The institution of private enterprise does not produce growth at an even pace; rather economies observe alternating periods of expansion and contraction giving rise to recurrent business and trade cycles where the growth of production, real incomes and spending fluctuates. Policymakers, investors and economic agents have avid interest in predicting the future course of economic activity and growth rates. Monetary aggregates, exchange rates and structural macroeconomic models have been traditionally used to forecast the direction of economic activity, however, all these have been shown to be problematic and unstable. The present study uses an indicator approach to portend future changes in the level of economic activity. The study has identified from a set of financial indicators, those indicators which register some significant aspect of the performance of the economy and thus have the ability to forecast changes in economic climate. Most of the research is done for the developed countries which are characteristic of free market economy where fluctuations in business activity are driven by endogenous factors. Similar studies for emerging market economies are lacking. The present study identifies from a wide array of financial variables those variables which can predict cyclical fluctuations in U.S.A., which is a free market economy and in India which is steadfastly proceeding towards a free market economy post liberalization that is, after 1991. The study then determines the lead of various variables in predicting recessions and provides the best model with highest predictive content for the world's largest economy, U.S.A. and the world's second fastest growing economy, India.
Financial variables, forecasting, business cycles, indicator approach, term structure
