Fourth Quarter 2018 FEDERAL RESERVE BANK OF PHILADELPHIA Volume 3, Issue 4 Tracking Business Conditions in Delaware The “Philly Fed Index” Turns 50 with Steadfast Success 1 Tracking Business 8 The “Philly Fed Index” Contents Conditions in Delaware Turns 50 with Steadfast Fourth Quarter 2018 Volume 3, Issue 4 How have business conditions in Success the First State evolved since the Over seven business cycles, the 1990s? Jonas Arias and Jesús Philly Fed Index has provided Fernández-Villaverde present a timely evaluations of changes in real-time daily index to assess regional and U.S. manufacturing business conditions in Delaware. conditions. The authors describe its history and predictive value. 22 Research Update Abstracts of the latest working papers produced by the Philadelphia Fed. A publication of the Research Department of the Federal Reserve Bank of Philadelphia The views expressed by the authors are not necessarily those of the Federal Reserve. The Federal Reserve Bank of Philadelphia helps formulate and implement monetary policy, supervises banks and bank and savings and loan holding companies, and provides financial services to depository institutions and the federal government. It is one of 12 regional Reserve Banks that, together with the U.S. Federal Reserve Board of Governors, make up the Federal Reserve System. The Philadelphia Fed serves eastern and central Pennsylvania, southern New Jersey, and Delaware. About the Cover The $100 bill is all about Philadelphia—and the founding of our nation. On its face is Benjamin Franklin, whose arrival in Philadelphia from Boston at age 17 helped change the course of history. On the reverse is the engraving adapted for our cover image of Independence Hall, where the Declaration of Independence and Constitution were debated and signed. 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Adam Steinberg Managing Editor, Research Publications Connect with Us Brendan Barry Data Visualization Manager We welcome your comments at: Twitter: [email protected] @PhilFedResearch Hilda Guay Editorial Services Lead E-mail notifications: Facebook: www.philadelphiafed.org/notifications www.facebook.com/philadelphiafed/ ISSN 0007–7011 Previous articles: LinkedIn: www.philadelphiafed.org/research-and- https://www.linkedin.com/company/philadelphiafed/ data/publications/economic-insights Tracking Business Conditions in Delaware To meet the need for a gauge of current regional Jonas E. Arias is a senior economist at the Federal conditions at high frequency, we have built a real-time Reserve Bank of Philadel- phia and Jesús Fernán- daily index to monitor business conditions in Delaware. dez-Villaverde is a visiting scholar from the University What are the current conditions in the First State? of Pennsylvania. The views expressed in this article are How have these conditions evolved since the 1990s? not necessarily those of the Federal Reserve. BY JONAS E. ARIAS AND JESÚS FERNÁNDEZ-VILLAVERDE ver since the first official measure of the U.S. economy, states, the case of Delaware is interesting because of the high prepared by Simon Kuznets, was submitted to Congress volatility of Delaware’s real GDP growth—about twice that of New E in 1934, substantial resources have been dedicated to Jersey and nearly triple that of Pennsylvania, and one of the developing more precise tools for systematically tracking eco- most volatile growth rates among the 50 U.S. states. This volatility nomic conditions. A major breakthrough in this line of research presents a major challenge for households, firms, and policy- came in the late 1980s with the development of monthly indexes makers alike when it comes to forming accurate views about for monitoring the current state of the economy using modern what is happening to the economy in the First State. time series econometrics.1 With this backdrop in mind, we will describe how the index These indexes have become an essential part of the toolkit of works, examine what it can contribute to our understanding of economists at policymaking institutions and in the private sector the evolution of Delaware’s economy since the 1990s, and because they provide a systematic framework for extracting, in discuss the challenges and limitations of trying to measure the real time, a succinct summary of the state of the economy from economy in real time. the vast and continually evolving economic data. Prominent examples of such summary indexes include the Federal Reserve Bank of Chicago’s National Activity Index and the Federal The Making of a Real-Time Index for Delaware Reserve Bank of Philadelphia’s State Coincident Indexes, which The index is based on Delaware’s readings for seven macroeco- track the U.S. and state economies, respectively. nomic variables: initial claims for unemployment insurance In recent years, the