Learning the Significance of Key Economic Indicators
- The foundations of broad macroeconomic principles
- Why GDP and the business cycle matter to financial markets
GDP at a glance
GDP is a key measure of economic activity, including the value of all products and services produced by a country during a specific period.
GDP serves as an indicator of a country’s general economic health. Changes in GDP over time (rate of GDP growth) signal how quickly or slowly an economy is growing. A negative GDP growth reading for two consecutive quarters may be considered a recession.
GDP and the business cycle
The business cycle, also known as the economic cycle, describes movements and fluctuations in the economy over time through a pattern of expansion and contraction, with peaks and troughs in between. The two main measures of the business cycle are GDP growth and unemployment.
A basic understanding of the two main phases of the cycle – expansion and contraction – may be useful for understanding how employment, consumer behavior, monetary policy and business productivity interconnect.
Business cycle phases
Expansion
In an expanding economy, employment levels rise, encouraging greater consumer spending, which makes up two-thirds of U.S. GDP. During the expansionary phase, demand for goods and services outpaces existing supply, often leading to price increases and higher GDP growth.
The expansion phase is accompanied by rising inflation. At this point, central bank policymakers often move to curb spending by consumers and businesses by raising interest rates.
Contraction
In a contracting economy, employment levels typically decline along with consumer confidence and spending, alongside falling prices and GDP.
The contraction phase culminates in a trough, prompting central banks to lower interest rates to promote economic recovery. The cycle then moves into the expansion phase once again.
GDP and financial markets
There is a strong link between GDP and financial market performance. Equity markets tend to rise when the economic outlook is favorable, as shown by strong corporate earnings, consumer confidence and GDP growth. On the other hand, equity markets may decline if the outlook for the economy is weak or uncertain, as companies may be less likely to deliver strong earnings, and investors may become more cautious.
For fixed income markets, the relationship between the business cycle and bonds is more complex. Bond investors pay attention to interest rates and inflation as key indicators of an expanding or contracting economy.
In an expansionary environment when the rate of GDP growth is strong, consumer spending increases, heightening the potential for rising inflation. If monetary policymakers become concerned the economy is in danger of overheating, they may elect to raise interest rates. And, because of the inverse relationship between interest rates and bonds, this can put downward pressure on bond prices.
In a contracting economy, when demand softens, inflation may decline and the central bank may lower its policy interest rates. In response, bond prices tend to go up.
There are a host of other key economic indicators closely watched by economists, policymakers and investors for hints on the direction and relative strength of the global economy and financial markets. These include industrial production, consumer sentiment, international trade, and various labor market metrics.