The Longest Expansion: A post mortem

According to the NBER´s Business Cycle Dating Committee (BCDC), the expansion that began in June 2009 ended in February 2020, having lasted 128 months, eight months more than the March 1991 – March 2001 expansion.

A comparative analysis of these two long expansions should be useful. I´ll fudge the dates of the 1991 – 2001 expansion, extending it to the end of the next cycle that began in November 2001 and ran through December 2007. The only reason behind this extension is to bring out the importance of a stable level path of NGDP. [Note: The 2001 recession was more like a growth retrenchment, with year-on-year real growth never turning negative. Also, the popular rule of thumb of negative real growth in two successive quarters never materialized].

What separated these two long expansions was the deep and longest post war recession that went on from December 2007 to June 2009 (18 months), being known as the Great Recession.

The main statistics (average over periods) for the two expansions is illustrated below:

The charts are telling. In order to have all the data on a monthly basis, for RGDP & NGDP I use the monthly estimates of those variables (available from January 1992) provided by Macroeconomic Advisers.

The first panel illustrates the behavior of NGDP & RGDP relative to the Great Moderation trend level path.

During the first expansion, both NGDP & RGDP hug close to the trend for much of the time. During 1998-03, there is some instability in NGDP, which is mirrored in RGDP instability. Note that towards the end of the first expansion, although NGDP remains close to trend, RGDP falls significantly below trend. What is going on?

In the second expansion, both NGDP & RGDP remain on a stable level trend path that has been permanently lowered! Later I will examine the ‘transition’ from the high to the low trend path brought about by the Great Recession.

The next panel shows the behavior of prices, both the headline and core versions of the PCE during the two expansions.

During the first expansion, both headline & core prices remained close to the 2% trend line from 1992. Towards the end of this expansion, just as RGDP fell below trend, headline PCE rises above trend. The fall in RGDP growth & rise in inflation implied by those moves is consistent with predictions of the dynamic AS/AD model in the case of a supply (oil price in this case) shock.

During the second expansion, after 2014, when oil prices dropped significantly, headline PCE shifted down and never “recovered”. Core PCE has remained significantly below the 2% trend and has risen at a rate below 2%.

The real and nominal output growth panel (and the price panel) indicate the two expansion phases were characterized by nominal stability. The differing characteristic is that during the recent long expansion, nominal stability followed a lower trend level path with lower growth.

To see how the economy transited from the “high” to the “low” path, I examine the details of the last years of the first expansion.

Those years were marked by oil shocks. As the dynamic AS/AD model tells us, growth slows and inflation rises. The best monetary policy can do in those instances is to keep aggregate nominal spending (NGDP) growth stable along the level trend path.

As the next charts indicate, the results are ‘model consistent’. An oil shock happened:

As predicted by the model, RGDP dropped below trend (real growth fell) and headline PCE shifted up (headline inflation increased):

NGDP, however, remained close to the trend level path, while Core PCE remained below the 2% level path, with core inflation remaining subdued:

The fall in real growth and the rise in headline inflation were the unavoidable consequence of the oil shock. Apparently, both Greenspan during his last year as Fed Chairman and Bernanke during his first two years as Chairman recognized this fact, keeping monetary policy on an ‘even keel’ (evolving close to the trend level path).

After that point, things unraveled. In the first six months of 2008, oil prices climbed an additional 44%. Headline PCE (and inflation) followed suit.

It is rare that a policymaker has the chance of putting his academic knowledge into practice. In 1997, Bernanke, with co-authors Gertler & Watson, published a paper titled:

“Systematic Monetary Policy and the Effects of Oil Price Shocks”. 

In the conclusion, they state:

“Substantively, our results suggest that an important part of the effect of oil price shocks on the economy results not from the change in oil prices, per se, but from the resulting tightening of monetary policy. This finding may help to explain the apparently large effects of oil price changes found by Hamilton and many others.”

At that point, June 2008, monetary policy was “crunched”, with NGDP growth turning negative! No wonder the “effects of the oil price changes became large”, and the recession became “Great”.

