Let’s talk about economic cycles. With the Covid-19 pandemic and the markets crashing, we hear a lot about a potential recession, so I think it is time I give you a better understanding of what economic cycles are.
What is the economic cycle?
The economy goes through growth and recession stages periodically.
We can split this cycle into two parts, a trend-growth component, and a cyclical component.
The potential output
Long-term factors drive the trend-growth element, and shorter-term factors drive the cyclical component. Since the economic output moves around the long-term trend-growth component, sometimes higher, sometimes lower, it represents the long-term potential of the economy. It is also called the potential output.
Technological improvements and increased knowledge drive the trend-growth component; they have lasting effects on the long-term. You can think about the invention of the steam engine, then the internal combustion engine. Or the Internet.
Even if the trend-growth is upward slopping, by adding the cyclical component, we now have an economy that is growing, then falling into recession, before rising again. The local effect of the economic cycle is more powerful than the long-term growth.
The cyclical component: Inventory and business cycles
We can divide further the cyclical component into two parts: the inventory cycle and the business cycle.
The inventory cycle is usually short, two to four years. The business cycle is longer, and it usually lasts from nine to eleven years.
I will come back to the inventory and business cycles later, but first, let’s focus on the forecasting challenges of the economic output and how it is measured.
The forecasting challenges: bubbles and external shocks
Forecasting the length of these cycles is hard because a lot of factors can have an impact on them! You can easily imagine that a bubble that bursts can disrupt the economic cycle, like with the market crash of 2008 or the dotcom bubble in 2001, those shocks led us to recessions. Though, the same dotcom bubble, when it started, extended the cycle begun at the end of 1987. You may not be aware of that, but between July and August 1998, the market crashed by nearly 20%. A correction was looming. Yet 1998 was also in the midst of the dotcom bubble.
Individuals and investors anticipated that the Internet would change the economy immensely. The bubble drove the stock market to newer heights until 2000 when it burst. In 2020, we now have a large part of the economy that happens online. Though in 2000, it was too early. One big lesson for your investments: being right too soon, like too late, can be catastrophic.
Another kind of shock can disrupt the economic cycle: external shocks. External shocks are disruptions in trade, wars, and natural disasters. Right now, to curb the COVID-19 pandemic, nations are effectively shutting down parts of their economic activities. Even if some workers can work from home, many more cannot work. Consequently, the markets went down sharply, and the overall fall might be far from over if the situation persists.
Measuring the business cycle
It is useful to know where in the cycle we are. To do so, we use different indicators of economic activity: GDP, output gap, and recession.
The Gross Domestic Product (GDP)
The GDP, which stands for Gross Domestic Product, is a measure of the market value, in dollars, of all the final goods and services produced in a specific period, typically a year. To be able to compare the GDP from one period to another, it is adjusted for inflation. When something is adjusted for inflation, it is expressed in “real terms.” It is a necessary step to get the true economic growth from one period to another.
The output gap
The output gap is another way to measure where we are in the economic cycle. Don’t be afraid of the name; it is way more straightforward than it looks. Do you remember I told you that the economic activity could be split into two parts, a trend-growth component, or potential output, and a cyclical component? The output gap is the difference between the current level of GDP and the expected GDP based on a long-run trend line, also known as the potential GDP.
When the economy is strong, the output gap is positive. The current level of the GDP is higher than the potential GDP. When the economy is weak, the current level of the GDP is below the potential GDP, and the output gap is negative.
You may hear or read about inflationary pressures, which mean does the economy tend to have low or high inflation tendencies. When the output gap is positive, it means the economic activity is vigorous. So are the inflationary pressures; this is why a positive output gap is also called an inflationary gap. On the contrary, when the output gap is negative, we have a recessionary gap; the inflationary pressures are low. And if the output gap is highly negative, we can have deflationary pressures: the prices fall instead of rising.
Policymakers, like the FED, use the relationship between the output gap and the inflationary pressures to adjust their expectations regarding the level of growth and inflation and make policy decisions.
The last measure, a recession, is defined as a decline in GDP over two successive quarters. It occurs when the output gap, after it peaked, declines over two quarters.
Let’s come back to what drives the economic activity: inventory and business cycles.
The inventory cycle
The inventory cycle is a short-term cycle, between two and four years. When businesses are more confident about future sales, they increase their inventory to be able to respond to the anticipated increased demand. This means that the economy starts growing, and it has a positive effect on employment. However, usually at one point or another, central banks may begin raising interest rates or tighten the money supply. Growth slows, inventories and employment decrease.
With better and better inventory management, the inventory cycle is less prominent now than in the past. Businesses are more efficient nowadays to manage their inventory to sales ratio.
The business cycle
The business cycle, which is a long-term cycle, nine to eleven years on average, can be split into five phases: initial recovery, early upswing, late upswing, slowdown, and recession.
We can sometimes divide the business cycle into four periods: expansion, peak, contraction, and trough.
I will dive deeper into the business cycle in another article, so don’t forget to come back!
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Question of the day:
Which way do you think the economy is heading? Do you think the COVID-19 pandemic will cause a recession, or worst, a depression?