Business confidence

What Is Business Confidence?

Business confidence refers to the collective outlook and optimism that businesses hold regarding the current and future state of the economy and their own industry. It is a crucial component of economic indicators and falls under the broader financial category of macroeconomic analysis. When business confidence is high, companies are generally more inclined to expand, invest, and hire, contributing positively to economic growth. Conversely, low business confidence often signals caution, leading to reduced spending and potential contraction in economic activity. Understanding business confidence is vital for policymakers, investors, and analysts seeking to gauge the overall market sentiment and anticipate shifts in the business cycle.

History and Origin

The concept of measuring business sentiment through surveys emerged in the early 20th century as economists and policymakers sought to better understand and predict economic fluctuations. One of the earliest and most influential business surveys is the Purchasing Managers' Index (PMI), which originated in the United States. The Institute for Supply Management (ISM), a non-profit organization, began conducting its manufacturing survey in 1931, making it one of the longest-running economic indicators derived from business sentiment. This survey, now known as the Purchasing Managers' Index, polls executives on various aspects of their operations to gauge economic activity.

Over time, similar surveys and indices were developed globally to capture business confidence across different sectors and regions. For instance, the Organisation for Economic Co-operation and Development (OECD) publishes a Business Confidence Index (BCI) as a standardized confidence indicator, based on opinion surveys in the manufacturing sector to provide insight into future developments.¹⁹ In Europe, the European Commission's Directorate General for Economic and Financial Affairs (DG ECFIN) conducts harmonized business and consumer surveys to gather perceptions and expectations across various sectors, including industry, services, retail trade, and construction.¹⁸ The Conference Board, a global research organization, also began its Measure of CEO Confidence survey in 1976, providing a barometer of the U.S. economy from the perspective of chief executives.¹⁷

Key Takeaways

• Business confidence reflects the optimism or pessimism of businesses about economic conditions and their future prospects.
• It serves as a key leading indicator, often signaling future trends in investment, employment, and overall economic output.
• Various surveys, such as the Purchasing Managers' Index (PMI) and the OECD Business Confidence Index (BCI), measure business confidence.
• High business confidence typically correlates with increased capital spending, hiring, and economic expansion.
• Low business confidence can indicate a slowdown, potentially preceding a recession.

Formula and Calculation

Business confidence indices are typically constructed as a diffusion index, which summarizes the breadth of change in a survey. While the specific methodologies vary by organization, a common approach involves polling businesses on whether conditions are improving, staying the same, or deteriorating.

For example, the Institute for Supply Management (ISM) Manufacturing PMI is a composite index derived from five equally weighted indicators: New Orders, Production, Employment, Supplier Deliveries, and Inventories. For each indicator, the percentage of respondents reporting an improvement is added to half the percentage reporting no change, resulting in a number between 0 and 100. A reading above 50 generally indicates expansion, while a reading below 50 suggests contraction.¹⁶

Similarly, the European Commission's confidence indicators are produced as an arithmetic average of the seasonally adjusted "balances" of answers. A balance is the difference between the percentage of positive and negative responses to specific survey questions.¹⁵ The OECD Business Confidence Index (BCI) is measured as an amplitude-adjusted index, with a long-term average set at 100, where numbers above 100 indicate increased confidence and below 100 indicate pessimism.¹⁴

Interpreting Business Confidence

Interpreting business confidence indicators involves understanding their baseline and historical context. For many indices, a reading above a certain threshold (e.g., 50 for PMI, 100 for OECD BCI) suggests expansion or optimism, while a reading below it indicates contraction or pessimism. The further the reading is from this neutral point, the stronger the sentiment.¹², ¹³

Analysts closely watch the trend of business confidence over several months. A sustained increase in business confidence suggests an improving economic outlook, potentially leading to greater capital investment and job creation. Conversely, a prolonged decline can signal an impending economic slowdown. Policymakers use these indicators to assess the effectiveness of current monetary policy and fiscal policy measures and to anticipate the need for adjustments. For instance, a notable drop in business confidence may prompt central banks to consider lowering interest rates to stimulate economic activity.

Hypothetical Example

Consider "Alpha Manufacturing Co.," a fictional company that regularly participates in a national business confidence survey. In Q1, the survey's overall index for the manufacturing sector registers 60, indicating strong optimism. Alpha Manufacturing, reflecting this trend, decides to upgrade its machinery and expand its production capacity, anticipating higher demand.

By Q2, the survey index drops to 45. This decline in business confidence across the sector signals that many companies are becoming pessimistic about future orders and general economic conditions. Observing this, Alpha Manufacturing postpones its plans for a new product line and becomes more cautious with hiring, opting to maintain current inventory levels rather than aggressively increasing them. This scenario illustrates how collective business confidence influences individual company decisions regarding production, investment, and employment, thereby impacting the broader economy.

