Profitability in Business Cycle Theory and Forecasting

Abstract

Given the important connections among profitability, investment, and economic activity, a profitability indicator can be used to assess where the economy is in the business cycle. Rising profitability suggests that the economy is on a secular growth path, while a peak or fall in profitability suggests that growth is slowing and the economy is headed for recession. One measure of profitability is to divide total business sector profit by total wages paid to labor. Let this variable be called the PW ratio.

This paper's research shows that the PW ratio leads recessions, and that it takes two to six quarters of decline in PW before the onset of recession. PW clearly peaks in stage three of the business cycle. The evidence demonstrates that the PW ratio compares favorably with other indicators used by forecasters. The paper concludes that wages are not responsible for squeezing profits until stage seven on average, and fluctuations in profit over the cycle exceed that of wages and the gap grows in late expansion.