Economic Indicators over the Business Cycle

As we will discuss below, the use of resources necessary for the production of goods and services fluctuates during a business cycle.

Fluctuations in Workforce and Company Costs

Recovery

In this phase, activity levels start to increase, closing the gap between the actual and trend GDP. The unemployment rate is still high, companies are starting to reduce employee layoffs, and businesses may prefer overtime to new hiring.

Economic indicators reflecting recovery include an increase in GDP and industrial production, a decrease in unemployment claims, and an increase in building permits.

Expansion

The economy starts to grow at an above-average rate. Businesses switch from using overtime and temporary employees to hiring, leading to a stabilization and eventual decrease in the unemployment rate.

Economic indicators of expansion include strong GDP growth, increments in consumer spending and confidence, and a rise in manufacturing orders.

Slowdown

During this phase, the economy is at its growth peak level. Activity levels are above average but are starting to decrease. The economy may experience a shortage in the factors of production caused by demand that exceeds supply. Businesses are still hiring, but at a slower pace, and the unemployment rate is decreasing at a lower rate.

Economic indicators that signal a slowdown include decelerating growth in GDP, a decrease in stock market indices, and potential increases in inflation indicators.

Contraction

In this phase, firms reduce expenses and eliminate overtime. Companies may retain workers even if they are underutilized to save on rehiring expenses. Firms may also gain from employee loyalty, which boosts productivity.

Prolonged contractions lead to more aggressive cost-cutting, such as laying off workers beyond the strict minimum and doing away with advertising campaigns.

Moreover, in the prolonged contraction phase, there will be low-capacity utilization, companies will reduce their investments in new equipment, companies will try to liquidate their unsold inventory, and banks will be more cautious about lending.

Economic indicators such as a rise in the unemployment rate, a decrease in GDP, and a fall in consumer spending confirm the contraction phase.

Fluctuations in Capital Spending

Capital spending refers to expenditures on acquiring tangible assets such as property, plant, and equipment, and it varies based on the phase of the business cycle.

Recovery Phase

The interest rates during the recovery phase are low, and therefore they support investments.

Capital spending begins at a low point but rises as economic conditions improve. Companies often invest in quickly advancing technology like software and hardware to modernize their operations. This helps them stay competitive and efficient.

Expansion Phase

As the economy enters the expansion phase, companies benefit from favorable business conditions and increasing demand. Capacity utilization levels rise from previously low levels.

Increased earnings and cash flows give businesses the financial capacity to increase their investment spending. Customer orders and capacity utilization further grow, prompting companies to focus on expanding their productive capacity. This phase is often characterized by heavy investments in complex equipment, warehouses, factories, and infrastructure that support increased production and capacity.

Slowdown Phase

During a slowdown, the economy is still growing, but the rate of growth begins to slow down. Business conditions may be at their peak, and companies might experience healthy cash flows.

However, interest rates tend to rise during this phase to prevent overheating and encourage investment slowdown. New orders intended for capacity expansion may signal the late stage of the expansion phase. Even in the slowdown phase, businesses continue to place new orders as they operate at or near their capacity limits.

Contraction Phase

In the contraction phase, characterized by reduced demand, declining profits, and cash flows, companies experience a fall in business activity.

Economic downturn leads to a halt in new orders and the cancellation of some existing orders. This initial cutback can be severe and worsen the downturn. As the contraction continues, the reduction in spending on heavy equipment intensifies. It begins with cuts in technology and light equipment spending and then extends to construction and heavy equipment as the economic situation deteriorates.

Fluctuations in Housing Sector Activity

The housing sector plays a crucial economic role and is closely tied to the business cycle. Changes in housing activity can be indicative of shifts in economic conditions. Here’s how the housing sector activity varies over the business cycle:

Recovery Phase

During the recovery phase of the business cycle, as the economy starts to emerge from a downturn, there is an increase in consumer and business confidence. This often leads to increased demand for housing as consumers feel more secure about their financial situation. Housing construction and sales begin to pick up, and real estate prices may start to stabilize or rise moderately.

Expansion Phase

As the economy enters the expansion phase, consumer incomes rise, and employment improves. This leads to further growth in housing demand as people have more disposable income to invest in homes. Home construction and real estate sales thrive during this phase, and property prices tend to rise.

Slowdown Phase

In the slowdown phase, economic growth starts to decelerate. This can lead to a slowdown in the housing sector as well. While demand for housing may remain relatively strong, the pace of growth in construction and sales may start to taper off. Property price appreciation may also slow down or stabilize during this phase.

Contraction Phase

In a contraction or recession, the housing sector often faces significant challenges. Economic uncertainty, job losses, and reduced consumer confidence can cause a drop in housing demand. Home sales may decrease, construction projects might be delayed, and property prices can decline. Tightened credit conditions can also play a role in the housing sector’s contraction.

