FRBSF Economic Letter
2005-24; September 16, 2005
Why Has Output Become Less Volatile?
 Over the past twenty years, output
growth in the U.S. has become noticeably less volatile.
During that time, the
economy has experienced two recessions, compared with four
in each of the two preceding twenty year periods. Further,
the loss in output during the last two recessions has been
smaller than what prior experience would lead one to expect.
Moreover, the reduction in output volatility is not confined
to business cycle frequencies. This can be seen in Figure
1, which shows the standard deviation of real output growth
over the previous 20 quarters for each quarter over the
1950:Q1-2005:Q2 period.
Does the reduction in volatility
represent some kind of fundamental, structural change
in the economy? Or is it
the result of good policy? Or is it the result of good
luck? These are the questions that economists are debating
in the research literature. Several different arguments
have been put forward, but as yet there is no agreement
on the cause or causes for the reduced volatility. This
Economic Letter reviews and discusses these arguments.
Structural change McConnell and Perez-Quiros (2000) were
among the first to document and discuss the reasons for
the decline in
the volatility of U.S. output. They first showed that
there had been a statistically significant break in the
volatility
of real output growth in early 1984. Disaggregating the
data into output of goods and output of services, they
then showed that the decline in volatility was concentrated
in the goods sector of the economy and, within that,
in the durable goods sector.
Next, they looked at the behavior
of sales, both for durable goods and for all goods and
services. They found no change
in the volatility of either series, implying that it
was the behavior of inventories that had changed over time.
A direct test on the behavior of inventories confirmed
this hypothesis. Subsequently, Kahn, McConnell, and Perez-Quiros
(2002) argued that the reduction in the volatility of
inventories
resulted from improvements in inventory management techniques
that were influenced by advances in information technology.
Others
have suggested that recent changes in financial markets
may have played a key role. Helped by explosive
growth in information technology, financial markets have
become much broader and deeper. Economic theory tells
us that individuals with increased access to financial
markets
will be better able to weather shocks to income, because
they can borrow to maintain consumption during periods
when income is low. Indeed, in a recent paper, Dynan,
Elmendorf, and Sichel (DES, 2005) find that consumption
has become
less sensitive to unusually weak income growth, while
there has been no change in sensitivity to unusually strong
income
growth.
DES argue that changes in government regulations
may have contributed to the reduction in output volatility
as well.
They highlight the role of Regulation Q (or Reg Q, as
it is known), which limited the maximum interest that banks
could pay on deposits until the early 1980s. When interest
rates rose sufficiently above these limits, depositors
would respond by withdrawing money out of banks, forcing
banks to curtail lending sharply. Housing was hit particularly
hard by this "disintermediation". Once the ceilings
on deposit rates were removed, banks were able to respond
to rising market rates by raising the rates they offered
as well, which would prevent a large scale withdrawal of
deposits and allow banks to continue to offer loans for
housing (as well as for other purposes), though at higher
interest rates. Consistent with this hypothesis, there
has been a substantial decline in the volatility of residential
investment since 1984. DES also present some statistical
evidence showing that a statistical measure related to
Reg Q plays a significant role in explaining residential
investment prior to 1984. Better policy
Another group of economists argues that improvements
in the conduct of policy are the main reason why output
has
become less volatile. By the end of the 1970s, the inflation
rate had risen into the double digits and appeared on
the verge of rising farther. Output growth had been unusually
volatile as well, as the economy experienced a recession
in the late 1960s and another in the early to mid-1970s,
interspersed with periods of strong growth. The Fed changed
the way it conducted policy in 1979. Following a deep
recession
in the early 1980s, inflation fell by a substantial amount.
Clarida, Galí, and Gertler (2000) analyze the behavior
of the Fed both before and after this change and conclude
that prior to 1979 the Fed did not raise rates to keep
pace with increases in expected inflation; in other words,
the Fed allowed real (or inflation adjusted) rates to decline,
and since lower real interest rates tend to boost economic
activity, the result was an unsustainable boom in output.
Since the early 1980s, the Fed has tended to raise both
real and nominal rates in response to a change in expected
inflation, which has the effect of keeping inflation contained
as well as preventing destabilizing increases in output.
The
role of policy has also been emphasized by Bernanke (2004),
a former member of the Federal Reserve Board of
Governors, who argued that during the late 1960s and
early 1970s, policymakers became excessively optimistic
about
the ability of monetary policy to affect output and unemployment.
Attempts to achieve higher output led to rising inflation,
which policymakers would periodically try to reverse
by tightening policy. This would lead to a sharp contraction
in output. Policy would respond by going back to stimulating
output, and the cycle would begin again. This process
tended
to make output growth more volatile than it would be
otherwise. Since that time, the idea that monetary policy
cannot have
a permanent effect on the level of output has become
generally accepted, as has the principle that monetary
policy is
likely to make a larger contribution to sustainable economic
growth by delivering a low and stable inflation rate.
So policy does not tend to destabilize output as it did
in
the late 1960s and the 1970s. Good luck
Many economists disagree with the claim that improved
monetary policy is the main reason for the reduction
in volatility.
Some of them argue that the volatility of output was
high in the 1970s because the economy was subject to unusually
large shocks, and smaller shocks since then are the reason
why the variability of output has fallen. Thus, the improved
performance of the economy is a matter of good luck rather
than good policy. Ahmed, Levin and Wilson (ALW, 2004),
for instance, point out that if improved monetary policy
were the main reason for the reduction in output volatility,
we should expect to see the reduction in volatility concentrated
at business cycle frequencies. That turns out not to
be
the case. Although business cycles do appear to have
become more damped of late, the reduction in volatility
at these
frequencies is not noticeably greater than the reduction
in the volatility of quarter-to-quarter changes in output
(for example).
