ECO 2 Understanding Business Cycles

An economy produces goods and services, and that output fluctuates around its long-term growth path. Those recurring, cyclical swings are the business cycle: recurrent expansions and contractions in economic activity that affect broad segments of the economy. The forces behind short-term swings, for instance shifting expectations, political events, natural disasters, and decisions on tax, spending, and interest rates, work mainly through aggregate demand and supply, and they bite hardest over short horizons.

The classic definition comes from Burns and Mitchell (1946). Four ideas in it are worth holding onto. First, cycles belong to economies built on private enterprise, so neither farming-based nor state-planned economies qualify. Second, the phases arrive in a predictable order, swinging between upswing and downturn. Third, they hit most of the economy at roughly the same time. Fourth, they recur without being periodic: they return again and again, but each one differs in strength and length, historically running from a little over a year to as long as 10 or 12 years.

Three ways to define a cycle

Analysts describe the same swings in three different ways, and mixing them up is a common source of confusion.

In what follows we use the growth cycle concept: the cycle is a set of fluctuations around potential output, where potential output is the rising trend line the economy would follow at full, sustainable use of its resources.

What happens in each phase

Recovery starts at the trough, where actual output sits at its lowest level relative to potential. Spending is below potential but starting to rise, so the negative output gap begins to close. In expansion the recovery gathers pace, growth runs above average, and actual output climbs above potential into a boom; firms raise production, employment, and investment, and prices and interest rates may start to rise. At the slowdown the output gap is at its widest positive point; growth begins to slow relative to potential and the positive gap narrows, while firms lean on overtime rather than new hires. In contraction actual output falls below potential, confidence declines, firms cut overtime and employment, and the economy may see an outright decline, a recession, or, if the fall is severe, a depression.

Adapted from the module discussion of phase characteristics.

Markets and investor behaviour

Because markets look ahead, risky assets get marked up as soon as investors sense a recession is ending. Share prices usually touch their low about three to six months ahead of the trough in the wider economy, which is part of why equities count as a leading indicator. Late in an expansion, a boom tests the limits of the economy with strong confidence and credit growth, and the riskiest assets often post large gains. As inflation fears build, safe government bonds can fall in price and rise in yield. In a contraction, investors prize safer assets and steady cash-flow businesses such as utilities and staple-goods producers, since a secure income stream is worth more when employment is insecure.

Business cycles are read through GDP; credit cycles instead follow how freely and how cheaply borrowing can be had. They trace the expansion of private lending, the credit that funds company investment and household home buying, so they are bound tightly to the same real activity that business cycles measure.

The link runs both ways. When the economy is strong, lenders are willing to extend credit on favourable terms. When it weakens, lenders tighten, making credit scarcer and dearer. Tighter credit depresses asset values such as real estate, which feeds back into weaker activity and higher defaults, because credit is central to financing construction and property purchases. Credit cycles are one part of a wider family of financial cycles.

Why analysts watch credit

For a long stretch, economists set financial factors aside as a sideshow to the real economy. That habit broke down once loose private lending was tied to one crisis after another: Latin America in the 1980s, Mexico, Brazil, and Russia in the 1990s, Asia across 1997 and 1998, and the global crisis of 2008 and 2009. Easy credit tends to inflate bubbles in asset and property prices, and those bubbles give way once fundamentals turn and capital heads for the exit.

With financial frictions present, credit can amplify the business cycle. Recessions that coincide with financial disruption, such as house-price and equity busts, tend to be longer and deeper, while recoveries paired with rapid credit growth tend to be stronger. Financial variables move closely together, yet their timing does not always line up with the traditional business cycle, and credit cycles are usually longer, deeper, and sharper, with an average length greater than that of the business cycle.

Investors track the credit cycle because it illuminates housing and construction, gauges how severe a recession may be when it coincides with a credit contraction, and helps anticipate policy. Beyond monetary and fiscal policy, which target the business cycle itself, macroprudential tools that lean against financial booms have grown in importance, because a pronounced peak in the credit cycle frequently precedes a systemic banking crisis.

The behaviour of firms and households drives the cycle, and it does so with characteristic leads and lags. Three areas repay attention: hiring and labour costs, capital spending, and inventories.

Workforce and company costs

Entering a contraction, firms cut costs and eliminate overtime, and they often retain workers rather than fire and later rehire, since finding and training staff is costly and loyalty supports productivity. In a prolonged downturn cost cutting turns aggressive: consultants, advertising, and headcount are trimmed to the minimum, capacity utilization is low, little new equipment is bought, and firms run down inventories while banks lend cautiously. By the end of a contraction firms are running lean production, squeezing maximum output from the fewest workers, which is why measured productivity tends to be highest at the bottom of a recession. Falling demand pushes down wages and input prices, and interest rates may be cut. As prices and rates fall, spending eventually revives, and that turning point marks the start of the next upswing. Because firms wait to confirm the turn before changing headcount, and because hiring and firing both carry real costs, employment lags the cycle. Early in a recovery the unemployment rate can even stay high or tick up, since new job seekers return to the labour force and rarely find work immediately.

Capital spending

Capital spending, the outlay on property, plant, and equipment, is among the most procyclical and swing-prone pieces of GDP, because the profits and cash flows behind it are themselves sensitive to activity. New-order statistics are widely watched because orders precede shipments, though analysts often strip out defence and aircraft to read the underlying trend, since a single order (for example, an airline ordering forty aircraft for delivery over five years) can distort the series.

Inventories

Inventories are small relative to the economy, but they build and unwind quickly, which is why swings in inventories can move growth measures. They reflect the difference between how fast sales and production are changing. The key gauge is the inventory-to-sales ratio, which compares stock available for sale with the level of sales.

Economic indicators are variables that carry information about the state of the overall economy. Policy makers and analysts use them to assess where the economy sits in the cycle and to predict or confirm turning points, which in turn helps forecast how different sectors, and the stocks and bonds tied to them, are likely to perform. Indicators are classified by when their turning points arrive relative to the economy.

Composite and leading indexes

An indicator can be a single variable or a composite that bundles several variables which tend to move together. The Conference Board publishes the Leading Economic Index (LEI) for the United States, built on the classical cycle concept, from ten components, including average weekly manufacturing hours, initial jobless claims, manufacturers’ new orders, building permits, the S&P 500, a leading credit index, and the interest-rate spread between ten-year Treasury yields and the federal funds rate. An inverted yield curve, where short rates exceed long rates, signals that short rates are expected to fall and activity to weaken. For roughly thirty countries the OECD publishes its Composite Leading Indicator (CLI) on a growth-cycle basis, using a consistent methodology that makes cross-country comparison easier.

Many of these composites draw on economic tendency surveys of businesses, consumers, or experts, such as the German ifo business-climate survey, the Bank of Japan Tankan Report, and the various purchasing managers indexes. Bigger datasets and techniques such as principal components analysis now feed indexes like the Chicago Fed National Activity Index, built from 85 monthly series, and the EuroCOIN statistic for the euro area, which draws on more than 100 macroeconomic series.

A composite index can rise even when only a few of its components are moving. A diffusion index measures how broad the movement is: it captures what share of the components are heading the same way as the overall index, giving analysts a read on the breadth of the change.

The Conference Board scores each of the ten LEI components: a value of 1.0 if it rises by more than 0.05 percent in the month, 0.5 if it moves by less than 0.05 percent, and 0 if it falls by more than 0.05 percent. Add the scores, divide by the count of components, and multiply by 100.

Unlike a simple arithmetic mean, a diffusion index is not swayed by an outlier in any single component; it captures the change common to all of them.