Beating the business cycle

The key to accurately forecasting economic conditions lies in identifying and tracking leading indicators, especially around turning points when most forecast continuation of existing conditions. Leading indicators point the direction the economy is heading, enabling individuals and policymakers to make decisions to better advantage themselves over competitors.

While economists differ in defining recessions and assigning blame, typical recessions see four factors decline together: unemployment rises, incomes fall, output declines, and consumer spending falls. For a recession to occur, all these factors must decline, creating a feedback loop that snowballs into an avalanche as job losses reduce spending, spreading the downturn until it engulfs most of the economy. This can spread region to region or country to country.

At turning points, a virtuous cycle emerges as sales, output, incomes, and employment increase in unison from people buying more, causing industries to produce more, requiring hiring more people thereby raising incomes. Recovery spreads like a recession.

The standard recession definition is two quarters of falling GDP, but this rule doesn't identify all recessions. GDP measures total output, so if unemployment, income, and sales don't all fall, there may not be a recession even with negative growth. There is also confusion over terminology, as some define recession as whenever annual growth falls below trend, but below-average growth doesn't necessarily mean imminent recession since it requires knowing the actual growth trend, which is difficult.

It is now feasible to leverage the work of economists to create a sophisticated “dashboard” to measure the overall state of the economy, much like the dashboard of a car or plane enables users to independently evaluate its functioning. While some companies may opt for a highly detailed dashboard attuned to even subtle shifts in economic conditions, most businesses do not require that level of precision. For the majority, a basic dashboard with one or two key indicators of near-term economic trajectory will suffice.

Clearly, knowing whether the economy is at an inflection point can prove advantageous when making major corporate or personal decisions that could be impacted by economic fluctuations. On the business side, impending turns in the economy may influence choices around expanding production capacity, adding or discontinuing product lines, reallocating assets, adjusting prices, and more. For individuals, shifts in economic conditions may shape decisions about taking on a large mortgage, allocating investments, retirement planning, changing jobs or careers, and furthering one’s education. By accurately identifying turns in the broader economy, one may be able to capitalize on emerging opportunities that others may be hesitant to pursue.

However, the conventional wisdom holds that no one can reliably and consistently predict the economy's future direction. Economists' past failures to anticipate recessions would seem to confirm this. Yet the key question is whether those predictive shortcomings stemmed from innate economic complexity and unpredictability, or simply reflected inadequacies in the underlying economic models themselves. By some accounts, there are over 4 million measurable economic variables, with 99.9% offering little practical value in signaling cyclical shifts. It is easy to become overwhelmed by the sheer quantity of available data.

Further confusing matters, financial publications occasionally tout “secret” indicators that purportedly enabled U.S. presidential economic advisers to recognize impending economic changes. While well-fitted to historical data, these indicators often fail as forward-looking predictive tools. The “Holy Grail” of economic forecasting remains an elusive singular, reliable measure of the entire business cycle. The closest approximation entails examining a limited set of key drivers, which together can signal likely directional turns with reasonable certainty.

“To accurately assess cyclical risk, two aspects of the economy must be monitored: economic growth and inflation. Together, they largely determine what most individuals and smaller businesses need to know to navigate the ups and downs in the economy," say experts Lakshman Achuthan and Anirvan Banerji. "We have developed two composite leading indexes for U.S. growth and inflation that we have made publicly available in business magazines, financial news wires, and on our Web site. The Weekly Leading Index (WLI) anticipates cycles in overall economic activity – recessions and recoveries – by summarizing the best leading indicators of growth at a given time. This allows one to focus on a single measure to get a read on the overall business cycle outlook. The other index, the Future Inflation Gauge (FIG), summarizes the best leading indicators of inflation. This is important because inflationary pressures influence changes in interest rates.”