Investing

From Recessions to Expansions, How to Make Sense of Economic Cycles

Twenty/20

American investors are enjoying the longest-ever period of booming economic growth, or expansion. But what does that mean, exactly?

The economy goes through distinguishable stages, depending on whether it’s growing quickly or slowly. One of those is called expansion.

Economists track what stage the economy is in to anticipate the transition to the next. In particular, they look at gross domestic product (GDP), or the sum of the value of all goods and services produced. They also take into consideration the unemployment rate, how the stock market is faring, and how average prices for goods and services are changing, which is also called inflation.

There are four stages to the economic cycle. Here’s what they are.

The four stages of the economic cycle

Economic stages are a bit like the four seasons of the year, as illustrated in the video below.

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How do economic cycles work?

Economic stages tend to last longer than seasons do, though. Measured from peak to peak, the average length of an economic cycle is nearly five years, according to figures from the National Bureau of Economic Research. And, on average, the parts of the cycle with rapid economic growth last more than twice as long as the periods where growth stalls.

For perspective: That record period of growth we’re in right now has lasted a decade. By comparison, the last contraction—the Great Recession of 2007-2009—lasted 1.5 years.

Expansion

During this springlike period, there are lots of favorable signs in the economy:

  • GDP growth is accelerating, in the range of about 2% to 3% annually
  • Inflation is about 2%
  • The unemployment rate is between 4.5% and 5%
  • Stocks are in a bull market, meaning prices are rising

Peak

Think of this like the hottest day of summer. Expansion comes to an end when the economy overheats:

  • GDP is growing at a pace of 3% or more
  • But inflation is higher than 2%
  • The stock market has reached a high as well

Contraction

After peaking, the economy begins slowing. During this autumnal period:

  • GDP is growing, but by less than 2%
  • The unemployment rate is rising, and is higher than 5%
  • Stock prices are falling

Trough

Think of this as the coldest day of winter, which marks the lowest point for the economy. During this time:

  • Depending on the severity of the contraction, the economy could enter a recession. That’s if GDP shrinks for at least two consecutive quarters (six months or more)
  • In much rarer cases, a depression occurs. That happens if economic growth falls by at least 10%
  • Stocks may enter a bear market, which is when prices fall at least 20% from the high

It’s not easy to forecast economic changes

While the four stages of the economic cycle are fairly simple to distinguish, it’s difficult even for professional economists to accurately predict when change is coming. The fact that the economic recovery since the Great Recession of 2007-2009 has set a record makes some people nervous the next economic downturn is on its way.

But the good news is these cycles are normal. Just as winter gives way to spring, every contraction prepares for another expansion.

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