Wealth Manager

Since 1857, the U.S. has endured 32 recessions,
according to the National Bureau of
Economic Research (NBER). The good news
is that, of late, the slumps have been fairly
modest compared with their predecessors.
Economic researchers have dubbed
the trend toward kinder, gentler downturns
the Great Moderation, a reference to
the sharp fall in the volatility of quarterly
changes in gross domestic product (GDP).
The fading of macroeconomic risk dates
to the mid-1980s, when GDP volatility fell
dramatically. Chart 1 shows that quarterly
GDP fluctuations in the early 1980s were
running at standard deviations of roughly
5 to 6, based on rolling cycles composed of
12 quarters. Midway through the decade,
volatility suddenly tumbled. Twenty years
later, business cycle fluctuations, so far,
remain relatively calm.

click to enlarge

Source: U.S. Bureau of Economic Analysis, Wealth Manager

The Great Moderation is visible in absolute
terms, too. Examples include real
(inflation-adjusted) declines in the quarterly
GDP ranging from -0.5 percent to -1.5
percent during the recession of 2001, and -2
percent to -3 percent in the 1990-91 slump.
That compares with quarterly dives of
nearly -8 percent at one point in the early
1980s contraction and a 10 percent-plus
loss in the 1957-1958 downturn.

Business slowdowns are also shorter.
The last two recessions lasted just eight
months, or less than half as long as the
average for all previous recessions going
back to the mid-19th century. Fewer recessions
necessarily translate into longer
expansions. The growth periods leading
up to the last two economic contractions
lasted 92 and 120 months—considerably
longer than the average 33-month expansion
that prevailed from the mid-19th century
through 1981, NBER reports.

Additional evidence that the Great Moderation reflects fundamental economic
change includes measures of labor growth,
wage inflation and industrial output. All
have become notably smoother and less
volatile in recent years relative to history,
reports a 2002 study by the National Bureau
of Economics Research (“Has the
Business Cycle Changed and Why?” by
James. H. Stock and Mark. W. Watson, NBER
Macroeconomics Annual: 2002).

Consider the jobless rate, which has
been swinging in a smaller and lower
band compared to decades past. Between
1948 and 1983, U.S. unemployment varied
from 2.5 percent to more than 10 percent—
a spread of 750 basis points. But in the last
20 years, the jobless rate has fluctuated in
a tighter, lower range of roughly 4.0 percent
to 7.5 percent.

Another striking feature of the Great
Moderation is that the smoother macroeconomic
ride is a global phenomenon
among the developed nations. Echoing
the American experience, GDP volatility
in Europe, Japan and other mature economies
dropped sharply in the 1980s, and
has stayed low ever since.

What’s behind all the calm? Several
theories have been circulating, including
improved inventory management, globalization
and financial innovation that
spreads risk. Another explanation is that
the world economy has just been lucky.
But the view favored in the academic literature
is that central banks have learned a
thing or two about keeping inflation under
control. In turn, the enlightened supervision
over the money supply has fertilized
a strain of economic growth that’s more
stable and enduring.

Central bankers, unsurprisingly, aren’t
shy about taking some of the credit. In a
speech a few years ago, Federal Reserve
Chairman Ben Bernanke (then a Fed governor)
said that “improvements in monetary
policy, though certainly not the
only factor, have probably been an important
source of the Great Moderation.” In
fact, the Great Moderation was directly
preceded by a sharp fall in the rate and
volatility of inflation in the 1980s. A number
of economists see a connection. “By
achieving low and stable inflation, many
analysts argue, monetary policy provides
a favorable environment for economic activity
generally,” advised a 2005 article in
Economic Review, a journal published by the
Kansas City Federal Reserve Bank.

