Calculating the Leading Indicator of Employment

The Indicator is designed to give advance warning of turning points in cyclical employment. It is based on five equally weighted components - two international series and three domestic series. These components represent a variety of economic factors that influence the rate of employment growth in Australia, including business investment, consumer spending and the demand for Australian exports.

The five components of the Indicator are:

1. the official (NBSC) Purchasing Managers’ Index for Manufacturing Output in China
2. the US Yield Difference
3. the NAB Forward Orders Index
4. the Westpac-Melbourne Institute Consumer Sentiment Index
5. the Westpac-Melbourne Institute Leading Index of Economic Activity

The first important thing to note about the Indicator is whether it is rising or falling, not whether its values are above or below zero. Rises or falls in the Indicator determine whether employment is likely to grow faster or slower than its long-term trend rate of growth in the future.

The second important thing to note is whether the Indicator has been rising or falling for six months or longer – this indicates either a trough or peak in the indicator. A trough in the Indicator suggests that that cyclical employment growth will switch from below to above the long-term trend growth rate in about a year and a half. A peak suggests cyclical employment will switch from above to below the long-term growth rate in about a year and a half.

The Leading Indicator signals changes in the growth rate of cyclical employment. Cyclical employment is important from a policy perspective as it is influenced by policies and program settings (such as economic stimulus packages) that benefit from early responsiveness. The (non-cyclical) irregular and seasonal components of total employment are less important from a policy and program perspective because they represent short-term variation in employment. Additionally, the long-term trend rate of growth does not change much from month to month, so there is less need for a predictive tool for this element.

Methodology

The time series of both the Indicator and employment have seasonal, trend, cyclical and irregular elements. The Leading Indicator is created by extracting the cyclical elements of the components and combining them. We do this using the following steps:

1. The component series and the employment series are smoothed using 13-term Henderson weights to remove their irregular elements. This gives the one-year trend employment level.
2. The resulting series are then extrapolated forwards three years using the average compound growth rate of the preceding five years. We then calculate the trend elements as six-year centred moving average. This allows us to obtain the six-year trend employment level.
3. The cyclical elements of the series are obtained by subtracting the six-year trend level from the one-year trend level of each series.
4. The cyclical elements are then standardised by subtracting the mean from each series and dividing each series’ by their standard deviation.
5. The five components are combined, applying equal weights of 20 per cent to each component.
6. We obtain the Indicator by dividing the combined set of components by its standard deviation to restandardise it. Then we compare the Indicator with the cyclical element of employment.

Turning Points in the Indicator

A ‘turning point’ (peak or trough) in the Indicator is confirmed when there are six consecutive monthly movements in the same direction after the turning point. A peak (or trough) in the Indicator implies that, after a lag, the growth rate of employment may fall below (or rise above) its trend rate. The average lead time of the Indicator (i.e. the time between a peak or trough in the Indicator and the corresponding peak or trough in cyclical employment) is around a year and half, although it has varied significantly over the past decade. Historical relationships between the Indicator and employment can also vary from time to time. Judgements about the changes in employment based on the Leading Indicator should therefore be qualified appropriately.

For further information, please see the most recent review of the Leading Indicator of Employment.