Economic Review

The notion that financial asset returns are predictors of future economic activity is widespread, but detailed analyses provide little support for financial markets’ ability to reveal future economic activity. Even though the evidence on various indicators used by different researchers is mixed, the authors of this article explore the notion that financial markets reveal useful information about future economic activity.

This article examines and answers two questions: First, what is a good way of extracting information about future economic activity from asset prices? Second, do financial asset returns help predict economic activity over horizons from one month to five years?

To determine whether news of an asset’s excess return can reveal information about unexpected economic activity, the authors construct a method of extracting the news about future economic activity from returns on financial assets. The authors use linear regressions to relate the unexpected parts of economic activity and the asset’s return to actual economic activity and the actual return on an asset.

The evidence in the article shows that movements in financial markets do presage developments in the economy. The authors find that movements in the overall stock market and bond returns are the most important financial indicators. It remains to be seen whether those indicators hold up to variations in technique or the passage of time.

Most emerging capital markets in recent years adopted a system that narrowly pegs their currencies’ exchange rates to the U.S. dollar. While such a system has a number of advantages, it makes a country vulnerable to shocks in mobile international capital markets and can lead to reactive strategies that can drive the country into a currency crisis and inflationary recession.

This article aims to construct an early warning system for international currency crises using financial variables reflecting investors’ expectations and banking distress, which are highly sensitive to changes in the economic environment. The authors use a dynamic factor model that switches between two regimes—representing periods of relative calmness and periods prone to currency crises—to construct leading indicators of country risk and currency crises.

The method is applied to evaluate the model’s in-sample and out-of-sample performance in anticipating currency crises in the last two decades in Thailand, Indonesia, and Korea. The model successfully produces early signals of these crises, particularly the most severe one, which occurred in 1997.

The study’s success in signaling future currency crises in real time demonstrates that the model’s “country risk” indicators can be informative tools that allow central banks to take preemptive counterpolicy measures to avoid a crisis or mitigate its severity.

As U.S. core inflation measures have declined in recent years, analysts have renewed their efforts to understand inflation dynamics. A common approach to this issue is to make inferences about how price changes of major components affect the aggregate inflation rate. This article takes a more rigorous approach, calculating and plotting the precise contributions of major consumer expenditure categories to core inflation measures over time.

This technique has distinct advantages. It highlights the underlying trends in inflation, enabling analysts to make more informed inferences about the near-term direction of inflation. It also allows analysts to distinguish broad-based changes in inflation from changes due to relative price movements of a few components.

The analysis focuses on the core components of the consumer price index (CPI) and the personal consumption expenditures price index (PCEPI). Over the long term, the authors note, the composition of core services inflation has remained relatively stable while the composition of core goods inflation has changed dramatically. Over the 2002–03 period, movements in core inflation measures resulted mainly from significant relative price changes of two components that were persistent enough to alter the path of core inflation for a sustained period, the authors conclude.

The results of this study highlight the importance of gauging the impact of relative changes in a low-inflation environment and suggest that recent concern about overall price deflation was perhaps overstated.