Defining Business Cycle to Monetary Policy Purposes

Monetary policymakers try to identify turning points in the economy. The important of detect turning points in business cycles is related primarily to the goal of detect on time critical developments on the output gap –actual GDP minus Potential GDP. An expansionary cycle phase increases the risk of upward price pressures given the level production in the economy above its potential. On the other hand, a recessionary environment, with a output below of potential level, causes less probabilities of high inflation, allowing the possibility to ease credit conditions to stimulate aggregate demand, to induce the economy to get in track to its potential level.

However, business cycle and its components (mainly: turning points), are unobservable in the short run by many reasons, mainly: lag of publishing the data, data revisions, measurement errors, fails in the design of the collecting of data ad hoc of the economic phenomena, and other methodology problems.

According to the according to the classical definition business cycle is:

"Business cycles are a type of fluctuation found in the aggregate economic activity of nations that organize their work mainly in business enterprises: a cycle consists of expansions occurring at about the same time in many economic activities, followed by similarly general recessions, contractions and revivals which merge in the expansion phase of the next cycle; this sequence of changes is recurrent but not periodic; in duration business cycles vary from more than one year to ten or twelve years; they are not divisible into shorter cycles of similar character with amplitudes approximately their own". (Burns and Mitchell, 1946, p. 3)

This definition justify why classically the business cycle is defined as two nevative variations of quarterly GDP. However, in United States, the NBER's Business Cycle Dating Committee employs other definition as the follow:

"A recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in production, employment, real income, and other indicators. A recession begins when the economy reaches a peak of activity and ends when the economy reaches its trough. Between trough and peak, the economy is in an expansion". (http://www.nber.org/cycles/dec2008.html).

This definition explicitly cite production, employment, income as key indicators. In fact labor market indicators was the main point to declare that recession in US started in December 2007:

“The committee views the payroll employment measure, which is based on a large survey of employers, as the most reliable comprehensive estimate of employment. This series reached a peak in December 2007 and has declined every month since then”. Even when “The product-side estimates fell slightly in 2007Q4, rose slightly in 2008Q1, rose again in 2008Q2, and fell slightly in 2008Q3” (http://www.nber.org/cycles/dec2008.html)

We didn’t see a two consecutive decline on quarterly GDP as classical definition say. The criteria employs to judge the phases of the business cycles and turning points is discretional, according to the goals of the office, committee or analyst in charge. Labor market conditions is a indicator not necessarily coincident to the business cycle, has been usual “jobless recovery” phases throughout the world. However, given the human nature of economic activity, as an activity where we mostly gain from income by selling our work in a job, the NBER's Business Cycle Dating Committee put more emphasis on labor markets as their importance rather than its coincidence with the business cycle.

That is the reason why a central bank must carefully employ and design a different criteria to detect turning points and define economic phases, maybe a little bit more near to the classical definition of two consecutive of quarterly fall on GDP, a definition to infer timely about the output gap to take timely monetary actions. These means take employment as one important indicator but it would be not the most suitable indicator, as it does according to NBER committee, because it could not be adequately synchronized to the business cycle, sending miss-signs of the direction of the economy.

Mexican economy could face circumstances where the recovery gain momentum even when employment doesn’t show recovery (another cycle of jobless recovery as firms delay hiring process in early stages of economic recovery). That could affect the effective of monetary policy considering the lagged impact of monetary policy in the economy.