“No one knows for sure what caused the Great Moderation. Some had credited increased sophistication of financial markets and the wisdom of the Federal Reserve Board... Well, folks, it turns out the great moderation was something of a fluke.” – Robert Reich, 15 July 2008
Is the Great Moderation over?
With the most severe recession since WWII coming to a close, there have been many claims that the Great Recession marks the end of the Great Moderation, amidst some derision of macroeconomists for studying a phenomenon that was, ex post, “something of a fluke” or “good luck.”
This dramatic end to the Great Moderation is viewed as particularly damning for “good policy” explanations of the Great Moderation based on the notion that – with the ascent of Federal Reserve Chairman Paul Volcker – monetary policy became more aggressive on inflation in terms of responding to inflationary shocks and reducing the level of inflation (Clarida, Gali, and Gertler 2000, Boivin and Giannoni 2006, Lubik and Schorfheide 2004, and Coibion and Gorodnichenko, 2009).
A key question is: “How can one reconcile the end of the Great Moderation with the absence of a clear change in monetary policy under the latter view?”
A greatly exaggerated death
In our view, the answer is that the current recession will not mark the end of the Great Moderation. Instead, we are experiencing a particularly severe business cycle that nonetheless pales in comparison to the volatility experienced in the 1970s. To illustrate this, Figure 1 plots the rolling standard deviation of annualised quarterly real GDP growth over a five-year horizon with equal and geometrically declining weights for past observations.1
One can clearly identify the Great Moderation, associated with a reduction in volatility of approximately 50%, from the highs in the late 1970s to the lows of the 1990s. With five-year rolling measures of volatility, each of the recessions since the Great Moderation has been associated with an uptick in measured volatility, with the current recession obviously leading to a bigger rise in volatility. Nonetheless, current levels of volatility as well as expected future levels of volatility based on forecasts (as of December 2009) from Macroeconomic Advisors and the Survey of Professional Forecasters from the Philadelphia Federal Reserve remain well below levels reached in the 1970s.
It is particularly apparent that the volatility has passed its peak when we use geometric discounting which downplays distant periods in general and the transitory volatility blip in 2009. Furthermore, even the most pessimistic forecasts made by professional forecasters point to levels of volatility that are simply not comparable in magnitude to levels reached in the 1970s.
Figure 1. Standard deviation of real GDP growth rate (top chart: equal weights, bottom chart: geometrically declining weights)
Neither “good luck” nor “good policy” explanations of the Great Moderation imply that recessions will not occur, not even that severe recessions cannot occur. However these two explanations have dramatically different predictions about whether the US economy will continue to enjoy the stability observed from the 1980s until the recent past. According to the “good luck” theory, there is little reason to expect stability in coming years as we have simply run out of luck. In contrast, the “good policy” theory suggests that we should not expect a considerably larger volatility in the future as the 1970s taught macroeconomists and policymakers a useful lesson in how to stabilise the economy in response to shocks. Consistent with the latter theory, Figure 1 illustrates that the current recession, while clearly severe by historical standards, does not imply a return to the levels of volatility observed in the 1970s. Most likely, the current episode will be remembered as a violent storm in otherwise temperate times.
1 With geometric discounting, the weights are computed as follows. The current period t has weight 1, the previous period t-1 has weight δ, period t-2 has weight δ2, and so on until the end of the window that has weight δT-19. Here we set δ=0.9 which appears to strike a balance between minimising short term noise and downweighting distant observations.
Clarida, Richard, Jordi Galí, and Mark Gertler (2000), “Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory.” Quarterly Journal of Economics, 115(1): 147-180.
Lubik, Thomas A. and Frank Schorfheide (2004), “Testing for Indeterminacy: An Application to U.S. Monetary Policy.” American Economic Review, 94(1): 190-217.
Boivin, Jean and Marc Giannoni (2006), “Has Monetary Policy Become More Effective?” Review of Economics and Statistics, 88(3): 445-462.
Coibion, Olivier and Yuriy Gorodnichenko (2009), “Monetary Policy, Trend Inflation and the Great Moderation: An Alternative Interpretation,” American Economic Review, forthcoming.