This article explains how the Federal Reserve Bank of Chicago’s Midwest Economy Index (MEI) can be used to produce quarterly estimates of the annual gross state product (GSP) growth of each state in the Seventh Federal Reserve District.Economic conditions - Federal Reserve District, 7th ; Federal Reserve District, 7th

Norman Wang

Scott Brave

English

Research Papers in Economics

Predicting gross state product growth with the Chicago Fed’s 
Midwest Economy Index
by Scott Brave, senior business economist, and Norman Wang, associate economist
This article explains how the Federal Reserve Bank of Chicago’s Midwest Economy Index 
(MEI) can be used to produce quarterly estimates of the annual gross state product 
(GSP) growth of each state in the Seventh Federal Reserve District.
Chicag­ o­Fed­Letter
ESSAYS ON ISSUES                                               THE FEDERAL RESERVE BANK  DECEMBER 2011
  OF CHICAGO                                                          NUMBER 293
1. MEI and Wisconsin real GSP growth rate, 1979–2010
Notes: The Wisconsin real GSP growth rate is calculated by the U.S. Bureau of 
Economic Analysis on an annual basis. The MEI is expressed as an annual average 
by taking the average of the March, June, September, and December values for 
each year. 
source: Authors’ calculations based on data from Haver Analytics.
percent standard deviations
1978 ’82 ’86 ’90 ’94 ’98 2002 ’06 ’10
–4
–2
0
2
4
6
8
–3
–2
–1
0
1
2
3
Wisconsin real gross state product (GSP) 
growth rate (left-hand scale)
Midwest Economy Index (MEI) (right-hand scale)
The­U.S.­Bureau­of­Economic­Analysis­
(BEA)­produces­measures­of­gross­
state­product,­which­are­the­state-level­
counterparts­to­the­nation’s­gross­do-
mestic­product­(GDP).­
Unlike­the­GDP­data­
that­are­updated­on­a­
quarterly­basis­by­the­
BEA,­the­GSP­data­
are­available­only­­
annually.1­In­this­
Chicago Fed Letter,­we­
describe­a­framework­
for­producing­quar-
terly­estimates­of­GSP­
growth­for­the­five­
states­of­the­Seventh­
Federal­Reserve­­
District.­To­do­so,­we­
exploit­the­historical­
correlation­between­
GSP­growth­in­each­of­
the­five­states­and­the­
Chicago­Fed’s­Midwest­
Economy­Index.­
The MEI and GSP
Earlier­this­year,­the­
Chicago­Fed­unveiled­a­new­index­
measuring­growth­in­nonfarm­business­
activity­in­the­five­Seventh­District­states­
called­the­Midwest­Economy­Index.2­
The­index­is­a­weighted­average­of­134­
state­and­regional­indicators­of­four­
broad­sectors­of­the­Midwest­economy:­
1)­manufacturing,­2)­construction­and­
mining,­3)­services,­and­4)­consumer­
spending.­The­weight­each­indicator­
receives­is­constructed­such­that­greater­
influence­in­the­index­is­given­to­those­
indicators­that­have­historically­been­
better­able­to­explain­broader­fluctua-
tions­in­the­Midwest­economy.­
MEI­values­correspond­to­deviations­
of­growth­in­Midwest­economic­activity­
around­its­historical­trend,­or­long-run­
average.­Values­above­zero­indicate­
growth­above­its­historical­trend,­and­
values­below­zero­indicate­growth­below­
trend.­Over­long­periods,­growth­in­
Midwest­economic­activity­around­its­
trend­has­tended­to­track­similar­devia-
tions­in­national­economic­activity.­How-
ever,­over­shorter­periods­this­has­not­
always­been­the­case,­particularly­around­
the­beginnings­and­ends­of­recessions.­
To­highlight­such­differences,­we­con-
struct­two­separate­index­values:­an­
absolute­value­and­a­relative­value.­
The­MEI­(absolute­value)­captures­both­
national­and­regional­factors­driving­
Midwest­economic­growth,­while­the­
relative­MEI­(relative­value)­provides­a­
picture­of­the­Midwest’s­economic­con-
ditions­relative­to­the­nation’s.­A­positive­
value­of­the­relative­MEI­indicates­that­
regional­growth­is­further­above­its­
trend­than­would­typically­be­suggested­
