Recession

Business-cycle dating rests on three tests applied together: how deep the decline in activity is, how widely it spreads across sectors, and how long it lasts. Extreme weakness on one dimension can compensate for weakness on another, which is why an exceptionally severe two-month collapse can qualify while a shallow, narrowly concentrated slowdown lasting three quarters may not.

Because real GDP is quarterly, heavily revised, and distorted by inventory swings and net exports, dating committees lean on monthly coincident series: payroll employment, household employment, real personal income excluding transfer payments, real consumer spending, industrial production, and real wholesale-retail sales. A peak is placed in the month activity stops expanding, a trough in the month it stops contracting. Dating is retrospective, so announcements typically arrive well after the turning point.

Contractions usually begin with a demand shock, a monetary tightening, or a financial disruption, then amplify themselves. When sales fall faster than firms can adjust production, unsold goods pile up and the inventory-to-sales ratio rises; producers then cut output below final demand to work stocks down, which magnifies the decline in GDP relative to the decline in spending. Capital spending, the most cyclical component of expenditure, is postponed because expected returns fall and financing conditions tighten.

Layoffs follow, cutting household income and consumption, which validates the original drop in sales. Credit reinforces the loop: rising default risk widens spreads, banks tighten standards, and collateral values fall. Automatic stabilizers work in the opposite direction, as unemployment benefits and progressive taxes cushion disposable income without any new legislation.

Markets move ahead of the data. An inverted yield curve, widening high-yield credit spreads, falling commodity prices, deteriorating purchasing-manager surveys, and a slowdown in broad money and credit growth are the classic advance signals; equity indices typically peak before the official cycle peak and bottom before the trough. Defensive sectors such as utilities, consumer staples and health care outperform cyclicals: industrials, consumer discretionary, and financials.

In financial statements the effect is visible as revenue decline amplified by operating leverage, so that a modest sales fall produces a much larger drop in operating profit for firms with high fixed costs. Receivable days lengthen, inventory turnover slows, impairment and restructuring charges appear, and highly levered issuers breach covenants. Default and downgrade rates cluster in and just after contractions.

A candidate should be able to sort indicators by timing. Leading indicators include the yield-curve spread, new orders, building permits, initial jobless claims and consumer expectations. Coincident indicators include industrial production and payroll employment. Lagging indicators include the unemployment rate, unit labour costs, the average duration of unemployment and inventory-to-sales ratios, which is why joblessness can keep climbing after a trough has already passed.

Two relationships are worth holding precisely. The output gap is actual real GDP minus potential real GDP, expressed as a percentage of potential; it is negative in a contraction and signals disinflationary pressure. Okun's relationship states that the unemployment rate rises roughly in proportion to the shortfall of output growth below trend, with the proportionality factor estimated from data rather than fixed by theory.