Economic Volatility: Expect More Business Cycles Than You Are Used To

I'm currently forecasting greater cyclicality in the economy than most people are used to. That's not an out-on-a-limb forecast, because we are just coming off the calmest period in American economic history. It may not have seemed calm at the time, but the era from 1983 through 2007 was indeed the least volatile on record.

Here's one measure of volatility. I look at a 20-quarter rolling standard deviation of changes in real gross domestic product.  That means that for every quarter, I calculate the standard deviation of the quarterly change in the economy over the most recent five years (20 quarters). Here's the picture:

Here's another way of thinking about it. Go back to December 1982 and imagine a business leader with 25 years of experience. That executive had managed through five recessions. Now fast forward to December 2007 and imagine the next generation business leader. In that person's 25 years of experience, he or she had managed through only two recessions--and those were two of the mildest recessions on record.

We only have official quarterly data since 1947, but with annual data we can go back to the 1890s:

So it's an easy forecast to say that the extremely low volatility we have recently experience won't last. But I actually have solid reasons, based on recent monetary policy. I'll address those in a later lecture.

The 1983-2007 era has been called by economists "The Great Moderation," and we've laid out several possible reasons for this benign era. Here are my favorite explanations:

1. Better monetary policy: the Fed chose a low-inflation policy, which reduced our tendency to have periodic anti-inflation recessions.
2. A shift of production toward services, which don't have inventory swings.
3. Better technology, allowing those companies that do carry inventory to avoid many of the large purchasing swings of past business cycles.
4. Globalization spread fluctuations more evenly
5. Good luck.

I think that much of the cause of the great moderation, reasons 2, 3 and 4, will continue. Eventually reason number 1, monetary policy, will get back to normal. For the next five to ten years, though, I expect monetary policy to add sharp fluctuations to the economy. I'll elaborate on that in my next post. We are not going to go back to the high cyclicality of the pre-World War II era, but neither will we be able to stay in the super-calm period.

Business leaders should understand that systems that were optimized for the 1983-2007 era are no longer in optimal condition. What you did in the past was fine, for the past. But what you do in the future has to be different. I'll talk about that, also, in future posts.