Business Cycle: Mean Reversion and Trends

The National Bureau of Economic Research publishes U.S. Business Cycle Expansions and Contractions in the economy. During an expansion, economic growth is rising and during a contraction it is slowing or actually falling.

Below is a chart of their idealized expansion and contraction phases. During each phase, different sectors of the economy are expected to do well or poorly. And, you can see what is happening at a peak and what happens afterwards. At a peak, economic data is strongest and news is good. Then it reverses down eventually. At a trough economic data is at its worst and news is bad, then it turns around. You may think about it and consider where the U.S. economy is now if you have an interest in the stage of the business cycle.

NBER Business Cycle

Source: National Bureau of Economic Research

A few concepts to think about.

Does it trend? Yes, it does. A trend is a directional drift over a time frame. The business cycle typically sees drifts up for 4 or 5 years and drifts down for 1 or 2 years. The trends are asymmetric, as you can see in the chart, the upward drifts tend to last longer and progress at a lower rate of change than the faster declining trends down. It seems that economic data, like prices, do trend over time.

Does it mean revert? Yes, while over shorter time frames of 1 year to 5 years we observe trends in the business cycle, when we look over a full business cycle we see that it oscillates up and down. However, the actual meaning of “mean reversion” means that it oscillates around an average, not just oscillates. If the data above has an average, and it necessarily must, then it does oscillate around that average. It’s just that the range up and down may be far away from the average. That is, the peak and trough in the chart above may stray far away from the actual “average” of the data series. Said another way, the business cycle is really volatile when you consider it over its full cycle because of the magnitude in range from high and low.

For those of you following along, you may see how I’m going to tie this in to something else next week…

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