The Economic Cycle

• People—including the workers making the cars—demand higher wages so they can afford to buy a car. The cost of building the car goes up—so the selling price goes up.

Economies tend to move through normally recurring cycles of growth and slowdown. But there can be problems if growth results in runaway inflation or if a slowdown ends in recession. The Federal Reserve works to prevent either situation.

• Unemployed people buy less of everything, so the economy slows down. This can lead to a recession. Car dealers—desperate to sell their small but stagnant inventory—offer their cars at sale prices or with special deals.
• If ten people now want cars and only seven are available, the cycle begins again.

The Inflation Struggle

Most economists agree that inflation isn’t good for the economy because, over time, it destroys value, including the value of money. If inflation is running at a 10% annual rate, for example, a book that cost $20 one year would cost $40 just seven years later. By comparison, if inflation averaged 3% a year, the same book wouldn’t cost $40 for 24 years.

Since inflation typically occurs in a growing economy that’s creating jobs and reducing unemployment, politicians are willing to risk its consequences. The Federal Reserve prefers to cool down a potentially inflationary economy before it gets out of hand. But since it also wants to prevent any long-term slowdown, it typically reverses its monetary policy when the economy seems likely to shrink.

Who Gets Hurt?

The people hit the hardest by inflation are those living on fixed incomes. For example, if you’re retired and have a pension that was determined by a salary you earned in less inflationary times, your income will buy less of what you need to live comfortably. Workers whose wages don’t keep pace with inflation can also find their lifestyle slipping.

Debtors get hurt too. Even though the money they repay is worth less than it was when they borrowed, the interest they pay is higher because the Fed has raised rates.

When There’s No Inflation

When the rate of inflation slows, it’s described as disinflation. So a 1% annual increase in the cost of living is disinflationary after a period of more rapid growth. Employment and output can continue to be strong, and the economy can continue to grow.

Deflation, though, is a widespread decline in the prices of goods and services. But instead of stimulating employment and production, deflation has the potential to undermine them. As the economy contracts and people are out of work, they can’t afford to buy things, even at cheaper prices.

Stagflation, a confounding combination of slow economic growth and high inflation, is yet another example of how components of the standard cycle can be out of step.

Charting a Recession

Recessions are periods when unemployment rises while sales and industrial production slows. Government officials, the securities industry, investors, and policymakers all try to anticipate when they will occur, but the factors that produce economic contraction are so complex that no predictor is always reliable.

The Index of Leading Economic Indicators, released every month by the Conference Board, a business research group, provides one way to keep an eye on the economy’s overall health. Generally, three consecutive rises in the Index are considered a sign of growth and three drops a sign of decline and potential recession. Its movement may signal economic downturns 18 months in advance, and it correctly forecast the recessions of 1991 and 2001. But it has also pointed to recessions that never materialized and missed or was slow to anticipate others.

The National Bureau of Economic Research (NBER), which tracks recessions, describes the low point of a recession as a trough between two peaks—the points at which the recession began and ended. Of course, peaks and troughs can be identified only in retrospect, though the fact that there’s a slump in the economy is evident.

Recessions may be shorter than the period of economic expansion they follow. But they can be quite severe even if they’re brief, and recovery can be slower from some recessions than from others.

The more segments of the economy that are involved, the more serious the recession. The market collapse and credit freeze of 2008 affected many consumers and businesses for years afterward.