Volatility has disappeared from the economy and markets. That could be a
problem
May 24th 2014 | WASHINGTON, DC
A DECADE ago, the business cycle was an endangered species. Recessions in the
rich world had become rare, shallow and short; inflation was predictably low
and boring. Economists dubbed this the Great Moderation and gave credit for
it to deft macroeconomic management by central banks. Such talk, naturally,
ended abruptly with the financial crisis.
But obituaries of the Great Moderation may have been premature. Since America
emerged from recession in 2009, its growth, although low, has been as stable as
during the Great Moderation s heyday, from the early 1980s to 2007, judging by
the volatility of quarterly gross domestic product (see chart) and monthly job
creation. That, in turn, has pushed the gyrations of stock and bond prices to
their lowest levels since 2007. The trend is less pronounced outside America,
but economists at Goldman Sachs nonetheless find that pre-crisis levels of
tranquillity have returned in Germany, Japan and Britain.
It is the absolute level of growth that has been disappointing. In America it
has averaged a little over 2% for the past four years, and fell almost to zero
in the first quarter of this year. This looks like a temporary setback due to
bad weather, but the Federal Reserve s hopes for an acceleration to nearly 3%
seem likely to be dashed once again. The euro zone, meanwhile, grew by just
0.8% in the first quarter (on an annualised basis), half the pace economists
had predicted, but perfectly in line with the average of the previous nine
months.
Strategists at Soci t G n rale, a bank, note that since 1969 the S&P 500 has
dropped by 1% or more 27 days a year on average; in the past 12 months, there
have been only 19 such days. This docility has increased investors appetite
for both stocks and bonds, which helps explain why the stockmarket hovers near
record highs and yields on Treasuries near historic lows.
Many of the causes suggested for the original moderation do not apply to its
revival. Just-in-time inventory management had enabled firms to adjust stocks
more judiciously. Instead of rising and falling together, inventories and sales
moved in opposite directions, tamping down a once significant source of swings
in output. But Jason Furman, Barack Obama s chief economist, notes that since
2008 inventories and sales have been moving in tandem again. Another theory was
that easier access to credit, such as through cash-out refinancing of
mortgages, had made it easier for consumers to keep spending even when their
incomes dipped. But since 2008, though credit-card debt and cash-out
refinancing have plummeted, consumption has remained stable.
A final theory invoked good luck: the world had endured fewer shocks since the
early 1980s. But Mr Furman points to several shocks since 2008, including the
jump in oil prices when Libya s exports were disrupted in 2011.
That leaves monetary policy. In a paper published in 2001, Olivier Blanchard
and John Simon noted that both the level and volatility of inflation fell
sharply in the 1980s. Stable inflation meant the Fed was less likely to tighten
in the face of supply shocks such as higher oil prices and quicker to ease when
recession threatened.
This seems to explain why, despite the Fed s failure to prevent the Great
Recession, the Great Moderation endures. Although the prices of energy and food
have bounced up and down since 2008, inflation expectations and, until
recently, core inflation have fluctuated around 2%, giving the Fed no reason to
raise interest rates. Of course, with short-term interest rates stuck at zero,
the Fed has also found it harder to stimulate the economy to combat high
unemployment. But it has developed substitutes: quantitative easing (the
purchase of bonds with newly created money) and forward guidance (promises to
keep rates at zero for a long time) have held down long-term rates. This has
provided some spur to spending and taken much of the guesswork out of
predicting interest rates, which explains why bond yields are both so low and
so stable. Similarly, the European Central Bank s promise in 2012 to do
whatever it takes to save the euro has brought peripheral European bond yields
down dramatically.
This also points to a dark side to the moderation. Hyman Minsky, an economist
who died in 1996, argued that long periods of stability are ultimately
destabilising. When assets are less volatile, buying them with borrowed money
seems safer. Financial innovation exploits the demand for leverage with
products like subprime mortgages. This briefly enhances stability, by enabling
consumers to keep spending even when their incomes take a hit. But the build-up
of debt raises the risk of a far more violent crisis and recession especially
if, as now, there is little room for central banks to cut interest rates. Thus
the deviation of annual growth from its long-run average is close to historic
lows, Mr Furman notes, but the deviation of the growth of the past decade,
which takes in the financial crisis, is near historic highs.
The big question is whether the return of the Great Moderation has also
prompted a return of the sort of risk-taking that produced the crisis. There
are troubling signs. Issuance of poorly-rated junk bonds has risen sharply,
as have loans to already highly indebted firms; former pariahs like Greece can
now borrow at single-digit rates. Charlie Himmelberg, an author of Goldman s
report, considers the appetite for leveraged assets rational, since the Great
Moderation makes borrowing safer. Any threat of a systemic crisis is far off,
he says, because new regulations have made it much harder for banks and
investors to lever themselves. But even he concedes, Eventually, this will
lead to no good. If leverage wants to come back to the system, it just does.