A new composite index of coincident economic indicators in Japan: How can we improve forecast performances?

The purpose of this paper is to construct a new composite index of coincident economic indicators in Japan and to demonstrate their usefulness in forecasting short-run economic fluctuations in the 1990s. The method of construction is based on the single-index dynamic factor model. Our two types of indexes are highly correlated with the traditional composite index compiled by the EPA over business-cycle horizons. However, standard leading indicators, which failed to forecast the traditional composite index, make a satisfactory performance in forecasting our indexes in the 1990s. In addition, lagged values of our indexes help to improve the leading indicators performance in forecasting the traditional composite index in the 1990s. The result is noteworthy because several research institutes in Japan made serious errors in forecasting business cycles and prolonged recessions in the 1990s.