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Tracking the Business Cycle

Macroeconomic Trends and Cycles

  • Objective: Learn to track the ups and downs of the economy.
  • Business Cycles: Short-term fluctuations in economic activity.
  • Trend Growth: Long-run economic growth reflecting an economy's potential output (output when all resources are fully employed).
  • Potential output reflects the quantity and quality of inputs to production.
  • GDP may be higher or lower than potential output in the short run.
  • Business cycles can significantly disrupt businesses and jobs.
  • Recessions lead to business failures and job losses.
  • Unemployment rises during and after recessions.
  • Recessions have long-lasting impacts on careers, with those graduating during recessions potentially earning less even decades later.
  • Economic conditions can affect various aspects of life, such as children's weight.
  • Output Gap: Measures the difference between actual output and potential output.
    • Formula: Output Gap = \frac{Actual Output - Potential Output}{Potential Output} \times 100
    • A negative output gap indicates idle resources.
    • A positive output gap suggests unsustainable resource utilization.
  • A business cycle progresses from a peak through a recession to a trough, then into an expansion.
    • Peak: High point in economic activity.
    • Trough: Low point in economic activity.
    • Recession: Period of falling economic activity.
    • Expansion: Period of rising economic activity.
  • GDP measures the level of output and GDP growth rates describe the rate at which the economy is expanding or contracting.
  • Business cycle peaks and troughs describe levels.
  • Whether an economy is in an expansion or a recession is about change.
  • The economy's fluctuations are not rhythmic, reliable, or predictable.
  • Predicting recessions is difficult.

Common Characteristics of Business Cycles

  • Objective: Describe the common features of business cycles.
  • Each business cycle is unique but they all have several common characteristics.
  • Recessions are typically short and sharp, while expansions are long and gradual.
    • Post-World War II: average recession lasts one year; average expansion lasts five years.
  • Causes of recessions vary: slowing productivity, oil price hikes, credit controls, high-interest rates, banking crises, overvaluation of technology stocks, housing market meltdowns, financial crises, and global pandemics.
  • Persistence: Macroeconomic conditions show persistence, meaning the state of the economy this year is closely related to conditions next year.
  • Co-movement: Many economic variables move up and down together over the business cycle.
  • The business cycle affects economic conditions in nearly every state.
  • Different economic indicators tend to move together (e.g., GDP, industrial production, retail sales, employment).
  • Other indicators that rise and fall together over the business cycle: the creation of new businesses, housing construction, automobile sales, imports from overseas, new investment projects, business profits, workers’ real wages, stock prices, inflation, and interest rates.
  • Recessions are generally bad for business, while expansions are generally good for business.
  • The business cycle primarily affects the private sector, with the public sector often following a different pattern.
  • Leading indicators predict the future path of the economy (e.g. business confidence, consumer confidence, the stock market).
  • Lagging indicators follow business cycle movements with a delay (e.g., unemployment).
  • Okun's Rule of Thumb: Quantifies the relationship between output gap and unemployment rate.
    • For every percentage point that actual output is less than potential output, the unemployment rate will be around half a percentage point higher.
    • When output is at potential, the unemployment rate is equal to the equilibrium unemployment rate (around 5% in the US over the past century).

Analyzing Macroeconomic Data

  • Objective: Learn to use macroeconomic data to track the economy.
  • Seasonally Adjusted Data: Data adjusted to remove predictable seasonal patterns.
  • Annualized Rate: Data converted to the rate that would occur if the same rate had continued throughout the year. They make comparing growth rates measured across different time periods easier.
  • Focus on real data (adjusted for inflation) to track the economy's performance over time.
  • Updates to earlier estimates are called revisions, and they can be quite substantial because initial estimates can be based on incomplete data.
  • Top Economic Indicators:
    1. Real GDP: Broadest measure of economic activity; focus on GDP growth.
    2. Real GDI: Cross-check on GDP; early reports may be more reliable than spending data.
    3. Nonfarm Payrolls: Tracks job creation each month; provides an early look at the economy's job creation rate.
    4. Unemployment Rate: Indicates the strength of the labor market.
    5. Initial Unemployment Claims: Timely indicator of job losses and applications for unemployment insurance.
    6. Business Confidence: Leading indicator; declining confidence may signal a recession; Purchasing Managers' Index is closely watched.
    7. Consumer Confidence: Leading indicator; rising confidence suggests increased spending, particularly on big-ticket items.
    8. Inflation Rate: Indicates price changes; rising prices may indicate an economy operating above potential, falling prices may indicate an economy operating below potential,
    9. Employment Cost Index: Measures the rise in labor costs experienced by businesses; accounts for both wages and benefits; a leading indicator of inflationary pressure.
    10. Stock Market: Indicates future expected profits of businesses; a strong market suggests optimism, while a falling market may raise concerns; can send false signals.

An Economy Watcher’s Guide

  1. Track Many Indicators: Use a variety of indicators to get a full view of the economy.
  2. Broad Indicators Beat Narrow Indicators: Give more weight to indicators that account for a greater share of the economy.
  3. Seek Just-in-Time Data: Prioritize indicators that are published quickly.
  4. Find the Signal Amid the Noise: Average over data points and look past volatile components to identify underlying trends.
  5. Adjust Your Outlook When Data Differ from Expectations: If data shows the economy is stronger or weaker than expected, adjust your outlook.