based­on­the­current­deviation­of­national­
growth­from­its­trend,­while­a­negative­
value­indicates­the­opposite.­2. Regression coefficients for real GSP growth
  Illinois  Indiana  Iowa  Michigan  Wisconsin
Constant  –0.2  0.5  –0.2  –0.4  0.8
GDP growth  0.8**  0.4*  0.6  0.3  0.5**
MEI  0.2  1.0**  0.1  1.3**  0.7*
Relative MEI  0.6**  0.4  0.7  –0.1  0.3
Lagged GSP growth  –0.1  –0.2**  0.0  –0.4**  0.0
Personal income  
growth  0.1  0.6**  0.5**  1.0**  0.2
Root mean squared  
error (RSME)  0.7  1.1  2.1  1.5  0.8
Number of  
observations  32  32  32  32  32
3. Variance decomposition of real GSP growth
  Illinois  Indiana  Iowa  Michigan  Wisconsin
   ( - - - - - - - - - - - - - - percent - - - - - - - - - - - - - - )
National factors  67  10  19  2  53
Regional factors  28  22  15  11  39
State-specific factors  5  68  66  87  8
Notes: National factors denote real gross domestic product growth. Regional factors are the 
Midwest Economy Index (MEI) and relative MEI. State-specific factors comprise lagged real 
gross state product (GSP) growth and contemporaneous real personal income growth.
source: Authors’ calculations based on data from Haver Analytics.  
   * Significant at the 5% level.
  ** Significant at the 1% level.
Notes: The sample period extends from 1979 through 2010 on an annual basis. Gross 
domestic product (GDP), gross state product (GSP), and personal income are expressed 
in constant price, or “real,” terms. Constant denotes the estimated regression intercept. The 
regression coefficients describe the marginal impact on real GSP growth in percentage terms 
from a one unit change in each variable. The Midwest Economy Index (MEI) and relative 
MEI are in standard deviation units, while the others are in percent. Robust standard errors, 
clustered by year, are reported. 
source: Authors’ calculations based on data from Haver Analytics. 
The­MEI­and­GSP­measure­growth­in­
economic­activity­in­complementary­fash-
ions,­although­their­methods­of­account-
ing­for­it­differ.­Consider­figure­1,­which­
plots­the­MEI­against­the­annual­growth­
rate­of­gross­state­product­for­Wisconsin.­
The­correlation­coefficient­between­
the­two,­at­0.87,­is­quite­high.­Among­
the­Seventh­District­states,­Wisconsin­
has­the­highest­correlation­coefficient­
between­the­MEI­and­GSP,­although­it­
is­followed­closely­by­Indiana,­at­0.86;­
Illinois,­at­0.84;­and­Michigan,­at­0.83.­
In­contrast,­for­Iowa­the­correlation­
coefficient­drops­to­0.60.
That­said,­the­MEI­and­relative­MEI­
provide­a­picture­of­the­Seventh­District’s­
state­economies­that­is­timelier­than­
the­BEA’s­GSP­data.­In­what­follows,­
we­show­that­the­two­indexes­can­be­
used­to­form­real-time­inferences­on­
GSP­growth­for­each­Seventh­District­
state;­and­in­doing­so,­we­gain­a­sense­
of­how­important­re-
gional­growth­factors­
summarized­in­the­
MEI­and­relative­MEI­
have­historically­been­
in­explaining­eco-
nomic­growth­for­the­
Seventh­District­states­
relative­to­national­
and­state-specific­
growth­factors.
Predicting GSP 
growth
We­construct­a­sta-
tistical­model—­
more­specifically,­
we­estimate­a­simple­
linear­regression—
to­explain­the­annual­
growth­in­GSP­for­
each­Seventh­District­
state.3­The­model­
succinctly­summa-
rizes­the­historical­
relationships­between­
national,­regional,­
and­state-specific­
factors­driving­each­
Seventh­District­
state’s­GSP­growth­
since­1979.­We­use­
GDP­growth­to­cap-
ture­the­importance­
of­national­growth­factors­to­GSP­
growth­in­our­model.­To­capture­re-
gional­influences­on­GSP­growth­in­
our­model,­we­rely­on­the­MEI­and­rel-
ative­MEI.­Finally,­to­account­for­state-
specific­growth­factors’­impact­on­GSP­
growth­in­our­model,­we­use­the­one-
year­lag­of­GSP­growth­and­the­contem-
poraneous­growth­rate­in­personal­
income­of­each­state.