The problem, I believe, is that Bernanke´s mind became increasingly focused on inflation. In that same year (1997) he had published a paper (coauthored with Frederick Mishkin) titled:

Inflation Targeting: A New Framework for Monetary Policy?

At that time he was still “flexible”, concluding that IT “construed as a framework for making monetary policy, rather than rigid rule, has a number of advantages…”

It seems “rigidity” set in because eleven years later, concluding the June 2008 FOMC Meeting, Bernanke states:

 “My bottom line is that I think the tail risks on the growth and financial side have moderated. I do think, however, that they remain significant. We cannot ignore them. I’m also becoming concerned about the inflation side, and I think our rhetoric, our statement, and our body language at this point need to reflect that concern. We need to begin to prepare ourselves to respond through policy to the inflation risk; but we need to pick our moment, and we cannot be halfhearted.”

Bernanke´s timing could not be worse because at that point, June 2008, a recovery appeared to be incipient. The rest, as they say, is history. The economy never recovered so the “longest expansion” should never be hailed or become a paradigm.

Appendix:

As the charts below indicate, the US economy has always recovered from deep recessions, even from the “Great Depression”. By recovery, I mean that the economy climbs back to where it should have been if not for the recession/depression. As the bottom right chart indicates, the economy never recovered from the Great Recession.

A big problem is that monetary Policy is “guided” by unobservable variables. The concept of “potential” output, for example, says that if real output is above “potential”, monetary policy should be tightened, because otherwise inflation will rise. Conversely, if real output is below “potential”, monetary policy should be loosened, otherwise inflation will fall.

The fact is that when guided by unobservable variables, monetary policy becomes a “matching game”.

The charts below indicate that when actual output is above the initial estimate of “potential”, “potential” output is systematically revised up until it “matches” actual output. The opposite happens when actual output is below initial estimates of “potential”. Note that in the first case, inflation, instead of rising was falling and remained low thereafter, while in the second case it remained low throughout.

This imparts a tightening bias to monetary policy. In the “longest expansion”, this bias proved “mortal”.

PS: Note that I make no mention of the house price bust or financial troubles, usually pinned as “causes” of the Great Recession. I believe those were minor actors in the “movie”. The “movie was a box-office bust” because monetary policy, the “leading actor”, forgot its lines!

James, the commodities expert

A James Alexander post

The Market Monetarist view on the reasons for the oil price has been discussed by Marcus NunesDemand fell as global growth has slowed, or at least risen a lot less fast than expected. The demand curve shits to the left as in the chart. But there is another element, supply conditions that have worsened the fall.

The oil supply curve is driven by a lot of things, but two of the biggest are simple cost of production and then the politics of production.

Most commodity cost curves show a long flat line where representing all the existing cheap plays, oil is no exception. And then the curve rises more or less quickly as unconventional or just new, unexplored/low invested capital areas are stuck on the curve. Shale oil is a great example, Artic oil another.

The shape of the cost curve tells us that if the market is in equilibrium on a steep part of the cost curve, a small shift in demand can have quite devastating consequences on the price (Phase One, equilibrium 1 to equilibrium 2).

And then when this happens the politics of oil kicks in as sovereign producers (think Saudi Arabia, Russia and Venezuela) cannot accept for all sorts of reasons less production/less revenues and so shift their production strategies and pump more oil at the lower prices. These changed strategies cause the oil supply curve to shift to the right and the oil price spirals lower (Phase Two, equilibrium 2 to equilibrium 3).

JA Oil

Add the Iraqi, Kurdish and Iranian increases in oil connectivity and it just adds fuel to the fire of falling oil prices and rightward shifting supply curves (pardon the pun).

It’s not the complicated to explain post hoc. Predicting beforehand means predicting monetary policy and the course of international relations, and that´s tough.

Much later, the “Great Inflation” was pinned on poor monetary policy. How long will it take to blame monetary policy for the “repressed economy” since 2008?

