The Importance of the Business Cycle - dummies

By David Stevenson

In the UK market and around the world, the longer-term GDP growth rate interacts with shorter-term interest and inflation rates with something called the business cycle.

Basically, this cycle contains three distinct phases: the expansion phase, also called the growth phase, when the economy is growing; the contraction, or slowdown, phase, in which the economy slows down; and the trough, or recession, phase in which the economy hits bottom (this phase can sometimes result in a deep depression).

This phasing of growth and recession (accompanied sometimes by that less frequent depression) can be attributed to all manner of underlying causes:

  • The inflation, interest and exchange rates: These can have a direct and immediate impact. For example, if interest rates increase sharply following a surge in inflation, you can expect to move from heightened economic growth to a sudden and sharp recession.

  • The ebb and flow of the credit cycle: Many economists brought up on a particularly free market version of history (called the Austrians after their Austrian-born founding fathers) believe that the ebb and flow of the credit cycle (lending) has a massive impact. This group in particular pays close attention to the boom/bust cycle of bubbles.

  • The state of the housing market: Another variant on the preceding business model approach looks at the housing market and how that affects the economic cycle and thus the business cycle. This group of economists tends to focus on economies such as the US and how the volume of new house starts, lending activity and local prices have an impact on the wider economy.

Whatever the exact cause of this ebb and flow within the economic cycle, a business cycle definitely exists and economists have minutely detailed every up and down of this cycle for the last 60 years. The table shows the US business cycle as defined by its main national economic forecasting service.

The US Business Cycle (in months)
Peak Trough Contraction Expansion Cycle
Peak to Trough Previous Trough to Peak Trough from Previous Peak Peak from Previous Peak
Feb-45 Oct-45 8 80 88 93
Nov-48 Oct-49 11 37 48 45
Jul-53 May-54 10 45 55 56
Aug-57 Apr-58 8 39 47 49
Apr-60 Feb-61 10 24 34 32
Dec-69 Nov-70 11 106 117 116
Nov-73 Mar-75 16 36 52 47
Jan-80 Jul-80 6 58 64 74
Jul-81 Nov-82 16 12 28 18
Jul-90 Mar-91 8 92 100 108
Mar-01 Nov-01 8 120 128 128
Dec-07 Jun-09 18 73 91 81
Average, all cycles:
1854‒2009 (33 cycles) 16 42 56 55*
1854‒1919 (16 cycles) 22 27 48  49**
1919‒1945 (6 cycles) 18 35 53 53
1945‒2009 (11 cycles) 11 59 73 66
* 32 cycles; ** 15 cycles

Source: National Bureau of Economic Research, Inc., 1050 Massachusetts Avenue, Cambridge MA 02138

The business cycle has a major impact on the pricing of financial assets. Put simply, a move into a recession is very bad news for shares and good news for government bond investors. A bottoming out of a recession offers a wonderful entry point for investors whereas a move into sustained growth (and possibly higher trend inflation) is bad news for bond investors.