A diffusion index is a statistical measure often used to detect economic turning points. It aggregates multiple indicators by examining whether they are trending upward or downward, but ignores the magnitude of the movement.
Many diffusion indices use 50 as a base value, indicating an equal number of advancing and declining component indicators. Expansion and contraction are in balance, so the economic sector is on average unchanged.
Consider six indicators over two periods. If three of the indicators advance and the other three decline, there is balance, and the diffusion index is 50. If five of them advance, the reading is, say, 65 (or some value greater than 50, depending on the exact method of combining the indicators). If a majority trend downward, the reading is less than 50.
A diffusion index cannot be used to examine the underlying level changes; the two can move in opposite directions. For instance, if two input measures increase by a large amount, but four inputs decrease by a small amount, the diffusion index will nonetheless be under 50, indicating a consensus of contraction. An overall unemployment rate is a weighted average of industry sectors, and it may improve, given improvement in a few of the large sectors; but if a majority of the sectors are deteriorating, then the diffusion index will fall.
Diffusion indices are used in, for example:
- Unemployment reporting by the U.S. Bureau of Labor Statistics.
- The Report On Business® produced by the Institute of Supply Management™ (ISM, formerly NAPM), which surveys purchasing and supply executives.
- The similar Ivey Purchasing Managers Index for Canada, which surveys 175 individuals with the question "Are your purchases in dollars higher or lower than last month?"