Using metrics provided by FRED to identify the business cycle

Question

I am interested to see how the "business cycle" is associated with our firms sales. The hope is that if we can show that our sales line up with the business cycle then we can make decisions accordingly.

If, for example, our sales have historically been hurt when in a recession, then it would be good to keep a pulse on this macroeconomic factor to know when we should increase or decrease spend.

The problem is that I am not sure how to identify the business cycle. I am not an economist by trade. I have been pulling some data from FRED, but I am not sure which indicators to look at for identifying the business cycle. I have two hypothesis:

1. Unemployment. Record low unemployment may be an indicator for a recession. I think that this is getting slightly more convoluted these days as I think that employment takes into account people with either W-2s or 1099s, but as the people who rely solely on 1099s increase I think that the meaning of unemployment changes. Something like a gig economy effect. This makes this metric maybe less reliable than it used to be as the gig economy becomes a reality.

2. % difference in real vs potential gdp This metric seems to ask, 'Is real gdp exceeding potential gdp'. I don't understand how it is possible to have gdp exceed potential gdp, but I am not an economist so I don't need to worry about that ;). This does seem like an okay metric to represent the business cycle since it seems to quantify if real gdp is too high.

Edit

My above thoughts simplify to the following question:

If someone asked you to show him/her the the business cycle, what graph --- on FRED --- would you show that person?

Answer 1

Identifying business cycles or short/medium fluctuations of an economy can be quite hard.

In business cycle theory it's pretty common to use the Hodrick-Prescott-Filter to identify short term (cyclical) fluctuations in gdp. The Hodrick-Precsott-Filter is in principle a bandpass filter that separates short term and long term fluctuations from each other. At the end the trend (or potential) gdp is like a line drawn by hand through the raw data (at least this is what Hodrick and Prescott are saying). But the Hodrick-Prescott filter itself and the theory behind it is not undisputed and in most cases people just use the filter because other people do (at least thats my experience and I made this mistake myself countless times).

In general, there are other filters you could use that are often better than the Hodrick-PRescott Filter. For example the Baxter-King Filter, different kinds of Kalman-Filters or just a moving average. But if you don't want to spend a lot of time thinking about these things I would suggest some different methods/indicators.

GDP: A basic rule of thumb for a recession is a decline in real GDP for more than two quarters; this is a not so official procedure used by the NBER (http://nber.org/cycles/recessions_faq.html). Another method you could use would be this graph: https://fred.stlouisfed.org/series/GDPC1#0

Unemployment: In my opinion unemployment is not so good because it often increases after a recession for some months while.

Capital utilization:
In my opinion one of the best indicators: https://fred.stlouisfed.org/series/TCU

Smoothed U.S. Recession Probabilities https://fred.stlouisfed.org/series/RECPROUSM156N

Maybe I will increase the list in the next days.

Answer 2

Prediction is difficult, especially about the future. (Berra, Goldwyn, Bohr et al.)

The problem with noting that recessions often occur immediately after low periods of unemployment is that you do not now at the time that it was a low rather than a pause.

There are several occasions when unemployment appeared to stop falling but which were not immediately followed by recession. Consider for example 1963, 1967, 1976, 1985, 1995, 2003 in your first linked FRED chart. Once unemployment shoots up, you are probably in a recession and so do not need to predict

Potential GDP is even harder to quantify meaningfully, as it is based on "the output the economy would produce with a high rate of use of its capital and labor resources." So if unemployment falls below levels previously thought typical before leading to inflation and high interest rates, this can lead to a suggestion that GDP is exceeding its potential; unemployment is certainly now well below what the Federal Reserve recently thought was possible. But this may merely mean that the judgement of what was typical was wrong: interest rates are still historically low, and inflation is not accelerating, while the fiscal position is loosening

Looking at your second linked FRED chart, actual GDP exceeding potential GDP can happen several years before a recession, or immediately before, or even not happen at all. So it is not a precise signal

So you may be correct that a recession is looming, or you may be wrong and it is several years away. Welcome to macroeconomic forecasting