The­GSP­growth­for­each­Seventh­­
District­state­tends­to­vary­over­time­
around­a­historical­trend,­but­the­rate­
at­which­it­converges­to­that­trend­de-
pends­on­national­and­regional­growth­
factors.­We­include­lagged­GSP­growth­
in­the­regression­to­capture­this­“con-
ditional­mean­reversion.”­In­addition,­
the­MEI­and­relative­MEI­only­measure­
activity­in­the­nonfarm­business­sector;­
therefore,­including­personal­income­
is­necessary­to­fully­capture­economic­
activity,­since­it­forms­a­considerable­part­
of­each­state’s­GSP.­The­MEI,­however,­
does­help­capture­the­impact­of­regional­
growth­trends­on­each­state’s­GSP,­and­
the­relative­MEI­does­help­explain­GSP­
growth­above­that­predicted­by­GDP­
growth­and­the­MEI.­
National, regional, and state-specific 
growth factors 
Figure­2­displays­the­regression­coeffi-
cients­estimated­using­our­model­for­
each­of­the­five­Seventh­District­states­
over­the­period­1979–2010.4­A­1%­in-
crease­in­GDP­growth­leads­to­about­a­
0.5%­increase­in­GSP­growth­across­the­
Seventh­District­states,­with­the­effect­
slightly­higher­for­Illinois­and­Iowa­
and­slightly­lower­for­Indiana­and­
Michigan­(figure­2,­second­row).­The­
magnitude­of­these­coefficients­point­
to­the­fact­that­holding­regional­and­
state-specific­growth­factors­constant,­
there­is­considerable­co-movement­
(tendency­to­move­in­parallel)­between­
the­Seventh­District­and­national­econ-
omies,­although­the­correlation­is­not­
one­for­one.­
In­contrast,­Michigan’s­and­Indiana’s­GSP­
growth­varies­one­for­one­or­better­with­
the­MEI­(figure­2,­third­row),­so­that­
holding­fixed­state-specific­and­national­
growth­factors,­the­performance­of­both­
state­economies­has­historically­been­
tightly­connected­with­that­of­the­other­
Seventh­District­states.­Only­Wisconsin­
also­demonstrates­a­statistically­significant­
correlation­with­the­MEI.­The­relative­
MEI­has­a­statistically­significant­impact­
on­GSP­growth­only­for­Illinois­(fourth­
row).­This­suggests­that­holding­fixed­
national­and­state-specific­growth­factors,­
Illinois’s­economy­has­historically­been­
most­affected­by­regional­growth­trends­
during­periods­where­large­differences­in­
regional­and­national­growth­occurred.­
Michigan­and­Indiana­also­demonstrate­
significant­conditional­mean­reversion­
based­on­the­regression­coefficients­for­
their­lagged­GSP­growth­(figure­2,­fifth­
row).­Therefore,­state-specific­growth­
factors­for­these­two­Seventh­District­
states­are­likely­to­be­nontrivial­in­his-
torically­explaining­their­GSP­growth.­
Furthermore,­personal­income­growth­
is­a­significant­predictor­of­GSP­growth­
for­Indiana,­Iowa,­and­Michigan—and­Charles­L.­Evans, President  ; Daniel­G.­Sullivan,­
Executive Vice President and Director of Research; 
Spencer­Krane, Senior Vice President and Economic 
Advisor ; David­Marshall,­Senior Vice President, financial 
markets group  ; Daniel­Aaronson,­Vice President, 
microeconomic policy research; Jonas­D.­M.­Fisher, 
Vice President, macroeconomic policy research; Richard­
Heckinger,Vice President, markets team; Anna­L.­
Paulson,­Vice President, finance team; William­A.­Testa,­
Vice President, regional programs, and Economics Editor ; 
Helen­O’D.­Koshy­and­Han­Y.­Choi, Editors    ; 
Rita­Molloy­and­Julia­Baker, Production Editors  ; 
Sheila­A.­Mangler, Editorial Assistant.   
