The Cycles in Economy

Economic cycles are successive periods during which the economic activity is more or less good. The evolution of economic activity is called economic situation. The growth of the economy is not continuous. There are 4 phases in an economic cycle:

- Rally : It is a reversal point between recession and growth phases. By all means economy fights to get out of the crisis and we can see many restructurations. The government tries then to give a growth relay by investing massively in order to find again some growth and bring confidence back. Little by little growth comes back and a "virtuous cycle" sets up.

- Expansion : It is a prosperity phase. All indicators are green and we can see an increase in production, salaries, benefits and consumption. Private investments are then very strong, economic actors wanting to increase their production capacities so they can respond to a growing demand.

- Overheat : It is a reversal point between the growth and recession phases. Indeed, as expansion develops, inflation appears because there is more and more currency circulating (salary increases, interest rates still low at the start of the expansion phase). We will then see a general price increase which will lead to a decrease of consumption and thus also a decrease in investments. As industrials have to get rid of more important inventories, they will try little by little to diminish their production and lower their prices so inventories can be sold. The start of the crisis is then very near.

- Recession : The overheat phase has brought about massive lay-offs which in turn has an important impact over consumption. Salaries are frozen and household discontent grows up. Then a confidence crisis installs itself at every level. Indeed, some of the economic actors (the less solid) disappear and there is a sort of distrust among them. On the interbank market, this translates to a dryness. Banks do not dare to make loans to one another and households consume very little, by fear of the crisis. Consumption being diminished, businesses keep on adapting their production level to that consumption and then a "vicious cycle" begins.

This is what we can call sectoral rotation. For example, when we enter the rally phase, it is better to invest in transportation, automobile and entertainment sectors so we can get a maximum profit from the economic situation.

The link between the Economic cycle and Interest rates

Economic cycles are then a succession of situational phases and to each of them there is a very precise associated configuration of interest rates (levels and structures).

This way we can observe that the rally of the economic activity happens generally in a situation where interest rates are quite low and with an ascending rate curve. Low interest rates are paramount to the rally, they allow to inject dynamism to investments (because of the low cost of the credits) by injecting liquidities massively inside the financial circuit. The rate curve has to be ascending which shows a regained confidence in the future.

In the expansion phase, interest rates partly increase so to limit inflation created by growth. At the same time, the rate curve is going to flatten (less spread between short rates and long rates) which shows a distrust in regard to a continued growth.

When we reach the overheat phase, we can see a reversal of the rate curve which is now decreasing. Short rates will remain high but the fall of long rates will reverse the direction of the rate curve. This means that the economic actors are not confident about future. Then, little by little, short rates will follow the descent of long rates seeking to recover the growth of the previous phase.

Finally, recession phase comes about and rates are at their lowest in order to re-impulse the economic activities. Lower short rates show a confidence close to none between economic actors. Short rates will go on falling until the rate curve becomes totally flat. The confidence crisis is then very important. Indeed, the actors estimate that lending money short term becomes as risky as lending money long term. Then, little by little the rate curve will begin to rise and get bullish again. It is a new start of the rally phase.

Different economic cycles

1 – Short cycles
- KITCHIN cycles : Kitchin is an American economist who estimates that an economic cycle lasts about 40 months. Stocks variation explains the transition from growth to recession. Indeed, in the expansion phase, stocks rise considerably, as businesses want to match the growing demand. This rise on stocks is then caused by an increase of production capacities which are going soon to become greater than demand and then important stocks will be created. After this, businesses will slowly anticipate or notice that economic activity is slowing and the inventory liquidation will then start. This is the beginning of the recession phase.

- JUGLAR cycles: Juglar is a French economist who estimates that an economic cycle lasts between 6 and 11 years. For him, the evolution of the economic situation explains itself through the evolution of investments. In the expansion phase, investments are strong because of interest rates that are still low. Overheat period corresponds to an over-investment period. Then, as interest rates grow to contain inflation, the credit demand will slowly reduce and investments will then become less important. At that moment the recession phase starts.

2 – Long cycles
- KONDRATIEV cycles: Kondratiev is an economist who estimates that an economic cycle lasts between 30 and 50 years. For him, the expansion phase can only be born from a major innovation which brings about a total revolution of our civilisation, and from which secondary innovations will stem. He speaks about innovation clusters which will generate growth in this way and the creation of new markets and the need of a massive investment. The market will be slowly reaching a saturation phase and we will progressively enter recession.