Business Cycle Patterns: What´s ‘different’ in this cycle?

First, regarding the slow, barely visible, recovery, the most popular ‘explanation’ is that´s what is to be expected following a financial crisis. Implicit is the view that the outstanding depth of the recession (dubbed “Great”) is also that it was a direct result of the financial (subprime) crisis.

So cause and consequence are related and in this tale the Fed (Bernanke) is the ‘savior’, acting promptly and forcefully to avoid a second “Great Depression”.

In my version of the story the financial crisis plays at most a ‘supporting role’, with the main ‘actor’ being the disastrous conduct of monetary by the Federal Reserve, directly affecting both the depth of the recession and the anemic recovery.

The Fed has close control of aggregate nominal spending (NGDP) and it is NGDP that drives the economy, i.e. real output, employment and prices. Over time real output is determined by structural (supply-side) factors. In the short run, nominal rigidities (of prices and wages) allow monetary policy to have a stabilizing role. A positive supply (productivity) shock, for example, will increase real growth and reduce the rate of price increase (inflation). If the Fed keeps spending growing on an ‘even keel’ the adjustment process will be ‘smooth’. The same happens in the case of a negative supply (oil price) shock. The adjustment will be smoother (and less painful) if the Fed, again, keeps spending growing on an ‘even keel’.

By controlling aggregate nominal spending along a stable level growth path the Fed also minimizes the occurrences of nominal (demand) shocks. These are caused by the Fed when it reduces nominal growth expectations. This will happen, for example, when the Fed sees a risk of rising inflation and signals that monetary policy will be tightened.

When Bernanke took over the Fed´s helm in January 2006, everyone knew that the Fed would become a de facto (officially after January 2012) inflation targeting central bank. In a sense, Bernanke was the ‘right guy’ at the ‘wrong time’. Just as he was sworn in, house prices peaked and began to decline. For the next two years declining house prices and financial sector problems did not have a marked effect on the economy because nominal spending growth did not deviate too much from trend.

The oil price increase that began in early 2007 quickly began to ‘worry’ the FOMC. By early 2008 the FOMC was jittery. The FOMC meetings signaled very clearly that the Fed would constrain nominal spending. Naturally nominal spending expectations began to decrease more intensively before tanking in the third quarter of 2008. A weakened financial sector will have difficulty ‘surviving’ a nominal spending crash. So the crisis came to pass…In this sense, it was a monetary policy driven crisis.

I want to ‘back-up’ my story with some illustrations of the present and the previous four cycles (1973, 1981, 1990, 2001).

The first panel shows the behavior of NGDP (nominal spending) from the cycle peak to 17 quarters after the cycle trough (indicated by 0); the behavior of the ration of wages to NGDP and the behavior of employment.

Cycle Comparison_1

On the left, notice the almost perfect ordering between nominal spending and employment. The only time nominal spending decreases is in the present cycle. Not surprisingly, employment falls the most. The recovery in spending in the present cycle is by far the slowest (despite being the deepest). Employment also shows the slowest recovery.

In the 1990 and 2001 cycle the behavior of NGDP is very similar. Nevertheless, employment recovers significantly faster during the 1990 recovery. Structural labor market factors may be at play here.

In the right hand side we see the workings of sticky wages. The magnitude of the drop in employment during the recession phase is connected to the rise in the wage/NGDP ratio. In the current cycle, the strong rise in the W/NGDP ratio is due to the strong and fast drop in nominal spending, given wage stickiness. In the 1981 cycle, nominal spending did not fall but the deceleration of spending growth was significant (remember Volcker was determined to eradicate inflation). The W/NGDP ratio rises and employment falls.

During the recovery phase, the slow growth in spending in the present cycle is associated with an also slow drop in the W/NGDP ratio (wages are really sticky). Employment recovers meekly. This contrasts with the strong fall in the W/NGDP ratio during the 1981 recovery (COLA clauses became mute, helping reduce stickiness) which is mirrored by the robust employment gains.

As mentioned before, structural factors in the labor market seem to have played a hand in the 2001 cycle.

The next panel shows NGDP and the behavior of real output (RGDP) and prices (PCE-Core) during the different business cycles.

Cycle Comparison_2

The 1973 cycle happened smack in the middle of the “Great Inflation”. The high nominal spending growth (too ‘easy’ monetary policy) translated directly into a high path of prices (high/rising inflation). Lower nominal spending growth in the 1981 cycle was associated with a higher path of RGDP and a lower path of prices.

The Volcker ‘war on inflation’ gave rise to the “Great Moderation”, a period that extends to 2007 and that is characterized by overall nominal stability (real growth close to ‘potential’ and falling/low inflation).

Note how the overall nominal stability is lost in the present cycle. The price path is very similar to the 2001 price path, so the much lower RGDP path directly reflects the low nominal spending path. With a much lower spending path and RGDP path, no wonder the employment path is also so much lower (overshadowing any structural factors in the labor market).

So, the big difference in the present cycle relative to the others can be found in the behavior of monetary policy. Likely because of Bernanke´s inflation targeting phobia, the more encompassing overall nominal stability, the hallmark of the Greenspan Fed, was ditched!

The Fed can keep inflation on target. So it is clear the Fed could, if it wanted, keep nominal spending on target. If the Fed had an NGDP level target the “Great Recession” would have at most been a “run-of-the-mill” recession.


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