A business cycle consists of an economic expansion and a recession. A recession is a period between a peak and a trough in economic activity, and an expansion is a period between a trough and a peak. During a recession, a significant decline in economic activity spreads across the economy and can last from a few months to a year or more. Similarly, during an expansion, economic activity rises substantially, spreads across the economy, and typically lasts for several years. (For information on why business cycles occur, see the classic “Cause and Control of the Business Cycle” by Col. E.C. Harwood, AIER’s founder.)
History of the BCM
Originally developed more than 50 years ago, our Business Cycle Conditions model has amassed an enviable track record of identifying turning points in the business cycle. Over the many decades that our model has been in use, we periodically review how well it is working and, when necessary, update it. Among the many forces that can lead to changes in an economy are improved technologies, demographic or political shifts, policy changes, new regulations, trade pacts, and cultural preferences. It’s not hard to recall a wide range of major changes in all those areas over the course of the past few business cycles.
At the time, AIER researchers reviewed the most popular and well-known business cycle theories including the Endogenous Business Cycle Theory, the Real Business Cycle Theory, Austrian Business Cycle Theory, and Keynesian Theory, as well as our own historical work in business cycle theory. Studying those business cycle theories and past recessions, we looked at 12 economic categories for potential business cycle indicators: (1) consumer spending, (2) housing, (3) business investment, (4) international trade, (5) government spending and fiscal policy, (6) monetary policy, money, banking, and credit, (7) prices and inflation, (8) capital markets, (9) the business sector – corporations and small businesses, (10) labor, wages, hours, demographics, and immigration, (11) manufacturing and trade (including production, utilization, sales, orders, and inventories), and (12) consumer and business sentiment.
Statistical tests were conducted to quantitatively verify how well each measure performed. Those tests covered two time periods: 1950 – 2014 and 1983 – 2014. The primary reason for using two periods was to balance the benefit of the larger number of cycles in the longer period with the empirical reality that business cycle behavior appears to have changed in recent decades
In 2016 AIER’s Business Conditions Monthly model was changed with the goal of keeping it more attuned to changes in the US and global economies. Its overall structure, as well as our commitment to data and scientific analysis, have been maintained. Periodic reviews of the BCM will be undertaken as well. .
Calculation of the BCM
The model utilizes a diffusion index methodology. A diffusion index measures breadth and is sensitive to the number of indicators that are rising, falling, and remaining stable. The model is not intended to estimate growth rates or to produce a specific numerical forecast. Rather, it anticipates whether a turning point is near. While some diffusion indices discard small month-to-month changes from the overall calculation, AIER’s BCM includes “stable” changes in indicators in the calculation of the final index.
When the Leading Indicators Index falls below 50, it is not necessarily a signal of broadening weakness in the economy. Such a move, within the context of other economic developments, may be interpreted as a warning that we might be entering “choppy waters,” and requires observing all the signals available to us. The final determination of a turning point and impending recession ultimately remains a matter of human judgment.
There are 24 indicators in total – 12 Leading Indicators (economic indices or metrics that tend to peak and trough ahead of a turning point in the broader economy), six Roughly Coincident Indicators (which peak and trough at roughly the same time as the broader economy), and six Lagging Indicators (indicators that peak and trough after a turning point in the broader economy).
After the indicator values are calculated, each is qualitatively reviewed and evaluated. As part of this evaluation, we consider whether the most recent data point represents a continuation of a trend or a turning point. Because this evaluation is qualitative, month-to-month changes may be assessed differently over time. “Noise” in the economy makes such an assessment more difficult than a straightforward mathematical evaluation of whether a given month’s index number is larger or smaller than the previous month’s index number. By moving qualitative assessment outside of the model, we believe the results are more attuned to sound social science practices.
The monthly BCM reports can be found at this link. In addition, the three components of the BCM are available on Bloomberg at under the following symbols:
Business Conditions Monthly, Leading Indicators: AIERBCLE Index
Business Conditions Monthly, Coincident Indicators: AIERBCCO Index
Business Conditions Monthly, Lagging Indicators: AIERBCLA Index