Chicago Fed Letter­is­published­by­the­Economic­
Research­Department­of­the­Federal­Reserve­Bank­
of­Chicago.­The­views­expressed­are­the­authors’­
and­do­not­necessarily­reflect­the­views­of­the­
Federal­Reserve­Bank­of­Chicago­or­the­Federal­
Reserve­System.­
©­2011­Federal­Reserve­Bank­of­Chicago­­
Chicago Fed Letter­articles­may­be­reproduced­in­
whole­or­in­part,­provided­the­articles­are­not­­
reproduced­or­distributed­for­commercial­gain­
and­provided­the­source­is­appropriately­credited.­
Prior­written­permission­must­be­obtained­for­
any­other­reproduction,­distribution,­republica-
tion,­or­creation­of­derivative­works­of­Chicago Fed 
Letter­articles.­To­request­permission,­please­contact­
Helen­Koshy,­senior­editor,­at­312-322-5830­or­
email­Helen.Koshy@chi.frb.org.­Chicago Fed 
Letter and­other­Bank­publications­are­available­
at­www.chicagofed.org.
­­
ISSN­0895-0164
IA
3.0%
IL
1.1% IN
2.3%
WI
2.1%
MI
2.2%
4. 2011 forecasts for real GSP growth
Notes: Forecasts are of the annual growth in real gross state product (GSP) for each Seventh 
District state (Illinois, Indiana, Iowa, Michigan, and Wisconsin) using annualized data through 
the second quarter of 2011. GDP growth indicates annualized real gross domestic product 
growth over the same period. 
source: Authors’ calculations based on data from Haver Analytics.
U.S. GDP growth 
0.8%
the­only­one­for­Iowa­(sixth­row).­Thus,­
omitting­state-specific­growth­factors­
from­our­model­would­likely­have­pro-
found­effects­on­our­ability­to­predict­
GSP­growth­for­a­number­of­Seventh­
District­states.
To­get­a­sense­of­the­relative­importance­
of­national,­regional,­and­state-specific­
factors,­we­decomposed­the­variance­in­
each­state’s­GSP­growth­into­that­ex-
plained­by­each­of­these­three­types­of­
factors­(figure­3).5­State-specific­factors­
(last­row)­do­indeed­dominate­in­ex-
plaining­Indiana’s,­Iowa’s,­and­Michigan’s­
GSP­growth,­while­national­factors­(first­
row)­dominate­in­explaining­Illinois’s­
and­Wisconsin’s.­That­said,­regional­
growth­factors­(second­row)­vary­in­
importance­from­11%­in­Michigan­to­
39%­in­Wisconsin,­and­they­account­for­
22%­or­more­of­the­explained­variance­
for­three­of­the­five­Seventh­District­
states.­It­is­in­this­sense­that­including­the­
MEI­and­the­relative­MEI­proves­to­be­
nontrivial­for­predicting­each­Seventh­
District­state’s­GSP­growth.­
Quarterly GSP growth projections
We­can­use­the­model­described­in­this­
article­to­make­projections­of­GSP­
growth­on­a­quarterly­basis,­updating­
its­predictions­for­an-
nual­GSP­growth­in­
the­Seventh­District­
states­throughout­the­
year­on­a­schedule­
similar­to­that­for­GDP.­
Doing­so­will­improve­
upon­the­timeliness­
and­frequency­with­
which­GSP­data­are­
currently­made­avail-
able.­In­addition,­doing­
so­will­help­connect­
recent­values­of­the­
MEI­and­relative­­
MEI­to­an­alternative­
method­of­describing­
Midwest­and­national­
economic­growth.­How-
ever,­first­we­must­assess­
the­accuracy­of­our­
model’s­predictions.­
The­fit­of­our­model­
is­surprisingly­good­for­
Illinois­and­Wisconsin,­
with­a­typical­prediction­error­(i.e.,­root­
mean­squared­error)­of­less­than­1%­(fig-
ure­2,­seventh­row).­The­fit­for­Indiana­
and­Michigan­is­slightly­worse,­but­with­
an­average­error­of­1.5%­or­less.­In­con-
trast,­Iowa­has­an­average­prediction­
error­of­2.1%.­Prediction­errors­of­this­
magnitude­represent­between­0.3­and­
0.6­historical­standard­deviations­of­the­
Seventh­District­states’­GSP­growth.­
Therefore,­with­the­possible­exception­
of­Iowa,­inferences­on­annual­GSP­
growth­based­on­the­MEI­and­the­other­
indicators­we­consider­are­likely­to­be­
reasonably­reliable­in­real­time.
