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A Look Back at the Economic Cycle

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To see clearly where we are and where we might be headed economically in the near future, it’s a good idea to look back at the economic cycle.

The Four Phases of a Business Cycle: Expansion, Crisis, Recession, Recovery

Business cycles, in general, have four main phases.

The first phase is expansion...

Expansion is characterized by an increase in the gross domestic product (GDP), business production and prices, and by low interest rates.

The United States Federal Open Market Committee (FOMC), which is charged with the level and direction of interest rates, uses interest rates as a tool in business cycles. They are kept low so that the borrowing cost to business is relatively low, and businesses can expand. GDP rises as a result.

Businesses can hire more people, which keeps unemployment low and ensures healthy consumer demand for products and services. Banks become more willing to make loans.

Expansion is sometimes (although certainly not always) followed by a crisis. If economic expansion has led to a rising stock market, stock exchanges may crash. While stock markets frequently correct by pulling back in price, corrections generally follow specific parameters. A 10% to 15% drop in stock prices is a correction, shading into a bear market. A stock market crash is a more significant drop than that.

A crash is a crisis that can precipitate a recession...

In a recession, businesses contract. They pull back on production to save money and in response to slackening demand. Employment is curtailed as sales fall. That can lead to a spiral, as businesses buy less from their suppliers and out-of-work consumers purchase less.

Fewer goods and services are sold, which may cause businesses to contract even more. Loan growth on the part of banks contracts.

The most famous stock market crash in U.S. history occurred in 1929 and ushered in the Great Depression of the 1930s — an immensely severe, and prolonged recession.

The most recent crisis in the United States was the Great Recession of 2008-2009. Although it was not precipitated by a stock market crash, it was accompanied by sharp declines in the stock market. The precipitating factor was the subprime mortgage crisis. The crisis was intensified by the fact that cash flows are increasingly global, not just confined to one locale or nation.

Although it was more severe than most, the Great Recession displayed all the characteristics of a recession. Recessions always follow expansions, whether or not there is a crisis. Recessions can be mild or moderate. They are accompanied by drops in GDP and consumption. These cause price declines, as businesses lower prices to spur the lackluster demand. Employment often declines.

Interest rates are often high at the beginning of recessions...

In the early stages of recessions, interest rates are often high, because they have been geared toward fostering and maintaining economic expansion. The Federal Reserve will begin lowering interest rates if they fear a recession or if the data show that one is happening, in order to spur the expansionary cycle again.

Recessions are accompanied by drops in the stock market, even if they aren’t crashes, or by lackluster performance. Equity prices mirror the worth of the businesses listed on the stock exchanges, so they will not rise when businesses’ worth is declining.

Once prices drop and interest rates fall, recovery often begins...

Rates are low enough to keep businesses going and growing. Businesses and consumers begin purchasing again. The GDP rises. More people are hired. Discretionary income gets spent on goods and services, so the economy starts to expand.

Stocks start to advance during a recovery. They often move on a price/earnings ratio, so as businesses recovery and earnings rise, stocks march upward.

Markets expand in a recovery.

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Right Now, We’re in a Recovery

For the past roughly 16 to 18 months, the economy has been in a strong recovery. Business has posted strong results, on the whole. The GDP has been rising. The unemployment rate has been at record lows. The stock market, despite the large drops in early February, has overall climbed very strongly since November 2016.

Analysts are predicting strong GDP growth not only in the U.S., but across most of the developed world for this year.

As a result of strong U.S. growth, the Fed, which kept interest rates at record lows from the Great Recession until 2016, has started to hike interest rates to keep inflation in check.

Small business lending is advancing.

Where Are We Going?

Hopefully, the business expansion we’re currently in will continue for a while. But we know from the business cycle that times of robust expansion will be followed by periods of contraction.

Banks need to be vigilant to manage their risk as business profits and consumer income contract in tandem with the cycle. Banks that manage risk optimally will be well positioned to profit when the cycle moves from recession back to expansion again.

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