Fluctuations in External Trade Sector Activity

External trade, also known as international trade, refers to the exchange of goods and services between different countries. The external trade sector activity is also influenced by the business cycle:

Recovery Phase

During the recovery phase, trade volumes gradually increase as demand begins to recover. This often leads to increased domestic consumption and higher demand for goods and services.

Expansion Phase

During the expansion phase, there are high levels of trade activity, with both imports and exports at elevated levels. This is mainly characterized by exports from a country rising, driven by the stronger demand abroad. This phase can contribute positively to a country’s trade balance.

Slowdown Phase

During the slowdown phase, economic growth starts to decrease. This can lead to a reduction in consumer spending, which in turn may impact the demand for imports. Exports may also experience a slowdown, especially if trading partners are also experiencing economic challenges. As a result, the trade balance might become more balanced or even show a surplus.

Contraction Phase

In a contraction or recession, both domestic and global demand for goods and services can decrease significantly. This can lead to a substantial reduction in both imports and exports. Many countries may experience a trade deficit during this phase as both imports and exports decline. Trade-related industries, such as shipping and logistics, can also be negatively affected.

Fluctuations in Inventory Levels

Inventory refers to the stock of goods and materials that a business holds in order to meet customer demand. Here’s how inventory levels vary over the different phases of the business cycle:

Recovery Phase

During the recovery phase of the business cycle, economic activity starts to pick up, and demand for goods and services begins to increase; hence, the decline in sales slows. As consumer confidence improves, businesses may start rebuilding their inventories to meet the rising demand.

As time progresses, production levels normalize as the surplus inventories accumulated during the downturn are eventually exhausted. As such, the inventory sales ratio starts to decline as the rate of sales recovery surpasses that of production.

Expansion Phase

In the expansion phase, economic growth gains momentum, leading to stronger consumer spending and business investment. As a result, the demand for goods and services continues to rise. Businesses often increase their inventory levels to ensure they can meet the growing customer demand. This can include raw materials, work-in-progress, and finished goods.

At this stage, the inventory sales ratio is stable.

Slowdown Phase

During the slowdown phase, economic growth starts to reduce, and consumer spending may slow down. Businesses become cautious about excessive inventory accumulation, as they don’t want to be left with unsold goods if demand further decreases. As such, the sales slow at a higher rate than the production.

Companies may reduce the rate of inventory buildup and focus on managing their existing stocks efficiently. This is evidenced by the production slowdowns and order cancellations.

Intuitively, in this phase, the inventory sales ratio increases, reflecting the weakening of the economy.

Contraction Phase

In the contraction phase or recession, economic activity declines, leading to reduced consumer spending and business investment. Businesses may face declining sales and excess inventory levels. As demand weakens, they may cut back on production and take steps to reduce inventory levels, including discounting prices, offering promotions, and reducing orders to suppliers.

In addition, the inventory sales ratio starts to decline back to normal.

Economic Indicators

Economic indicators are numbers or statistics that give insights into how well an economy, a sector, or a specific aspect of economic activity is doing. These numbers are important for economists, policymakers, investors, and analysts because they show the current condition and potential future directions of the economy, and help in studying the business cycle, predicting economic trends, and making important decisions.

Types of Economic Indicators

Economic indicators are classified based on their relationship to changes in economic activity and their predictive value. There are three main types of economic indicators: leading indicators, coincident indicators, and lagging indicators.

1. Leading Indicators

   Leading indicators are economic variables that tend to change before the overall economy starts to change direction. They provide insights into potential future economic trends and turning points. Investors and analysts often use leading indicators to anticipate shifts in economic activity. Examples of leading indicators include:

   • Stock market indices.
   • Consumer confidence indexes.
   • Housing permits and construction.
   • New orders for capital goods.
   • The average workweek for manufacturing employees.

   Leading indicators help in forecasting economic trends, providing early warning signals about potential economic shifts.

2. Coincident Indicators

   Coincident indicators move in tandem with changes in the overall economy. They reflect the current state of economic activity and are useful for assessing the present economic condition. Coincident indicators provide a snapshot of the current economic environment. Examples of coincident indicators include:

   • Gross Domestic Product (GDP).
   • Industrial production.
   • Personal income.

   Coincident indicators help in evaluating the real-time performance of the economy and its present health.

3. Lagging Indicators

   Lagging indicators change after the economy has already shifted. They confirm trends that have already occurred. They are used to assess the long-term effects of economic shifts. Examples of lagging indicators include:

   • Unemployment rate.
   • Consumer price index (CPI).
   • Business spending on new equipment.
   • Loan delinquency rates.

   Lagging indicators provide a retrospective view of economic changes, helping to validate and understand trends that have already taken place.