Practical Applications

Business confidence indicators are widely used in various facets of finance and economics:

• Economic Forecasting: They serve as valuable leading indicators for future economic activity, often preceding changes in official statistics such as Gross Domestic Product (GDP), industrial production, and employment.¹⁰, ¹¹ Businesses and economists analyze these reports to anticipate shifts in the business cycle.
• Investment Decisions: Investors monitor business confidence to inform their portfolio strategies. High confidence may suggest a favorable environment for equities, while declining confidence could signal a need for more defensive assets.
• Monetary and Fiscal Policy: Central banks and governments consider business confidence when formulating monetary policy and fiscal policy. For example, if business confidence plummets, policymakers might consider stimulus measures to prevent a downturn. The Federal Reserve, for instance, has noted that confidence plays a vital role in economic fluctuations and the transmission of uncertainty shocks.⁸, ⁹
• Sectoral Analysis: Many confidence surveys provide data broken down by industry, allowing for granular analysis of specific sectors like manufacturing, services, or construction. This helps businesses and analysts understand particular industry trends and potential supply chain disruptions.
• Corporate Planning: Individual businesses use these indicators to benchmark their own outlook against the broader market. A company with significantly lower confidence than its peers might reassess its strategies, while one with higher confidence might pursue more aggressive growth. For instance, The Conference Board's CEO Confidence measure helps chief executives gauge the health of the U.S. economy and plan future actions in areas like capital spending and employment.⁷

Limitations and Criticisms

While highly regarded, business confidence indicators have certain limitations and criticisms:

• Subjectivity and Sentiment: As survey-based measures, they are inherently subjective. The results reflect perceptions and expectations, which can be influenced by recent news events, media coverage, or even behavioral biases rather than purely objective economic fundamentals.⁶
• Lagged Data: Although considered leading indicators for economic trends, the surveys themselves are conducted and compiled over a specific period, meaning the published results always reflect sentiment from a slightly earlier point in time.
• Limited Scope: Some surveys, like earlier versions of the OECD BCI, primarily focus on the manufacturing sector, potentially not fully capturing the sentiment across the entire economy, particularly the growing services sector.⁵
• Correlation vs. Causation: While business confidence often correlates with economic activity, establishing a direct causal link can be complex. Some research suggests that while confidence indicators provide important information, their ability to predict economic development, especially sustainability, has limitations.³, ⁴ Economic factors like inflation or interest rates can influence confidence, and vice versa.²
• Volatility: Confidence indicators can be volatile month-to-month, especially in response to significant political or economic events. This volatility can make it challenging to discern a clear underlying trend, requiring careful analysis over a longer period.

Business Confidence vs. Consumer Confidence

Business confidence and consumer confidence are both vital gauges of economic sentiment, but they reflect the perspectives of different economic actors. Business confidence measures the optimism of companies regarding their sales, production, investment, and hiring plans. It is particularly relevant for understanding corporate spending and the supply side of the economy. Surveys capturing business confidence typically poll executives and purchasing managers.

In contrast, consumer confidence reflects the optimism of households regarding their personal financial situations, job prospects, and overall economic conditions. It is crucial for anticipating consumer spending, which forms a significant portion of aggregate demand in an economy. Surveys for consumer confidence, such as The Conference Board Consumer Confidence Index, poll individuals on their current assessments and future expectations.¹ While both types of confidence indicators influence and are influenced by the overall economic environment, business confidence tends to drive production and investment decisions, while consumer confidence drives consumption and savings behavior.

FAQs

What causes business confidence to change?

Business confidence can change due to a variety of factors, including shifts in government policy (e.g., fiscal policy or trade agreements), changes in consumer demand, raw material costs, labor market conditions, global economic events, geopolitical stability, and technological advancements. Expectations about future inflation and interest rates also play a significant role.

How is business confidence typically measured?

Business confidence is typically measured through monthly or quarterly surveys conducted by government agencies, research organizations, or private firms. These surveys ask executives and managers about various aspects of their current business conditions and their expectations for the near future, such as new orders, production, employment, and inventories. The responses are then compiled into a composite index.

Why is business confidence important for the economy?

Business confidence is important because it influences key economic decisions. When confidence is high, businesses are more likely to invest in new equipment, expand facilities, and hire more workers, which stimulates economic growth and reduces unemployment. Low confidence can lead to reduced investment and activity, potentially contributing to an recession.

Does high business confidence always lead to economic growth?

Not always. While high business confidence generally correlates with positive economic outcomes, it is not a guarantee. Other factors, such as real economic shocks, unforeseen global events, or significant policy changes, can counteract positive sentiment. Furthermore, confidence can sometimes be overly optimistic or pessimistic, leading to imbalances that may eventually correct.

What is the difference between an opinion survey and a hard economic data point?

An opinion survey, like those measuring business confidence, captures subjective perceptions, expectations, and intentions of individuals or businesses. Hard economic data, such as GDP, unemployment rates, or industrial production figures, are objective, measurable statistics that reflect actual economic activity. While opinion surveys can be timely leading indicators, hard data provides concrete evidence of past or current performance.