Diffusion Index

What Is a Diffusion Index?

A diffusion index is a measurement used to show the dispersion of change relative to a reference point, and a series of data can determine if there are vertically or descending trends.
Diffusion indexes are commonly used to highlight results from a survey. Reactions are as values, and contingent upon those values, a base number is designated. Numerous indicators utilize a baseline of 0, 50, or 100. A series of data shows how far results are from the baseline. While a datapoint not a long way from the base number would show little change, a datapoint a long way from the base could propose a massive change.
In economics, the diffusion index is utilized in the formulation of indicators, for example, purchasing supervisors' indexes and the Richmond Manufacturing Index. Dissimilar to economic indicators, in which the data are based on prices or units, those that utilization a diffusion index are based on surveys. Furthermore, contingent upon how the survey questions are outlined, the diffusion index can be utilized as a device for prediction, similarly that the PMI is viewed as a leading economic indicator.

The most effective method to Calculate a Diffusion Index

There are various manners by which a diffusion index is calculated, and the formula can be either in long or short form.

Federal Reserve Formula

The Federal Reserve involves the fundamental formula for computing a diffusion index. This formula is utilized in working out indexes for some indicators among the Fed's 12 regional banks, including surveys by the Richmond and Kansas City Feds.
Diffusion Index = [100 * (I − D)]/(I + N + D)
I = Number of Respondents Reporting Increases
N = Number of Respondents Reporting No Change
D = Number of Respondents Reporting Decreases

IHS Markit Formula

IHS Markit, a research group that distributes purchasing chiefs' indexes on the U.S. furthermore, different countries, has its own formula, which is unique in relation to the Fed's.
IHS Markit's Diffusion Index = (% Reporting 'Up') + [0.5 * (% Reporting 'the Same')] + [0.0 * (% Reporting 'Down')]

That can be communicated in short form as:
Index = Percentage of Positive Responses + 0.5 (Percentage of Neutral Responses)

Illustration of a Diffusion Index

For instance, for a sample survey question on whether the economy will go into recession at any point in the near future, the outcomes showed that 70 percent of respondents responded to that there was a high probability, 20 percent responded to that there was no probability, and 10 percent responded to that there was a low probability.
In the event that the outcomes are inputted into the Fed's formula for the diffusion index, it would be calculated thusly:
[100 * (0.70 − 0.10)]/(0.70 + 0.20 + 0.10) = 60/1 = 60
On the off chance that calculated utilizing IHS Markit's formula, the response would be:
0.70 + (0.5 * 0.20) + (0.0 * 0.10) = 0.70 + 0.10 + 0.00 = 0.80
The outcomes vary for either contingent upon the formula utilized. Doling out a baseline of 0 or 100 would be ideal in this model since the response could be controlled as double digits.

Instructions to Interpret a Diffusion Index

A series of data could show momentum and uncover whether there is are vertically and descending trends. Data that are over the baseline would show expansion, while data below would demonstrate contraction. Data close or at the baseline would mean next to zero change.
A sample graph below outlines a data series showing expansion and contraction. The farther the data are from the baseline, the more the probability of one or the other expansion or contraction there is over a given period.

What Are the Limitations of a Diffusion Index?

A diffusion index might address a one-sided view. In this way, contrasting the diffusion index with other datasets can give extra confirmation or disprove a determination made utilizing a diffusion index. Utilizing different metrics, for example, the correlation coefficient, can show whether a diffusion index is a dependable prediction instrument.

Highlights

• A diffusion index alludes to the common propensity inside a group of numbers or statistics.
• The diffusion index can be utilized to spot divergences, which could signal strength or weakness that isn't noticeable by taking a gander at the stock index all alone.
• A decreasing diffusion index shows there are less stocks moving higher, which demonstrates buying pressure is debilitating or potentially selling pressure is expanding on the stock index.
• In the stock market, a rising diffusion index means there is a rising number of stocks moving higher, which is positive for stock indexes moving higher.