The conflicting conclusions from these “old” arguments are still present today!

Alan Blinder (2009)

From the end of 2002 to the middle of 2008, the US economy was in the throes of a significant oil price shock. The dollar price of oil rose fivefold, with spot prices briefly hitting $145/barrel. Even adjusting for inflation, the rise in oil prices was stunning. At their peak, real oil prices stood about 50% above their previous record high – reached following the second OPEC oil shock of 1979-80. (After hitting its 2008 peak, the price of oil fell rapidly, tumbling over the past six months into the $30-$50/barrel range.)

Although the recent run-up in oil prices is comparable in magnitude to the first two OPEC shocks, its effects on the economy seem to have been very different. Textbook accounts of the 1970s and early 1980s blame “supply shocks” (which included sharp rises in the price of food as well as oil) for the prolonged periods of both high unemployment and high inflation, or “stagflation,” that followed.

By contrast, the most recent increase in oil prices appeared to have very little effect on the expansion that followed the 2001 recession. (While the US economy did enter a recession at the end of 2007, this was widely attributed to the collapse in consumer and business confidence that attended the subprime crisis and subsequent financial panic.) Similarly, core consumer price inflation – inflation excluding food and energy prices – was relatively stable over this period, which again contrasts sharply with the earlier episodes.

One interpretation of the experience of the past several years is that it vindicates “revisionist” views of the role played by oil shocks (and other supply shocks) in precipitating the stagflation of the 1970s. According to this view – variants of which have been propounded by DeLong (1997), Barsky and Kilian (2002), and Cecchetti et al. (2007) – the root cause of the abysmal macroeconomic performance from 1973 to 1983 was poor monetary policy, not the oil shocks.

Jim Hamilton (2009)

The implication that almost all of the downturn of 2008 could be attributed to the oil shock is a stronger conclusion than emerged from any of the other models surveyed in my Brookings paper, and is a conclusion that I don’t fully believe myself. Unquestionably, there were other very important shocks hitting the economy in 2007-08, first among which would be the problems in the housing sector. But housing had already been subtracting 0.94% from the average annual GDP growth rate over 2006:Q4-2007:Q3, when the economy did not appear to be in a recession. And housing subtracted only 0.89% over 2007:Q4-2008:Q3, when we now say that the economy was in recession. Something in addition to housing began to drag the economy down over the later period, and all the calculations in the paper support the conclusion that oil prices were an important factor in turning that slowdown into a recession.

Let´s consider Jim´s arguments first: There´s no doubt, just imagining a dynamic AS-AD model that a price shock increases inflation and reduces real output, so Jim´s conclusion is not special. But the strength of the oil price effect on real output is predicated on how the Fed reacts to the shock.

If the Fed reacts to the rise in inflation by contracting nominal spending (NGDP), real output is going to decrease more than if the Fed kept nominal spending “constant”. This is clearly seen in the following graph, representing a dynamic AS-AD model, where point 1 is the initial state and points 2 and 3 represent, respectively, the states following the oil price shock and the oil shock cum contraction in AD:

When will MP take blame_1

There´s an interesting experiment to be made. In 2003-2006 the economy was buffeted by an oil price shock that was even stronger (higher percent price increase) than the one that occurred in 2007-08. This is shown in the charts below.

When will MP take blame_2

As the next charts indicate, in the 2003-06 period NGDP growth was kept stable, so that RGDP growth was only little reduced. This was not the case in 2007-08. In the later period, the Fed remained so worried about inflation that it kept contracting NGDP and that´s the reason a “run of the mill recession” became “Great”!

When will MP take blame_3

Going back to Blinder, he´s very off hand about the “Great Recession”. Unlike the 1970s, he thinks it had nothing to do with monetary policy. Maybe that reflects his concentration on the inflation side of the ledger!

I wonder if it will take another 25 or thirty years for someone to say “the root cause of the abysmal macroeconomic performance from 2008 onwards was extremely poor monetary policy, (not the oil shocks, subprime crisis and ensuing financial panic)