Business Cycle Indicators

Business Cycle

Note

Data on this page was last updated on December 05, 2022

A rhythm to business activity has repeated continuously since the Industrial Revolution, called the business cycle. This rhythm is aggregate economic output fluctuating around an economy’s long-term capacity. If an economy operates above its capacity, inflation sets in. To keep prices stable, the Federal Reserve cools down the economy through monetary policy, often overdoing it and causing a recession. Recessions are an effective means of lowering inflation, and once inflation falls, the Federal Reserve’s monetary policy shifts to creating jobs and stimulating the economy. This starts the process all over, causing a rhythm in economic activity.

A more formal definition comes from Burns and Mitchell (1946), they says that business cycles are a type of fluctuation found in the aggregate economic activity of nations…a cycle consists of expansions occurring at about the same time in many economic activities, followed by similarly general recessions…this sequence of changes is recurrent but not periodic.

We know the economy does not operate at an exact equilibrium but runs above or below it in a rhythm. This relationship can be quantified by taking the capacity at which an economy can operate and subtracting the actual output, it is called the GDP output gap.

GDP Output Gap

For us, the business cycle is the aggregate economic activity of a nation fluctuating around the nation’s long-term equilibrium consisting of periods of expansion and contraction. Measured by the GDP output gap.

Monthly Output Gap

While monitoring the real GDP output gap is important from an economic perspective, the lag in the time the data is reported does not make the indicator a viable option for making investment decisions. We need more timely information.

I will not get into the details about how and where we found the indicators to forecast monthly GDP. But I will note that when building a forecast model we apply a theory called Occam’s Razor where Rasmussen and Ghahramani (2000) states if one has various models that arrive at the same outcome, one should choose the one with the fewest assumptions. Simplicity in forecasting tends more reliable than more complicated models. With Occam’s Razor in mind we developed a simple monthly GDP forecast with only four variables: industrial production, total non-farm payroll, real personal income, and real personal consumption expenditures.

Adding other indicators to the forecast improves the model, but just slightly. We believe that less is more in this case and opted to stay with these four. Simple but elegant. Our model can predict real GDP growth with a correlation of 0.92 explaining 85% of the variance in real GDP growth. We can estimate a monthly real GDP and build a monthly GDP output gap with this model.

Coincident Indicators

There is no single measure that tracks the business cycle. The NBER is the official arbiter of the beginning and endings of recessions. The period between one recession and the beginning of the next one generally involves a recovery of output lost during the recession and expansion beyond that level until the next recession begins.

There is a widespread public perception that a recession is defined by two sequential negative quarters of real GDP growth. This is a pretty good rule of thumb. However, in the United States, the Business Cycle Dating Committee of the NBER is the most widely accepted authority for dating recessions. The Committee relies heavily on the index of coincident indicators because the four components that it includes have been determined to best coincide with turning points in economic momentum. These four components are employees on nonfarm payrolls, real personal income less transfer payments from the government, industrial production, and real manufacturing trade and sales. Basically, a recession involves a suitably prolonged decline in production, jobs, incomes, and spending.

The Cycle Dating Committee has a bit of discretion in deciding the necessary duration and degree of decline, but generally speaking, its decision will usually, but not always, coincide with the onset of at least two down quarters in real GDP, hence the attraction of that simpler definition.

Omega’s Coinicent Index

Statistics show the overall growth rate of the U.S. domestic economy follows four leading economic indicators: industrial production, nonfarm payrolls, personal income, and personal consumption. Alone, these indicators often show false signals in economic growth. But when put into an index, they do a relatively good job tracking the direction of the development of the U.S. economy every month as opposed to the quarterly basis of real GDP.

Following the coincident index’s trend provides a decent thesis on the current state of the U.S. growth rate.

Leading Indicators

Understanding where the economy is in the cycle is important, but it is also essential to know where the economy is going. The Conference Board created the Composite Index of Leading Economic Indicators (LEI) to manage this. However, it is much maligned and often ignored by economists and strategists. Partly, it is put together well after most of its ten components have already been released. Some call it the index of misleading indicators. Paul Samuelson famously quipped that it had caused economists to predict nine of the last five recessions. Nevertheless, it does provide helpful information about the economy’s momentum. Unlike the coincident indicators, which essentially tell us where the economy is, the LEI tries to tell us where it will be a few months down the road, offering a useful, albeit relatively short, lead time. Different leading indicators vary in lead times—long leading and short leading. The financial market-related components of the LEI, especially credit conditions and the yield-curve spread (the difference between the ten-year Treasury note yield and the Federal funds rate), seem to have the longest lagged effects on the economy. At the same time, most real activity indicators, such as building permits, new orders, and unemployment claims tend to have shorter lags.

We find it more beneficial to use and monitor some of the components of the LEI than the actual LEI. These are the leading indicators that allow us to gauge where the economy is going, not just where it is.

Manufacturing is more cyclical than the overall economy. Producers tend to trim or expand factory hours before laying off or adding workers, giving an early indication of changes in the direction of the economy. Average weekly hours relate to the average hours per worker for which pay was received and is different from standard or scheduled hours. Factors such as unpaid absenteeism, labor turnover, part-time work, and stoppages cause average weekly hours to be lower than scheduled hours of work for an establishment. Group averages further reflect changes in the workweek of component industries. Average weekly hours are the total weekly hours divided by the employees paid for those hours.

An initial claim is a claim filed by an unemployed individual after a separation from an employer. The claim requests a determination of basic eligibility for the Unemployment Insurance program. Weekly claims gives an early read on rising or falling layoffs.

Composite Indicators: OECD Indicator for the United States which combines results from surveys of business sentiment for manufacturing.

Composite Indicators: OECD Indicator for the United States which combines results from surveys of business sentiment for manufacturing.

This indicator helps assess the outlook for business equipment investment.