Great economic moderation invites broad consensus

As reported in last week’s Fund Strategy (see Fund managers’ views unchanged despite global market surge), a survey by Merrill Lynch shows that, while world stockmarkets have risen strongly in recent months, investor perceptions of the global business cycle have barely changed. Of the 216 portfolio managers, strategists and chief investment officers who responded to the poll’s global questions, 46% say the world economy is mid-cycle, with 53% saying late-cycle. The figures are similar to those from March (43% and 55% respectively), February (48% and 50%) and January (49% and 48%).

The survey concludes that “the great moderation”, which is the decline in inflation and output growth volatility in industrialised economies since the 1980s, is leading investors to ignore traditional cyclical economic theory.

In a speech in 2004, Ben Bernanke, now governor of America’s Federal Reserve, called the great moderation “one of the most striking features of the economic landscape over the past 20 years”. The reduction of macroeconomic volatility in the American economy brings several benefits, he said. Lower fluctuations in inflation improve the functioning of the markets, make economic planning easier, and reduce the resources needed to hedge against risk. In addition, lower volatility of output brings employment stability and a reduction in economic uncertainty for households and firms.

Bernanke proposed three explanations for the moderation: structural change, improved macroeconomic policies and good luck. Theory focusing on structural change centres on the improved ability of economies to absorb shocks, he said. For example, the improved management of business inventories has reduced the severity of fluctuations in inventory stocks, a factor that previously affected cyclical instability.

Bernanke also gave industrial deregulation, the trend away from manufacturing and increased international capital flows as important structural factors. On macroeconomic policies, he suggested that poor decision-making in the 1970s and early 1980s contributed to volatility in both output and inflation. Central bankers overestimated the ability of their policies to offset output shocks and deliver long-term low levels of unemployment.

In addition, bankers underestimated their own contributions to the inflationary problems of the period. Since then, improved policies have led to a shift in the “Taylor curve”, Bernanke said. The curve, which attempts to calculate the trade-off point reached when policymakers seek to moderate the two types of volatility, has moved to the left since 1984. In other words, the new, more efficient curve means that reducing inflation has a less-pronounced negative impact on output, and vice versa, he added.

Overall, Bernanke emphasised his belief that good macroeconomic policy has changed the environment and largely ignored the “good luck” theory – the belief that the economy has simply been hit by less severe and more infrequent shocks. However, he added that all three explanations “probably contain elements of truth”.

Although much of the discussion has centred on America, economies around the world have seen increased stability in the past 20 years. Strategists continue to debate the reasons behind the shift. In a speech last year, Kate Barker, a member of the Bank of England’s monetary policy committee, said the good luck hypothesis could not be discounted when considering macroeconomic stability.

Barker also noted that some countries that have apparently succeeded in achieving stability have not adopted measures to target inflation, potentially weakening the good policy argument. But, she added, there is evidence that policy is allowing economies to moderate the effects of shocks. Barker highlighted the Asian crisis in the late 1990s and the terrorist attacks in September 2001 as examples.

More recently, the great moderation was discussed at the Royal Economic Society’s annual conference last week. Chaired by Stephen Nickell, an MPC member, the session entitled “On the sources of macroeconomic stability: good luck or good policy?” discussed three papers on the subject.

Richard Batley, European economist at Schroders, says there are several reasons behind the past two decades of stability. “The popular thinking recently is that, because of extended supply chains, developed world economies are outsourcing volatility to the developing world,” he says. “But improved economic policy is certainly part of the argument. We are seeing an improvement in central bank credibility, where I believe the battle is essentially won. Inflationary expectations are very low and this makes managing the economy easier.”

Batley is sceptical about other aspects of the moderation theory. “The word ‘great’ is obviously being used to refer to previous economic theories but I do not think it is anything new,” he says. “We are seeing a replication of the conditions of the 1950s. People talk about the level of Chinese wages as unique but looking at the levels of Japanese earnings in the 1950s, they are similar, compared with the US.”

Batley sees the development of China as a key factor in future global inflationary stability. “There has been a big increase of supply at low cost and we expect the pace of rural to urban migration in China to continue for the next 10 to 20 years.” he says. “This flow will ensure Chinese wages stay extremely low by G7 standards. If China continues to increase its share of global production, the deflationary impetus will continue.”

Richard Batty, global investment strategist at Standard Life Investments, says the transparency of the Federal Reserve and other financial institutions has played an important role in stability. He also highlights reduced union power as significant. “If people know power does not lie with the wage bargainer, they can make long-term investment decisions,” he says.

Overall, Batty is optimistic that the great moderation will continue. “We think macroeconomic volatility will remain fairly subdued,” he says. “We expect inflation to pick up a bit but it will still be low by historical standards. The US government is in good shape and companies are in fine fettle. The outlook is pretty good. It still looks like a fairly benign environment.”