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.