Manufacturers' Optimism Don't Tell Us Much About Economic Growth

The index that measures the strength of the US manufacturing sector jumped to its highest level since 2010 in June.

In one sense, that is great news. The Markit Preliminary Index of US Manufacturing, which polls purchasing managers on whether or not they are upping orders and production, is a monthly pulse of expectations about the US economy from an industry that is very sensitive to booms and busts. Not only that - the more managers expect production to increase, the more hiring they'll have to do. It's another example of how expectations are so crucial to the economy's health. A fortuitous cycle of expectations really *can* bring true growth back.

But on the other hand, these types of indicies aren't worth much when it comes to forecasting future economic outcomes. Looking at data since 1984, movement in the ISM manufacturing index accounts 36% of the movement in GDP. That's a modest correlation for real world data, but isn't strong enough to be considered a leading indicator of the state of the economy. Looking at a graph of the data, you can see the limitations of the manufacturing index: it does a good job of forecasting recessions but a bad job of predicting booms.

Look at 2009-2011. Manufacturers seemed bullish about the US economy, but the growth never came. Now it seems like manufacturers are getting out ahead of economic growth again. Of course, we can hope that the optimism that manufacturers have is going to flow into the economy as a whole, but the track record of this index doesn't indicate so.

This is the problem with one number indicators, as we've seen in the last few months with unemployment and GDP growth: a single number can't tell us the whole story. Now we're all looking for something more simple, something that can tell us a lot about the economy in just 1 number. First, we saw the Fed, and Janet Yellen in particular, stop focusing so hard on run-of-the-mill unemployment. Instead, she emphasized broader and more vague measures of labor market health.

Second, we saw the GDP figures for the first quarter of this year come in at a terrible -0.1% growth rate. As soon as it happened, however, everybody from the Fed to the IMF to my entire Twitter feed wrote off the numbers as an aberration due to a cold and unforgiving winter. The Fed and IMF even lowered their 2014 growth projections - although without changing their forecasts for the last 3 quarters of the year. 

So that leaves observers looking for another number to tell them how the economy is doing. Unfortunately, the US economy isn't as simple as one number (and never has been). Even if it were, manufacturing indicies aren't accurate enough to help us.