The Business Cycle and the Economy

Economic activity in the United States changes from year to year. The production of goods and services increases in one time frame while normal economic growth does not occur in another. Although these changes are irregular and unpredictable, most of the macroeconomic variables involved are interrelated and move together. This is particularly true about real output and unemployment. Fluctuations in real GDP and the unemployment rate are inversely related…as output drops, unemployment rises. These short-run changes in output and unemployment are known as the business cycle.

A business cycle is changes in output, income, and employment within the total economy. When businesses operate near capacity and real GDP (output) is rising, a peak occurs. As business slows, the economy contracts, sales drop, real GDP slows down, and unemployment increases. The business condition bottoms out at a trough where real GDP is dropping and unemployment is rising. When business conditions improve, an expansion phase occurs where sales increase, GDP grows quickly, and unemployment drops until economic growth reaches a peak again. Then the cycle starts over. Economic growth does not go on for an indefinite period because extended periods of growth, as well as short periods of concentrated growth, are eventually joined by higher rates of inflation. These higher prices spur policymakers to stimulate a downturn in hopes of reducing inflationary pressures by slowing economic growth.

Economic policy makers, the Federal Reserve Board with its monetary policies and the government with its fiscal policies, interpret and react to business cycles. They try to forecast just where the economy is going in the near future based on leading economic indicators. The ultimate goal is to sustain real GDP growth at a constant 3% non-inflationary rate, to keep the unemployment rate at the full-employment level of 5% to 6%, and to curtail inflation by keeping it at no more than 3%. In essence, policy makers try to level out the business cycle by diminishing the extent of differences in economic growth over the cycle. The explanation of how the Fed carries out monetary policy is the manner in which it responds to changes in output. The Fed can reduce output in the short-run by contracting the money supply. It can increase short-run output by increasing the money supply. The Federal Reserve can also increase or decrease interest rates to try and parallel aggregate demand growth with aggregate supply growth from year to year. For example: if the Fed decides that GDP is slowing down to a meaningfully lower growth rate, it may reduce interest rates to stimulate economic growth. Actions by the Fed definitely affect the quantity of output produced in the U.S. economy.

The Fed scrutinizes several economic variables that are indicators of economic growth and inflation. Monitoring changes in unemployment, the cost of labor, the use of productive capacity, the price of commodities, business inventories, and worker productivity allow the Fed to predict where the economy is headed. By monitoring the combined effect of economic indicators, the Fed is able to take action to either slow growth before inflation increases or expand growth if the economy has taken a downturn.

GDP, Durable Goods, Finding Business Cycles

Bernanke is Cautious on Employment, Looks at Demand

Last week, Fed Chairman Ben Bernanke appeared before Congress to provide his semi-annual monetary policy testimony. He said that improvement in employment must be closely monitored in view indicators that show demand not strengthening in kind. Such sentiment disappointed equities markets, which closed down, despite good GDP numbers and success coming from the European Central Bank’s second LTRO.

Unemployment has fallen to 8.3% from 9%, where it hovered for most of 2011. Apparently the fall in unemployment has been rather fast and deep, with the current rate at the Fed’s low end of its year-long 2012 forecast. Unemployment started to decline in November of last year dropping to 8.6%. What is surprising is that quarterly GDP numbers leading up to November weren’t very strong. Q1 showed GDP advancing by.4%; Q2, 1.3%; Q3, 1.8%. Today, GDP showed Q4 growth at an impressive 3.0%, with an annual gain of 1.7%.

Still, throughout 2010, a time when GDP numbers were consistently stronger than in 2011, and in fact ended with 3.0% annual growth, unemployment numbers didn’t budge. What’s special about Q4 2011 to bring down unemployment in a dramatic fashion…

Fed forecasts have GDP growth in the area of trend at 2.3% to 2.6% for 2012. According to Bernanke, “with output growth in 2012 projected to remain close to its longer-run trend, FOMC members did not anticipate further substantial declines in the unemployment rate over the course of this year.” For rates of job growth to be repeated, Bernanke said that it would “likely require stronger growth in final demand and production.”

Headwinds are starting to blow against growth in final demand and production. Bernanke saw elevating gas prices pushing up inflation and depressing consumer purchasing power.

Vehicles Have Led Demand, But Demand Needs a Broader Base

Final demand can be seen in retail sales indicators. Monthly results for retail have been flat through Q4, except for the motor vehicle component. Vehicle sales have also influenced consumer credit expansion and the growth of associated manufacturing sectors.

According to last week’s release of GDP numbers by the Bureau of Economic Analysis, motor vehicles lead growth across GDP components in Q4, posting growth of.81%, and annual growth at.19%. Last time growth was seen in motor vehicles of this magnitude was in Q3 of 2009, with a rate of.92%. Of course, when vehicle sales increase, associated production also increases and, with it, investment. Investment in industrial equipment showed basic strength through 2011, growing.22% in Q4. Transportation equipment was also strong in 2011, with Q4 results growing.18%.