Based on their statistical analysis, ALW
conclude that somewhere between 50% and 75% of the reduction
in output
volatility since the 1970s can be attributed to "good
luck" with the remainder attributable to improved
policy as well as changes in business practices. Interestingly,
they also find that the decline in inflation variability
over this period cannot be attributed to smaller shocks,
but is mostly due to improved policy. Stock and Watson
(2003) reach a similar conclusion; further, they show that
output volatility has fallen not only in the U.S., but
also in the other G-7 countries. Based on their statistical
analysis, they conclude that the most important reason
for the decline in volatility across these countries is
a reduction in common international shocks. The debate continues
These issues are far from settled.
Bernanke (2004) argues that changes resulting from better
monetary policy could
appear to be the effects of structural change in the
economy or even the results of smaller shocks. For
example, the
prices of oil and commodities have remained volatile
even after the 1980s (in fact, we are experiencing
an unusually
large increase in oil prices now). However, because
inflation remains low and because inflation expectations
are stable,
these increases have not been passed on to other prices
in the way that they were during the 1970s. According
to Bernanke, an analyst who did not take these changes
into
account could mistakenly conclude that the shocks were
smaller or that the structure of the economy had changed
in such a way that oil and other commodity price shocks
had become less important. Similarly, based on an analysis
of the yield curve, Rudebusch and Wu (2005) argue that
a favorable change in economic dynamics, likely linked
to a shift in the monetary policy environment, appears
to have played an important part in the reduction in
volatility that some have labeled the Great Moderation.
Other researchers
have disputed the Kahn, McConnell and Perez-Quiros conclusion
that the reduction in output volatility
reflects an improvement in inventory management techniques.
Using more disaggregated data and sometimes different
techniques, these researchers argue that the decline in
volatility
is not confined to inventories alone but can also be
seen in the data on sales. Many others have joined the
debate,
too many to mention here.
To a considerable extent, the
debate now seems to be about the relative importance
of the different factors that we
have discussed so far. Structural change is an ongoing
process, and, to the extent that it improves the ability
of consumers and firms to deal with various shocks, it
could be responsible for the downward trend in volatility
since the 1950s that is evident in the figure. Against
this background, the increase in volatility in the 1970s
could reflect the unfortunate confluence of both policy
mistakes and large shocks (some of which affected more
than just the U.S.). Thus, the unexpected and hard to
detect productivity slowdown of the 1970s appears to have
occurred
at a time when policymakers had an exaggerated sense
of their ability to control output. Existing regulations
such
as Reg Q may have made things worse in an environment
of high and volatile inflation. And rising commodity prices
not only may have reflected both rising inflation and
inflation
expectations but also may have fed back into the inflation
process.
Even if several different forces have contributed to
the decline in volatility, determining their relative importance
remains an important task. That's because whether the
reduction
in volatility is permanent or temporary depends upon
the reasons behind it. The volatility of output is more
likely
to increase again if a reduction in the size or number
of shocks hitting the economy is the main reason behind
the recent decline. After all, good luck cannot be expected
to continue forever. But if structural changes in the
economy are the reason for the reduction in volatility,
then a
return to the high volatility of the 1970s is much less
likely.
Bharat Trehan
Research Advisor References
[URLs accessed September 2005.]
Ahmed, Shaghil, Andrew Levin,
and Beth Anne Wilson. 2004. "Recent
U.S. Macro Stability: Good Policies, Good Practices, or
Good Luck?" Review of Economics and Statistics 86(3)
(August) pp. 824-832.
Bernanke, Ben S. 2004. "The
Great Moderation." Remarks
at the meetings of the Eastern Economic Association,
Washington, DC, February 20.
http://www.federalreserve.gov/boarddocs/speeches/2004/20040220/default.htm
Clarida,
Richard, Jordi Galí, and Mark Gertler.
2000. "Monetary Policy Rules and Macroeconomic Stability:
Evidence and Some Theory." The Quarterly Journal
of Economics 115(1), pp. 147-180.
Dynan, Karen, Douglas Elmendorf,
and Daniel Sichel. 2005. "Can Financial Innovation
Help to Explain the Reduced Volatility of Economic Activity?" FEDS
Working Paper 2005-54, Board of Governors, and forthcoming
in the Journal of Monetary Economics.
http://www.federalreserve.gov/pubs/feds/2005/200554/200554pap.pdf
Kahn, James, Margaret
McConnell, and Gabriel Perez-Quiros. 2002. "On
the Causes of the Increased Stability of the U.S. Economy." FRB
New York Policy Review (May) pp. 183-202.
http://www.ny.frb.org/research/epr/2002n1.html
McConnell,
Margaret, and Gabriel Perez-Quiros. 2000. Output Fluctuations
in the United States: What Has Changed since
the 1980s?" American Economic Review 90(5) (December)
pp. 1464-1476.
Rudebusch, Glenn, and Tao Wu. 2005. "Accounting
for a Shift in Term Structure Behavior with No-Arbitrage
and
Macro-Finance Models." FRB San Francisco, mimeo.
Stock, James, and Mark Watson.
2003. "Has the Business
Cycle Changed? Evidence and Explanations."
http://www.kansascityfed.org/publicat/sympos/2003/sym03prg.htm
Opinions expressed in this newsletter
do not necessarily reflect the views of the management
of the Federal Reserve Bank of San Francisco or of the
Board of Governors of the Federal Reserve System. Comments?
Questions? Contact
us via e-mail or write us at:
Research Department
Federal Reserve Bank of San Francisco
P.O. Box 7702
San Francisco, CA 94120
|
