The Great Moderation Is Dead, Revisited

Oct 26, 2012 – In what has been one of the greatest signs of economic and financial hubris over the last quarter century was the argument that the business cycle had been conquered by central bankers and the modern economy. The idea that recessions were a thing of the past and that economic volatility since 1980 through 2007 had been greatly reduced lead to economists calling the period “The Great Moderation.”

You can visually see “The Great Moderation” by looking at the reduction in amplitude for swings in overall economic growth (Gross Domestic Product, GDP) and employment below which shows the period between 1982 to 2007 experiencing more moderate swings in peaks and troughs.

Source: Bloomberg

Current Fed Chairman Ben Bernanke even commented on the topic in a speech he made back in 2004 in which he gave a great deal of credit to the moderated economic volatility to the central bank as his comments below show (emphasis added).

Remarks by Governor Ben S. Bernanke
At the meetings of the Eastern Economic Association, Washington, DC
February 20, 2004

The Great Moderation


The Great Moderation, the substantial decline in macroeconomic volatility over the past twenty years, is a striking economic development. Whether the dominant cause of the Great Moderation is structural change, improved monetary policy, or simply good luck is an important question about which no consensus has yet formed. I have argued today that improved monetary policy has likely made an important contribution not only to the reduced volatility of inflation (which is not particularly controversial) but to the reduced volatility of output as well

I have put my case for better monetary policy rather forcefully today, because I think it likely that the policy explanation for the Great Moderation deserves more credit than it has received in the literature.

While Fed Chairman Bernanke gave central bankers a big pat on the back for the moderation of the business cycle since 1980, I argued previously that it was a massive explosion in debt that moderated economic contractions and extended economic expansions. Perhaps the single most important chart that supports this case was a figure I presented in an earlier article which is shown below.

Source: Federal Reserve, BEA

I believe that we are returning back to the normal business cycle of greater economic volatility and that the average growth rates in both overall economic output (Gross Domestic Product, GDP) and employment will be subdued relative to prior periods of the last half century. Post WWII through 1982, on average economic contractions lasted just under a year (11 months) while expansions lasted roughly 4 years (49 months). However, in the credit boom that began in 1982 with the secular decline in interest rates, contractions moderated from 11 months to 8 months in length while the big change occurred with expansions that nearly doubled in duration from 49 months to 95 months.

Source: NBER

With consumers deleveraging and weak employment we are not likely to see a credit boom to sustain average expansions that last nearly 8 years in length. Instead we are likely returning to a normal business cycle which peaks roughly 4 years after a recessionary trough. If that is the case then there is a great deal of concern ahead as 2013 will mark the fourth year of the current expansion and may now be running on fumes.

Investors need to be on the lookout for recessionary warnings as the average stock market decline during a recession is more than 30%. While I disagree with the Economic Cycle Research Institute (ECRI) and other prominent money managers that maintain we are currently in recession, I will be monitoring economic breadth intently ahead and perhaps my favorite indicator for economic breadth comes from the Philadelphia Fed State Coincident data. What the Philadelphia Fed does is measure coincident data such as personal income, employment, manufacturing and retail sales, and industrial production for each of the 50 states. One can then look at how robust an expansion is by seeing how many states are participating in the expansion. Strong expansions have 80% or more states expanding while declines below that 80% threshold show a recovery that is losing steam.

The Philadelphia Fed’s 1-Month Diffusion Index for the State Coincident data shows that a recession typically begins when there is an equal number of states expanding and contracting to give a 0% reading on the diffusion index. Recessions typically end when the number moves into positive territory after previously falling into negative territory, with the zero line essentially serving as bookends to recessions. While we received some yellow flags in both 2011 and this year with declines to sub 25% levels we never breached 0% and currently we are improving to a 68% reading for September data.

Source: Bloomberg

In the months ahead if we fall back below 50% I would consider that a red flag given this is the fourth year of an average business cycle expansion prior to "The Great Moderation." Readings below 0% will be the call to batten down the hatches. With that said, from the figure above, we are currently not in recessionary territory and are still improving from weakness felt this summer. For now, it appears the current expansion will leave into its 4th year as a recession in 2012 looks incredibly unlikely.

Source: PFS Group

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