The Great Modulation


The Great Moderation was a phrase apparently coined by James Stock of Harvard and Mark Watson of Princeton. It was, for those of us who are devotees of Hyman Minsky, simply the precursor to a more volatile period to come. And while not many people on the planet foresaw the Great Recession that we call the GFC in Australia a casual acquaintence with the teachings of Minsky at least prepared us for it.

I have been lucky enough to sit through day to day trading on markets for almost 25 years. Watching markets go up and down, minute charts, quarter hour, hour, 240 minute, day, week and monthly charts on all sorts of assets traded on all sorts of markets. One thing this teaches you is to respect but be wary of the range for when it breaks it is often a large move that follows.

I remember back in the 90’s hearing two things from my FX dealers about the currency (I was a fund manager at the NSW State Super Board back then and we were one of the more active FX traders in Sydney) which spoke volumes about why a rote adherence to a dogma, or a new or existing paradigm is dangerous. One such comment was when the AUS dipped below 0.64 cents against the USD for the first time since Paul Keating’s famous “Banana Republic” comment – the dealer on the other end of the phone rang and told me we should buy because the Aussie had only spent 1% of its life below 0.64. The subsequent fall and the FX derivative structures that were placed below it blew up a few miners.

If you’ve ever traded and sat in front of screens you know that periods of high volatility lead to periods of low volatility but the other instance that sticks in my mind to reinforce Minsky’s teaching was a time when the Aussie dollar pricing of Vol fell to something like 10 or 15 year lows. We were running an option replication strategy so low volatility meant we weren’t trading much but my boss and I knew that now was the time to switch from replicating options to buying them. Anyway, we couldn’t get approval in the time frame needed and inevitably the Aussie broke out and volatility increased both in price and actualised.


From low volatility to high volatility and back again.

So I never believed in the so called Great Moderation and claims that the business cycle had been conquered.

Which brings me to a paper I read from the New York Fed today. The paper posed the question of whether the Great Moderation caused the Great Recession and it does it in a pretty nifty empirical way.

But first to summarise the intent of the paper:


The Great Recession of 2007-09 was a dramatic macroeconomic event, marked by a severe contraction in economic activity and a significant fall in inflation. These developments surprised many economists, as documented in a recent post on this site. One factor cited for the failure to anticipate the magnitude of the Great Recession was a form of complacency affecting forecasters in the wake of the so-called Great Moderation. In this post, we attempt to quantify the role the Great Moderation played in making the Great Recession appear nearly impossible in the eyes of macroeconomists.

You know my view but the authors, Ging Cee NG and Andrea Tambalotti proved it:

Our interest is to quantify the role that the Great Moderation—and the perception that it represented a permanent shift to more moderate business cycles—might have played in reducing the odds of the Great Recession in the minds of economists. To do so, we conduct an experiment using a fairly standard dynamic macroeconomic model of the type used by central banks around the world for forecasting and policy analysis (the details of the model can be found in a paper by Justiniano, Primiceri, and Tambalotti). We use this model—which we consider representative of mainstream macroeconomic thinking before the crisis—to forecast GDP growth, inflation, and the federal funds rate (the rate at which banks lend funds to each other overnight) over 2008-09 under two alternative scenarios.

Scenario 1 assumes that “this time is different”—meaning that the Great Moderation permanently changed the structure of the U.S. economy and the nature of the shocks that buffet it. Therefore, the first set of forecasts is based on model estimates from the Great Moderation (fourth-quarter1984 to fourth-quarter 2007). Scenario 2 relies on the same parameter estimates to capture the dynamics of the economy, but uses data going back to 1954 to measure the volatility of the shocks. This forecasting approach is based on the idea that “we have been here before”: in other words, while the structure of the economy—and monetary policy in particular—might have changed following the mid-1980s, the overall level of uncertainty in the environment is better gauged by taking a long-term perspective.

By comparing the likelihood of the macroeconomic outcomes associated with the Great Recession under these two forecasting strategies, we are able to quantify the extent to which the relative stability of the U.S. economy during the Great Moderation might have misled the model (and therefore the economists who relied on it) into concluding that an event such as the Great Recession was virtually impossible.

What they find is depicted in the chart below:


The median forecast is similar in the two different scenarios (the dark blue line) but the degree of uncertainty (the width of the light and dark green lines) is grreater in the longer data set. This would lead economists and forecasts to be less certain, because there is more margin of error in their forecasts and thus, in my estimation, less doctrainaire in their views on the prospects for growth.

The authors find that the forecast blindness shown by standard macroeconomics and their belief in the Great Moderation did indeed contribute to the Great Recession. Clearly there are questions for Australia, China and our more hopeful and sanguine economic future and outlook that only time will answer.

But for the moment with the Great Recession, Minsky is proven right again.


Have a great day

Gregory McKenna

Please remember these are not recommendations for you to trade these are my views and I have my risk management tools and risk parameters that you do not have access to. Thus, this blog is for information only and does not constitute advice. Neither Greg McKenna nor Lighthouse Securities has taken your personal circumstances, objectives or financial situation into account. Because of this you should, before acting on this information, consider its appropriateness, having regard to your objectives, financial situation or needs.