Round and Round: The Basics of the Business Cycle

September 17, 2019

person facing the viewer while holding magnifying glass over a transparent surface with various charts and data

The word cycle contains the notion of regularity. Yet one of the most important cycles of all, the business cycle, is anything but predictable.

Plainly put, the business cycle is how economists refer to the inevitable ups—expansions— and downs—contractions, or recessions—of economic activity over time. But determining exactly when a cycle ends and when a new one begins is often not clear, even to experts, until well after the fact, economists say. What's more, though some of the effects of economic slowdowns are consistent—higher unemployment, less consumer spending, or diminished factory production, to name a few—the precise forces that cause an expansion to end can vary.

Despite plenty of statistics, tools, and models developed to track the economy, knowing exactly what might kill an expansion is elusive, says Atlanta Fed research economist Patrick Higgins, who developed the Atlanta Fed's GDPNow, a popular instrument that provides a "nowcast" of the current quarter's economic growth as measured by gross domestic product, or GDP.

"There are definitely commonalities, but there are differences as well," Higgins said of the way business cycles end.

The path from climb to descent is not always straightforward

The economy is a web of innumerable forces affecting one another in unpredictable and changing ways. Figuring it all out, solving every puzzle, is essentially impossible, economists like Higgins agree.

The path from economic growth to economic slump does not typically go A to B to C. "It's not really linear," Higgins said. "I don't know if we have a good sense of exactly what causes people to hold up on spending or investment, but afterward, you can identify things that happened."

photo of Pat Higgins
The Atlanta Fed's Pat Higgins.
Photo by David Fine
Psychology and real-world surprises contribute to downturns

What do experts think causes economic booms to end? For many decades after World War II, there were two basic schools of thought. One side, the Keynesians—devotees of the British economist John Maynard Keynes—generally believed that a lack of confidence among consumers and the business community led them to pull back on spending and investment, thus hobbling overall economic activity. Keynes, who died at age 62 in 1946, called the psychological forces "animal spirits."

The other school of thought put more stock in "real business cycle theory," which holds that recessions are less a psychological phenomenon than they are rational responses to concrete events such as a sudden disruption—or "shock," as economists say. This could be a sudden surge in the price of an important commodity like oil, or a change to current or expected technological possibilities, or a big shift in government fiscal policy. Although the financial crisis that triggered the Great Recession would appear to fit some parts of this definition, the events surrounding it were also fueled by a pervasive lack of confidence in the ability of various institutions and individuals to meet their debt obligations.

So, broadly speaking, the pendulum appears to have swung in the direction of the "animal spirits" camp and its offshoots for now, Higgins said. As just one bit of evidence of this, a recent article in the influential British magazine The Economist said that "recessions, to no small degree, are a state of mind."

Personal consumption is most of the economy

To be sure, there is plenty we do know. Start with the basics of the business cycle.

During expansions, such as the present one the nation has enjoyed for more than 10 years, the economy is growing as measured by GDP, the basic economic yardstick that measures all the goods and services produced in the country.

The U.S. Bureau of Economic Analysis tallies GDP each quarter. GDP's single biggest component—nearly 70 percent each year—is personal consumption, or the sum total people spend on goods and services. The next biggest categories are total fixed investment and government spending, each representing about 17 percent of GDP. Total fixed investment consists mostly of money that companies spend on machinery, buildings, software, and so on. But the category also includes investment in the construction of houses and apartment buildings. The total share of those three categories comes to more than 100 percent because net exports of goods and services as a category are subtracted from GDP. (The St. Louis Fed has a graph showing the components of GDP.)

When GDP growth slows from one quarter to the next but is still positive, that is not a recession. A standard, but unofficial, definition of a recession is when GDP falls for two straight quarters. Signs of recession show up in statistics gauging such things as industrial production (the amount of manufacturers' output), total numbers of jobs, the real income (which is adjusted for inflation) of all workers, and manufacturing and trade sales, or sales among firms.

The current economy is strong but sending mixed signals

The current expansion is the longest in the post–World War II era. But in recent months, conflicting signals have emerged about the economic outlook, as Federal Reserve officials have pointed out.

On the one hand, important economic engines including employment and consumer spending are humming along nicely. Taken as a whole, American workers' incomes have grown steadily during the past year. And although consumer confidence has ticked down, surveys show that people generally continue to feel all right about their economic prospects, a key sign that shoppers might keep spending generously.

On the other hand—as economists are prone to say—a few significant warning signs are appearing. The global economy is growing more slowly, U.S. factories are producing less, and business investment growth in capital goods like machines and software has softened. Also, interest rates on government debt—set by supply-and-demand market forces among those buying and selling the debt instruments—are showing signs that could be an indication of oncoming economic weakness. For example, the yield curve recently inverted, meaning that longer-term bonds earn a lower interest rate than shorter-term bonds.

Finally, uncertainty among business executives has been rising, according to the Atlanta Fed's Survey of Business Uncertainty. Such uncertainty tends to tap the brakes on economic growth by making companies hesitant to commit to big investments that can generate new business.

Inflation has gotten lower, business cycles longer

Part of the challenge in predicting the direction of the cycle comes from the numerous complex interactions that make up the cycle. Moreover, the forces that shape the business cycle change over time.

For example, for about 20 years starting in the mid-1960s, inflation was a huge concern. It was over 4 percent throughout much of that period, even soaring above 10 percent at times. However, that changed as the Federal Reserve began more aggressively fighting inflation. Over the past 25 years, it has averaged a bit less than 2 percent, and low inflation has been the main concern for the past decade, Fed chair Jerome Powell said in an August 23 speech.

"By the turn of the century, it was beginning to look like financial excesses and global events would pose the main threats to stability in this new era rather than overheating and rising inflation," Powell said.

Business cycles have also become longer, perhaps partly because greater economic knowledge has helped policymakers formulate monetary and fiscal policy that better nurture macroeconomic growth. Higgins points out that macroeconomic performance today is less volatile than it was from the mid-1940s to the mid-1980s.

Indeed, counting the current expansion, three of the four longest economic growth periods in U.S. history have happened since 1983, according to the National Bureau of Economic Research, the body that officially declares the beginnings and ends of recessions. Since 1945, expansions on average have lasted about six years compared to just under four years, while contractions have grown shorter.

Ultimately, nobody can say definitively when the economy will change direction. Even the best experts generally only know for sure it has turned at least half a year after it happens. The business cycle will continue to present vexing puzzles, but plenty of smart people will keep trying to solve them.

photo of Charles Davidson
Charles Davidson

Staff writer for Economy Matters

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