Projections­for­annualized­GSP­growth­
through­the­first­half­of­2011­in­each­of­
the­five­Seventh­District­states­are­dis-
played­in­figure­4.­The­growth­projections­
for­all­of­the­Seventh­District­states­ex-
ceed­national­GDP­growth­over­the­same­
period.­They­also­show­some­diversity,­
reflecting­the­results­for­regional­and­
state-specific­growth­factors­we­reported­
earlier.­For­instance,­Illinois’s­relative­
weakness­stems­from­the­recent­weakness­
in­national­growth­being­only­partly­off-
set­by­the­strength­in­the­relative­MEI­in­
the­first­half­of­2011.­In­contrast,­strong­
regional­and­state-specific­factors­boost­
GSP­growth­in­the­other­states.
Conclusion 
The­results­from­using­our­model­sug-
gest­that­the­MEI­can­be­reliably­used­
to­project­GSP­growth­for­the­five­states­
in­the­Seventh­Federal­Reserve­District­
on­a­quarterly­basis.­The­value­in­doing­
so­is­that­it­provides­us­with­another­
way­to­make­direct­and­timely­compar-
isons­between­national­and­regional­
economic­growth.­We­will­make­these­
estimates­available­in­the­future­as­part­
of­the­monthly­release­for­the­MEI;­we­
will­update­them­on­a­quarterly­basis­
following­the­BEA’s­final­release­of­
GDP­data­for­each­quarter.
1­Technically,­the­GSP­data­are­available­
semiannually,­as­they­are­updated­near­
the­beginning­and­middle­of­each­year.­
However,­these­updates­are­for­the­prior­
year,­unlike­the­GDP­releases,­which­are­
for­the­prior­quarter.
2­For­more­information­on­the­MEI,­go­to­
www.chicagofed.org/mei.­The­Seventh­
District­comprises­all­of­Iowa­but­only­the­
greater­parts­of­Illinois,­Indiana,­Michigan,­
and­Wisconsin.­In­contrast,­because­of­the­
form­in­which­state­and­regional­data­are­
available,­the­construction­of­the­MEI­en-
tails­the­entire­boundaries­of­all­five­states.
3­The­notation­for­our­model­is­expressed­
as­follows:­GSPit =­αi­+­βiGDPt­+­γi MEIt­+­
δi RMEIt­+­ρiGSPit–1­+­φi   Iit­+­εit.­ Growth­rates­are­approximated­by­log­first­
differences­for­real­gross­state­product­
(GSP ),­real­gross­domestic­product­(GDP ),­
and­real­personal­income­(I )­data.­To­
construct­annual­averages­of­the­Midwest­
Economy­Index­(MEI )­and­relative­MEI­
(RMEI ),­we­take­the­average­of­the­March,­
June,­September,­and­December­values­of­
each­year­to­conform­to­the­fact­that­each­
represents­a­three-month­moving­average.­
4­To­allow­for­prediction­errors­to­be­corre-
lated­across­states,­we­use­a­cluster-robust­
variance­estimate­to­calculate­standard­errors­
of­the­predictions,­where­the­clustering­unit­
is­the­year­of­observation.­This­structure­
allows­for­arbitrary­correlation­between­the­
prediction­errors­for­each­Seventh­District­
state­in­each­year.
5­The­regression­constant­was­excluded­for­
each­state­in­this­calculation.

Predicting gross state product growth with the Chicago Fed's Midwest Economy Index

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Predicting gross state product growth with the Chicago Fed's Midwest Economy Index

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