Understanding the economy in a business cycle framework is crucial for forecasting what is likely to happen next. The first step is to appreciate which stage of the business cycle we are in now. Then we can investigate the drivers of the cycle to judge how long this stage might last. We can also look for signs that the stage we are in might be coming to an end and ushering in the next stage. Different drivers are more critical at each stage of the cycle (see table opposite). In the Late Upswing stage the most important things to watch are the path of inflation (which will strongly influence monetary policy), the strength of business investment including any signs of over-investment, and any areas of growing financial fragility from over-leverage or asset bubbles.

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Unfortunately, academic economics downplays business cycles, preferring to use the word fluctuations. The typical textbook does not even look at cycles in any detail until towards the end and then it is usually only a short chapter. In fact many academics don’t believe there is a natural cycle: they believe the economy would grow steadily left to itself, but periodically gets knocked off course by unexpected shocks such as jumps in oil prices or monetary policy mistakes. And these generate a path which looks like a cycle but is really just random fluctuations. 

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Many market participants don’t put much weight on cycles either. This could be the influence of academic economics. Or it may be because many have only seen one or two cycles in their career. With the typical cycle lasting 7-11 years, you have to be over 40 to have seen more than a couple.

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My research convinces me that the economy is not ever in equilibrium, nor is it on an equilibrium growth path. Rather it is always somewhere in a cycle, moving from recession to upswing and back to recession. Most of the impetus for the cycle comes from factors internal to it, as each stage creates the conditions for the next stage. 

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Shocks such as oil price hikes can also play a role, but crucially their effect varies according to where we are in the cycle. As the cycle matures it becomes increasingly vulnerable to a shock, which can tip it into recession. Once in recession, forces act to naturally pull the economy out after some months or a year, often with the help of easier policy. Mostly the cycle is internally generated, with these elements evolving and interacting through time.