TSLombard with a note. This goes to whether today’s inflation breakout is structural or cyclical. I am still in the latter camp so think of this more as a few years of interlude as global energy rearranges itself without Russia than it is the end of the Great Moderation. Aussie households had better hope I’m right because the local housing bubble is about a pure figment of the GM that I can pinpoint.
Everyone is talking about a global recession, an issue that will become even more heated this week if the US prints a second consecutive decline in real GDP. But as I explained in my latest Macro Picture, whether economies record a “technical” recession is largely irrelevant at this point. It makes more sense to focus on what is happening in labour markets. There are two reasons why the jobs market, though lagging now, are crucial for the broader outlook. First, a decline in employment usually brings dangerous “reflexivity”, leading to more spending cuts and additional rounds of jobs losses. That is why once employment cracks, there is always massive uncertainty about the ultimate depth and duration of any downturn. Second,
central banks are extremely worried about inflation. But an economic downturn that does not involve significant job losses is unlikely to generate sustained disinflation. And given current labour shortages, we are a long way from the sort of downturn that will cause serious reflexivity or allow a genuine “monetary pivot”.
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More generally, the “recession” we are discussing today looks very different from those of the past 30 years. Investors are obsessed with the R-word precisely because they have been accustomed to long US economic expansions punctuated by a sudden plunge in asset prices, which usually happened alongside sharp declines in employment and output. Excluding the artificial COVID-19 downturn, every US recessionhas had a distinctive “end of cycle” vibe, which was always linked to developments in financial markets.Investors needed to anticipate cyclical turning points in order to avoid catastrophic losses. This was theera policymakers dubbed, without irony, the Great Moderation. Most of the time everything seemed good.
Inflation was low and most economies grew, sometimes for a whole decade. But when things went wrong, they did so spectacularly. Below the surface of the Great Moderation, there were serious macro-financial imbalances, deep balance-sheet vulnerabilities and a sequence of bubbles (S&L, various EM disasters, LTCM, dotcom, subprime, etc.). You do not have to be an acolyte of Hyman Minsky to see how the illusion of perpetual macro stability encouraged instability in the financial sector. But it was not always like this. And what we are seeing now is a throwback to an earlier era, when macro instability was inherent in the economy itself, not the result of “casino finance”.
Several things happened during the Great Moderation that altered the business cycle:
1. The shift from manufacturing to services: Manufacturing is inherently more cyclical than the services sector, so it makes sense that overall macro volatility declined as the developed world made this transition. The demand for “durables” such as housing and autos, which tend to be the most volatile components of GDP, diminished, which made the real economy more stable over time. And with a smaller share of the workforce employed in the most cyclical industries, recessions have tended to have a smaller impact on employment. This reduced the reflexivity of the economy during downturns, damping the feedback loop between jobs and spending.
2. Better inventory management: Business logistics and inventory management improved during the Great Moderation, too. This was important because large swings in inventories amplify the business cycle, causing greater cyclical variation in GDP. Before the 1980s, in fact, a shortfall in sales did not typically lead to an immediate reduction in production that prompted the involuntary stockpiling of raw materials and finished goods and eventually led to even larger reductions in orders and output. Things changed with the invention of computers and better, faster communication. Businesses could track demand and monitor their supply needs in real time, which meant production could respond more quickly and smoothly to changes in demand.
3. Low and stable inflation: Before the Great Moderation, inflation itself was a source of instability in the real economy. Every large inflation shock in the 1970s automatically squeezed consumers’ spending power, leading to sharp declines in real output and employment. In a bid to tame these high levels of inflation, central banks often had to tighten forcefully, which itself became a source of wider macro instability. What changed after the 1980s? Naturally, central banks like to take a lot of the credit. They believe their “credibility” anchored expectations, which made inflation more stable – since even large shocks to commodity prices failed to generate the “second-round” effects of the 1970s. But inflation is ultimately about power, and there were big political and structural changes after the 1980s – neoliberalism, globalization, demographics and technology – that surely played a more important role in delivering an era of “price stability”.
Wild inventory swings (logistical chaos), volatile inflation, excessive reliance on manufacturing and an economy weighted towards durable goods, especially housing and autos – if all this sounds familiar, that is because it is the perfect description of the economy over the past three years. And this is why the “recession” we have today is reminiscent of the downturns we had before the Great Moderation. In fact, we have managed to combine the bullwhip inventory downturns of the 1950s and 1960s with a 1970sstyle inflation squeeze. The good news is that today’s economy does not seem to exhibit the deep underlying imbalances that have proved so deadly in the post-1980s era. Sure, asset prices surged during the pandemic; but without the excessive leverage of the early 2000s, tighter monetary policy has deflated those bubbles without causing serious collateral damage (so far).
So, we have a period of instability in the real economy, but this is not necessarily the sort of “Minsky moment” investors usually associate with US recessions. Perhaps, even, it is a taste of “a new macro regime”. With inflation likely to remain more volatile in the 2020s (partly owing to climate change) and businesses set to reconfigure their supply chains, perhaps the artificial – but ultimately deceptive – macro stability of the Great Moderation has now ended. This could mean more frequent, but perhaps less extreme, recessions with fewer underlying imbalances/“bubbles”.