Composite Indicators

Composite indicators refer to an aggregate of different variables that all tend to move together. Composite indicators used to measure an economy’s cyclical state consist of up to twelve variables published by organizations like the OECD or research institutes. The variables in these indicators can be different from one place to another, but they all always bring together economic and financial measures that match an economy’s overall state.

Leading Indicators

The Conference Board, a US industry research organization, publishes a composite leading indicator called The Conference Board Leading Economic Index (LEI), using the classical business cycle as the underlying concept). The LEI comprises 10 components, as discussed below.

Components of the LEI and Their Significance

1. ISM new order index: Measures the percentage of components in a series that are rising, reflecting widespread trend movements.
2. Manufacturers’ new orders for consumer goods and materials: Anticipates upturns and downturns, capturing business sentiment.
3. Average weekly hours in manufacturing: Reflects workforce dynamics, as businesses cut overtime before layoffs and increase it before rehiring.
4. Average weekly initial claims for unemployment insurance: Sensitive indicator of initial layoffs and rehiring trends.
5. Interest rate spread between 10-year treasury yields and overnight borrowing rates: Predicts yield curve inversions, indicating changes in economic activity.
6. Leading credit index: Combines six leading financial indicators to assess the financial system’s resilience to stress.
7. S&P 500 index: Reflects stock market trends, thus helping anticipate economic turning points, serving as an early signal.
8. Building permits for new private housing units: Indicates upcoming construction activity; permits are required before the construction of a new building can commence.
9. Manufacturers’ new orders for non-defense capital goods excluding aircraft: Reflects business expectations, providing early insights into trends.
10. Average consumer expectations for business conditions: Reflects consumer optimism and spending, offering insights into the economic direction.

OECD Composite Leading Indicator (CLI)

The OECD Composite Leading Indicator (CLI), calculated by the OECD, is a powerful tool for understanding economic trends. It calculates an economy’s business cycle state using the growth cycle concept. Several countries use the same underlying methodology to calculate the OECD CLI, making it a good measure of comparing the state of many regions. Some of the components used to calculate the LCI are listed below.

• M2 money supply: A measure of the money circulating within an economy, reflecting liquidity and potential economic activity.
• Economic sentiment index: An aggregate sentiment gauge reflecting the outlook of businesses and consumers, influencing their spending and investment decisions.
• Permits and orders: Provides data on building permits and manufacturing orders, indicating future economic activity related to construction and manufacturing sectors.
• Equity index: Accesses performance of the stock market, often seen as a leading indicator of economic sentiment and overall economic health.
• Interest rate spread: Provides the difference between long-term and short-term interest rates, providing insights into future economic expectations.
• Manufacturing and Service Sector Indicators: Provides metrics from these sectors. Reflects production, output, and demand levels.

Surveys

Economic tendency surveys conducted by central banks, research institutes, and trade associations contribute to a richer understanding of economic conditions. These surveys offer qualitative insights into various aspects:

• Finances: Gauging the financial health of businesses and individuals, providing clues about spending patterns and investment decisions.
• Activity: Measuring the level of economic activity across sectors, helping to identify growth trends or slowdowns.
• Confidence: Assessing the confidence of businesses and consumers in the economic outlook, influencing future behaviors.

Harmonized survey results, particularly for EU, OECD, and supranational agencies, provide a broader view of economic sentiment across regions, facilitating international comparisons and collaborative analysis.

Big Data and Nowcasting: Real-time Insights

Big data and nowcasting have transformed economic analysis by offering real-time insights. Economists can quickly assess current economic conditions by using data from various sources, such as financial market transactions and Internet searches. This approach, called nowcasting, gives timely estimates for economic indicators that aren’t updated frequently. Notable examples of nowcasting applications include:

1. GDPNow: An estimation tool that utilizes real-time data to forecast current-quarter GDP growth.
2. EuroCOIN: A measure that employs diverse data sources to assess the state of the Eurozone economy.
3. Purchasing Managers’ Indexes (PMIs): These surveys capture current business conditions and act as leading indicators, offering an early signal of economic performance.

These innovative techniques provide analysts with a more detailed understanding of economic fluctuations. It allows for quicker and more informed decision-making in different sectors and industries.

Question

Which of the following statements accurately describes leading, lagging, and coincident indicators?

1. They are consistent across different economies.
2. They are derived from historical cyclical patterns.
3. They are based on Keynesian or Monetarist economic theories.

Solution

B is correct: Leading, lagging, and coincident indicators are determined based on historical observations of how certain variables have behaved in relation to the business cycle over time.

A is incorrect: Leading, lagging, and coincident indicators can vary across different economies due to differences in economic structures, policies, and other factors. Economic indicators may have different relationships to the business cycle in different countries.

C is incorrect: Leading, lagging, and coincident indicators are not inherently tied to specific economic theories like Keynesian or Monetarist theories. Instead, they are empirical tools used to assess and predict the state of an economy.