In addition to economic benefits, the
Great Moderation has been cited as a catalyst
for higher valuations in the stock market.
The rise in equity market valuation
in the 1990s and—to a lesser extent—the
2000s is a response to the fall in macroeconomic
risk, says a forthcoming study in The
Review of Financial Studies (“The Declining
Equity Premium: What Role Does Macroeconomic
Risk Play,” by Martin Lettau, et.
al.). The reasoning is that investors accept
a lower prospective equity risk premium
(i.e., prices are higher) when economic risk
declines. As the paper observes, “It would
be surprising if asset prices were not affected
by this fundamental change in the
structure of the macroeconomy.”

Indeed, the U.S. stock market’s priceearnings
ratio as of this past January was
still in the mid-20s, which is generally the
highest in the past 150 years, save for the
bubble peaks of 1929 and 2000, according
to Yale professor Robert Schiller’s Web site
(aida.econ.yale.edu/~shiller). Meanwhile,
long-term interest rates are hovering near
40-year lows.

Now the obvious question: If lower economic
risk rationalizes a lower equity risk
premium, might the reverse apply at some
point? Answering “yes” seems reasonable.
But if GDP volatility scaled its old heights,
last seen in the early 1980s, investors may
demand a higher premium on stocks as
compensation, implying that equity prices
would have to fall and perhaps stay low for
an extended period.

The idea that economic tranquility
eventually gives way to a more perilous
environment isn’t new. Economist Hyman
Minsky, for example, famously observed
that stability is unstable. The seeds of
higher risk are planted in periods of calm,
he advised, because investors pursue
higher risk in good times to the point of
excess. Eventually the cycle turns, risk is
repriced and the lure of easy money is re-
placed by a fear of loss, a reversal that lays
the foundation for the next boom.

On that note, consider that inflation volatility—
a key factor associated with the Great
Moderation—has been rising recently. Chart
2 shows that inflation volatility recently
jumped to levels last seen in the early 1980s,
when economic volatility was much higher.
Is the rise in inflation risk a harbinger of
higher macroeconomic risk, too?

click to enlarge

Source: U.S. Bureau of Economic Analysis, Wealth Manager

The Great Moderation may come under
attack from other corners, warns Robert
Dieli, an economist who heads the consultancy
NoSpinForecast.com. By his
reckoning, much of the smoothing in the
U.S. business cycle is linked with growth
in the foreign outsourcing of the manufacturing
sector, which suffers relatively
volatile boom-bust swings compared
with the calmer services sector that now
dominates the American economy. “In the
old days, recessions were nothing more
than giant inventory cycles,” he explains.
Thanks to the growing use of industrial
capacity in the developing world, “we’ve
been reducing the size and importance of
manufacturing,” Dieli says. That, in turn,
has smoothed the economic cycles.

Along the way, the American economy
has become more entwined with the economies
of China, India and the developing
world generally. The relationship has proven
mutually beneficial so far, although the
short history of the new world order of globalization
only reflects the good times.

A study by the International Monetary
Fund last October noted that last year,
China was the single-biggest contributor
to world growth, followed by India in
second place and the U.S. in third. Indeed,
China’s economy grew more than 11 percent
last year—roughly four-times faster
than that of the U.S. and Euro region.
When growth is robust, it’s easy to overlook
the fact that emerging market economies
are more volatile compared with
the developed world. Upside economic
volatility, after all, pleases everyone. But
the volatility may not moderate when the
cycle turns, as it inevitably must.

The challenge, Dieli says, is that the
increased dependence on emerging
markets hasn’t been stress-tested. The
fear is that a sharp downturn in other
emerging markets may transmit economic
shock into the developed world,
effectively ending the Great Moderation
in the process.

The notion that the emerging markets
have decoupled from the U.S. is just a theory,
of course, and an unproven one. It’s
also a theory on which the Great Moderation’s
fate rests, says Quincy Crosby, chief
investment strategist at The Hartford.
“One of the things we’re going to find out,
over the next year or so,” she predicts, “is
whether the decoupling thesis that would
extend the Great Moderation is a viable
thesis after all.”