All Reports

Dec 19 2017

The Most Widely-Ignored Shift in U.S. Economy

The plunge in GDP growth volatility has actually been much more dramatic than the drop in stock market volatility in recent years. And yet, the nosedive in GDP growth volatility has gone mostly unnoticed. ECRI first raised this issue of lower volatility in economic growth a couple years ago, calling it the Greater Moderation, and we believe that it will play a key role in business cycle analysis in the coming years.

Here, the volatility of GDP growth refers to how much GDP growth fluctuates, as measured by the standard deviation.

For instance, average stock price volatility for the last seven years has been about one-third its average for the early 20th century, when booms and busts were more common. However, the same comparison for real GDP growth volatility finds that it is now less than one-sixth its earlier volatility.

Notably, the reduction in GDP growth volatility can be observed over four discrete time periods (chart). There was a huge drop in volatility from the period covering most of the first half of the 20th century (red bar) to the pre-Great Moderation period (green bar), which started after World War II and lasted until the mid-1980s.

This was followed by another big decline during the Great Moderation period (blue bar), which stretched from the mid-1980s to the beginning of the Global Financial Crisis (GFC). In the most recent period, following the initial recovery from the GFC, which we call the Greater Moderation, the volatility of GDP growth fell a bit further (purple bar).

The remarkable decline in economic cycle volatility over the decades has unfolded alongside the structural decline in trend growth that ECRI first identified in 2008. While lower volatility may induce a sense of complacency, low trend growth makes cyclical downturns in growth more liable to result in recessions.

A key nuance is that longer-term trend growth is mostly set in stone by the simple math of potential labor force growth and productivity growth, but the volatility of economic growth can rise quickly. With low trend growth making it easier for actual growth to dip below zero, an exogenous shock, occurring when the economy is already in a window of cyclical vulnerability, raises the risk of recession drastically.

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