Contrast vehicle and associated numbers with broader demand numbers. Clothing and shoes, as a component of GDP, looked weak through 2011 with Q1 growth at.07%; Q2 at.05%; Q3, -.19%; and Q4 ending the year with.07% growth resulting in an annual rate of.07%.. Food and beverage purchases looked like clothing—weak, and the particular numbers almost identical. Whereas in 2010, both components were about twice as strong, posting annual growth of.13% each.

Economic numbers show two concerns. Firstly, employment improvement might be more a reflection of vehicles, as opposed to a broader base. Secondly, given the quarterly GDP numbers for most of 2011, with a jump in Q4, is this growth sustainable.

Durable Goods Orders, With GDP Can Tell of Bottom Cycles

Durable Goods Orders reported by the Census Bureau today show a decline in January of -4.0%, following three consecutive months of increase. This data shows anticipated future production. The motor vehicle component looks healthy with January numbers at a.9% increase and a year over year increase of 12.2%. These results comport well with other trends in other economic indicators showing strength in vehicles.

In fact, looking at the stock performance of the Dow Jones Automobiles and Parts Index ($DJUSAP) versus the S&P 500 ($SPX), we see that the auto index outperformed the S&P by growing 27% from a December 20, 2011 low through to a February 17, 2012 high. For the S&P, the growth rate has been 15.4%. However, currently everything is moving sideways, not really advancing and not really declining.

More important, nonetheless, are the areas of weakness in durable goods orders. The most significant class is “computers and related products”, which is different from “computers and electronic products” which includes the semiconductor industry.

For “computers and related products”, surprising decline is seen month over month with a fall in January of -10.1% versus December’s fall of -5.9%. Of considerable note in this industry is a year over year decrease of -13%, that is from January 2010 compared with January 2011. This component is experiencing the largest decreases of all durable goods.

Looking at a similarly related component on the GDP report, its growth has been weak over 2011. This implicates a business cycle ready for an uptick in demand.

Ultimately, vehicles really showed up in Q4, while other things weren’t as strong as one would like to see. Ideally, one would like to see employment steady at its rate or obviously improve, while retail aside from vehicles improves. From there, perhaps the cycle for some of these underperforming components will tick up.

Managing the Business Cycle – You Can’t Stop Pedaling!

Isaac Newton taught us that anything that goes up must come down. So, why should businesses be any different? Managing the business cycle is one of the biggest challenges that entrepreneurs and their senior management team will face. And the reality is that it will never go away.

In today’s global economy, the impact of any macroeconomic event travels at the speed of light. The Federal Reserve sneezes, and boy, the rest of the world catches cold in next to no time. The blood pressure levels of many a CEO mirror the changing patterns in oil prices and stock market indices. This is where the skill in managing the business cycle spells the difference between success and doom, and separates the men from the boys. “Beating the Business Cycle” by Lakshman Achuthan and Anirvan Banerji listed in the Professional and Technical books section provides greater insight.

For an entrepreneur, it is very important to learn this lesson early on, lest he or she is forced to learn it the hard way. Let us discuss some of the common tactics that are used by masters of the art of managing the business cycle.

The first thing to do is anticipate. Many a conglomerate has been caught flat-footed by an “unexpected” recession. Sure, macroeconomic developments in far away continents might seem of no relevance, until you scratch the surface. Businesses are highly interwoven these days, and therefore negative repercussions spread far and wide, quickly. If you don’t have an advanced degree in Economics, leave the number crunching to someone who does. Ensure that your business forecasting techniques do take into account such developments.

Managing the business cycle invariably starts with realigning capital expenditure. Having anticipated a downturn, most conservative business heads might cut back on new capital investment. On the other hand, proactive thinkers actually increase capital expenditure prior to a recession, in order to gain a first mover advantage when the economy recovers. Of course, this depends on the business you’re in – for example, this tactic is favored by real estate companies. Likewise, the decision to acquire or sell a company must also be timed accordingly. The temptation to buy is strong in good times, but comes at a price. At the micro level, you will also need to manage cash flow differently.

To stock or not to? Inventory management is tough enough as it is, but approaches the complexity of rocket science closer to a recessionary period. Not cutting back production in anticipation of a downturn and therefore being saddled with stagnating inventory is a cardinal sin… but so is being caught unawares by surging demand in times of economic recovery, and having no product to sell! Particularly in the case of businesses that make seasonal products, or even those with a high degree of obsolescence, the inventory decision is make-or-break.

Don’t cut advertising. No, that’s not a typo error, we mean what we said. The reactive way of managing the business cycle is to freeze promotional activity. Tell yourself repeatedly that advertising is investment, and not expenditure, till you start to believe it. Advertising demand goes down during a slack season, and so do rates – which means, you get more visibility at a lower price.

Reassess your human resource needs – by that we don’t necessarily mean downsize. Your employee headcount may well fluctuate in accordance with the business cycle. However, do remember, that during off season, the labor pool is in spate! If you have been struggling with finding the right people, it may be a good time to redouble your efforts during a recession. Not only are you likely to find a wider selection of candidates, you can probably hire them at a lower cost.

While macroeconomic events have a far reaching impact, they can also bring about unexpected opportunities. Managing the business cycle is no mean task, and yet, there is hardly anything that is more critical.