How Traders Use Economic Indicators to Determine the Strength of the Economy

By Joe Duarte

Considering the amount of lag time between events and official pronouncements, you’re likely wondering how you can determine which part of the cycle the economy is in and how you, as a trader, can use this information. Most economists attribute changing business cycles to disturbances in the economy.

Growth spurts, for example, result from surges in private or public spending. One way public spending can surge is during a war, when government spending increases and companies in industries related to the war effort prosper. They often need to increase hiring to fulfill government orders. Employees at these companies usually receive increases in their take‐home pay and start spending that extra money. As consumer optimism increases, other companies must fulfill consumers’ wants and needs, so production and output also increase in companies that are unrelated to national defense.

When these same factors work in reverse, the start of a recession is sure to follow. For example, a cut in government spending will likely result in layoffs at related industrial plants, reduced take‐home pay, and finally declines in output and production in order to cope with reduced spending.

In addition to government spending, a decision by the Fed to either raise or lower interest rates causes another major disturbance in the economy. When interest rates rise, spending slows, and that can lead to a recession. When interest rates are cut, spending usually goes up, and that can aid in spurring an economic recovery.

Even though the Federal Reserve has kept interest rates at near zero since the financial crisis began in 2007, recovery has been very slow. The Federal Reserve raised the target rate to 0.75 percent in late 2016 for the first time since the financial crises of 2007 began, and it is expected to raise rates several times in 2017.

Another school of economic thought disagrees with the notion that government policy or spending is responsible for changes in the business cycle. This second group of theorists believes that differences in productivity levels and consumer tastes are the primary forces driving the business cycle. From this point of view, only businesses and consumers can drive changes in the economic cycle. These economists don’t believe that governmentally driven monetary or policy changes impact the cycle.

Which camp you believe is not critical; the key is picking up the signs of when the economy is in a recession and when it’s in an expansion. Peaks and troughs are flat periods (periods where the high or low stays primarily even before moving in the opposite direction) and are impossible to identify until months after they end. As a trader, you can identify shifts in buying and spending behavior by watching various economic indicators. By doing so, you can discover when the economy is in the early stages of a recovery or recession or if it’s fully into a recession or recovery.