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Moving Average

There's great temptation to jump to a conclusion about the economy's health from just one month's data, but that's not a wise practice. Economic numbers can be faulty, inaccurate, or at the very least, misleading because of unusual events such as a major labor strike or severe weather conditions. Such situations can diminish the reliability of an economic indicator in the short term, so it's important to use caution when extrapolating information from just a single month's data.

To get a truer sense of the underlying trend in the economy, it's far better to rely on a moving average of economic numbers. Simply put, a moving average is a computation in constant motion because it always averages data for the most recent fixed number of months. As a result, the average changes with the introduction of each new monthly report. For example, let's say consumer price inflation shot up 1% in the most recent month. Obviously a rise of that magnitude could raise lots of red flags. However, before anyone panics, it's far more prudent to consider inflation's actual trend by looking at its moving average over the past three or six months. To do this, simply add up the inflation changes over the last three or six months and divide by the total number of months you considered. When the next set of inflation figures are released a month later, recalculate the moving average by including the new figure in the equation and discarding the oldest monthly data so that you are always averaging the latest three- or six-month periods. The virtue of moving averages is that they smooth out random fluctuations and make long-term trends clearer. One disadvantage of a moving average is that it's a lagging indicator. Averages are slower to respond when there's a genuine change in the economy's direction.


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