is only regarding the months of April, May, & June. No information will be gleaned regarding July, August, & September (which is really what we care about after seeing that GDP Based Recession Indicator Index).

That's where Industrial Production comes in. IP numbers come out on a monthly basis, providing us information about… you guessed it, the prior month. So Thursday's release on August 15th provided us information about July's production -- that's information that won't show up in GDP releases for another quarter.

Take a look at the series below, which plots the 12 month exponentially smoothed log changes between Industrial Production and Real GDP, along with shaded grey regions to illustrate recession.


Clearly the two series are highly related, and there's a lot of information that Industrial Production provides regarding the economic growth path (although I caution the reader to beware of "overlay" graphs that illustrate spurious relationships and don't take the necessary next step to implement statistical testing). In order to verify to the reader "the relationship is more than just looks," I perform a simple univariate regression using quarterly log changes in Real GDP as my explained variate and quarterly log changes in Industrial Production as my independent variate. The scatter plot below shows the Quarterly log changes of IP and Real GDP, along with the regression equation and coefficient of determination (R-Squared) of the regression.


Therefore, when the release yesterday showed IP up to 98.9462 from 98.9085, a log change of 0.0381% (which gets reported as 0.0), that's not a great sign, nor is it reassuring evidence that this is clearly another "head fake" of the GDP Recession Indicator Index. I'm certainly not saying that we are dipping back into recession, but I reiterate my temperament regarding subdued hiring and national output and will be keeping an eye on this same statistic over the next two months.

Noteworthy Reads / Events of the Week

  • - A Divided Europe: On Wednesday, the European Union officially announced it had risen from Recession, posting the first positive growth numbers since Q1 2011. Unfortunately, the consistency of expansion remains lumpy -- Germany & France grew at 0.2% and 0.5% respectively whereas some of the most important "periphery countries", Italy and Spain, continued to contract by 0.2% and 0.1%, respectively.
  • - Put on Your Thinking Caps: David A. Rosenberg, the Chief Economist from Gluskin Sheff, provides a great, albeit dense, piece on on his economic forecasts. Namely, inflationary pressures are going to come from two main sources: 1. Price increases due to the increased inelasticity of the supply curve and 2. Wage increases. He argues that the persistently high unemployment rate is due to a skills mismatch, rather than job availability -- therefore, even though unemployment numbers may not greatly decline, positions in high demand will garner higher prices by those with the necessary skills to fill them and will push prices higher.

Benjamin is a Managing Director in Newfound’s Product Development and Quantitative Strategies group, where he is responsible for the ongoing research and development of new intellectual property and strategies. Specifically, Benjamin’s focus is in the area of exploring model applications to fundamental, economic and systemic market variables. Drawing on his years of experience in the financial services industry, he helps to ensure that Newfound’s products and messaging effectively meet the needs of investors and portfolio managers. He also plays a critical role in developing new business and client relationships.