work on monthly indexes has been ad- benefits, nonfarm payroll employment growth, the unemploy- vanced by Borağan Aruoba, Francis X. Diebold, and Chiara Scotti’s ment rate, an electricity consumption index, new building development of a methodology for monitoring the state of the permits, new car titles, and real personal income growth.3 These economy at even higher frequencies—weekly and daily. This economic variables, which are the index’s input variables, pro- work has evolved into the Philadelphia Fed’s Aruoba–Diebold– vide snapshots of different aspects of the economy. Initial jobless Scotti (ADS) Business Conditions Index. claims, employment growth, and the unemployment rate are To date, this high-frequency approach has been employed barometers of labor market conditions. Electricity consumption exclusively to provide timely information about the national and the pace of building permit issuance contain information economy. Yet, it has become increasingly clear that economic about the health of commerce, construction, and industrial conditions in a particular region of the country can at times differ production. New car titles and real personal income growth are from the overall state of the U.S. economy.2 Furthermore, state- reasonable indicators of households’ purchasing power. level real GDP—one of the chief indicators of what is happening While the input variables depict economic conditions from to the economy—is typically released with a lag of more than five different angles, they generally move with the underlying state of months. In an attempt to meet the need for a gauge of current the economy, or latent business conditions. This underlying regional conditions at high frequency, we have built a real-time level of economic activity cannot be directly observed. Instead, it daily index to monitor business conditions in Delaware, which is inferred from the levels and movements of various relevant along with most of Pennsylvania and southern New Jersey, makes economic indicators. But different economic indicators can point up the Third Federal Reserve District served by the Philadelphia in different directions at the same time, which suggests that Fed. While similar indexes could also be built for the other two factors other than intrinsic economic activity may be in play. Tracking Business Conditions in Delaware Federal Reserve Bank of Philadelphia 2018 Q4 Research Department 1 FIGURE 1 What we are after, though, is a measure of economic activity that Real Time Business Conditions Index for Delaware firms and households can use in their daily decision-making. Standardized units; 1990–2018 For example, when firms are deciding whether to expand pro- Delaware Business Conditions Index PFED national ADS duction or households are deciding whether to purchase big- 5 ticket items such as a house or a car, they often rely—explicitly 4 or implicitly—on a concise summary about the state of the 3 economy based on the information they absorb from the news 2 or other sources. The approach that firms and households use to extract this 1 succinct measure of economic conditions will vary depending 0 on their budget and experience. Central banks frequently rely on −1 a class of statistical models from which it is possible to optimally −2 extract a reading of what is happening to the economy given the −3 information available this week or even today. −4 We will follow one of these statistical frameworks to assess −5 the latent business conditions prevalent in Delaware in real time 1990 1995 2000 2005 2010 2015 2018 over the past 27 years. In particular, we will use the procedure Note: The years shown on the x-axis correspond to the first day of the year; e.g., developed by Aruoba, Diebold, and Scotti.4 2000 refers to January 1, 2000. Assessing Business Conditions in Delaware By feeding the seven input variables into the statistical model, we obtain an estimate of the evolution of latent business conditions FIGURE 2 in Delaware since the 1990s (Figure 1).5 An informative point of Delaware in the reference for evaluating these conditions is latent U.S. business BEA Mideast conditions during the same timespan, as measured by the Phila- delphia Fed’s ADS index.6 Three results stand out. First, business conditions in Delaware corresponded reason- ably closely with those of the nation from the beginning of our sample in January 1990 until the end of the Great Recession in June 2009.7,8 The correlation between business conditions in Dela- ware and in the nation was nearly 0.6 over that period. This Delaware fairly close correlation is perhaps not surprising, given that Delaware is located within an important region of U.S. economic activity, the Bureau of Economic Analysis’s (BEA’s) Mideast Re- gion (Figure 2).9 Real GDP for that region equals nearly 20 percent of U.S.