Recession Watch: Understanding the business cycle

Business cycle primer

Over the course of the past two centuries the economy has grown at around a positive trend. The business cycle is defined as economic activity against that trend. As a result, the business cycle can be categorised into two large phases (above or below trend growth) and then subdivided into contracting and expanding. An economy growing faster than trend and expanding is typically characterised as booming. When the economy is still above trend growth but contracting then the economy is in a slowdown.

The critical point is when the economy begins to operate below trend and is also contracting. This phase is often when policy responses emerge as policymakers begin to realise that the economy is potentially slipping into a recession. An economy can operate under trend growth and contracting but still not be in a recession. However, if policy responses such as fiscal stimulus and monetary easing are implemented too late relative to evolving downside dynamics, then the economy will continue to contract and deviate further from trend growth. In that case the economy typically slips into a recession with all its negative consequences.

When the business cycle turns again into expanding while growing below trend growth then the economy is recovering and the business cycle repeats. It is not always the case that the business cycle travels orderly through the various phases. In some cases policy responses or external shocks can make the business cycle deviate from its normal sequence.

Where is the economy now?

Saxo Bank uses OECD’s Composite Leading Indictors amplitude adjusted as an indicator for where the economy is headed. This time series measures the business cycle using leading indicators relative to an estimated trend growth. According to the OECD, the latest available data as of November 2018 suggest that the OECD countries are growing below trend and contracting. The change in the time series suggests that the business cycle has not yet reached its turning point and the downside deviation from trend growth suggests that OECD countries have alarmingly high probability of entering a recession within the foreseeable future.

Acknowledging this contraction, policymakers ranging from the Fed to the Chinese government have implemented stimulus polices in order to avoid a hard landing and recession scenario. Whether policymakers have acted fast enough to changing conditions will determine whether the economy enters a recession in 2019 or not.