The Great Moderation, Forecast Uncertainty, and the Great Recession

The Great Recession of 2007-09 was a dramatic macroeconomic event, marked by a severe contraction in economic activity and a significant fall in inflation. These developments surprised many economists, as documented in a recent post on this site. One factor cited for the failure to anticipate the magnitude of the Great Recession was a form of complacency affecting forecasters in the wake of the so-called Great Moderation. In this post, we attempt to quantify the role the Great Moderation played in making the Great Recession appear nearly impossible in the eyes of macroeconomists.

In the twenty years that preceded the Great Recession, the U.S. economy had displayed remarkable stability—a phenomenon that James Stock of Harvard and Mark Watson of Princeton dubbed “the Great Moderation.” Most economists attributed this relatively sudden reduction in the volatility of macroeconomic variables, starting around 1984, to a combination of “good luck”—in the form of less severe external shocks hitting the economy—and “good policy,” especially in the form of greater Fed vigilance on inflation, as well as to other forms of structural change (see this 2004 speech by then Fed Governor Ben Bernanke for an overview).

Our interest is to quantify the role that the Great Moderation—and the perception that it represented a permanent shift to more moderate business cycles—might have played in reducing the odds of the Great Recession in the minds of economists. To do so, we conduct an experiment using a fairly standard dynamic macroeconomic model of the type used by central banks around the world for forecasting and policy analysis (the details of the model can be found in a paper by Justiniano, Primiceri, and Tambalotti). We use this model—which we consider representative of mainstream macroeconomic thinking before the crisis—to forecast GDP growth, inflation, and the federal funds rate (the rate at which banks lend funds to each other overnight) over 2008-09 under two alternative scenarios.

Scenario 1 assumes that “this time is different”—meaning that the Great Moderation permanently changed the structure of the U.S. economy and the nature of the shocks that buffet it. Therefore, the first set of forecasts is based on model estimates from the Great Moderation (fourth-quarter1984 to fourth-quarter 2007). Scenario 2 relies on the same parameter estimates to capture the dynamics of the economy, but uses data going back to 1954 to measure the volatility of the shocks. This forecasting approach is based on the idea that “we have been here before”: in other words, while the structure of the economy—and monetary policy in particular—might have changed following the mid-1980s, the overall level of uncertainty in the environment is better gauged by taking a long-term perspective.

By comparing the likelihood of the macroeconomic outcomes associated with the Great Recession under these two forecasting strategies, we are able to quantify the extent to which the relative stability of the U.S. economy during the Great Moderation might have misled the model (and therefore the economists who relied on it) into concluding that an event such as the Great Recession was virtually impossible.

The results of this exercise are depicted in the chart. The left panel corresponds to Scenario 1 (“this time is different”) and the right column to Scenario 2 (“we have been here before”). From top to bottom, the solid red line plots data for per capita GDP growth, inflation, and the federal funds rate, respectively, through fourth-quarter 2007, the peak of the expansion. This is the last quarter of data used in estimation, so the forecasts start in the first quarter of 2008, when the recession began. The solid blue line represents the model’s median forecast (that is, the forecast in the middle of all the model’s forecasts). The dark and light green areas represent 50 percent and 95 percent probability regions for the forecast, respectively. This means that, given the available data through the end of 2007, the model assessed a 1 in 2 chance that subsequent data would fall within the dark green regions, and a 19 in 20 chance that the data would fall within the light green regions. Wider probability regions therefore reflect a more uncertain forecast. Finally, the red line represents the data observed since 2008 (and through second-quarter 2010), which were not used when estimating the model and computing the forecast.

Although the median forecast is similar in the two panels (and very far from the realized outcomes, especially for GDP growth and the funds rate), there is a significant difference in the uncertainty surrounding the forecasts. Under Scenario 1, “this time is different” (left panel), realized GDP growth lies outside the light green area for about a year and its trough is far below even the 5th percentile of the forecast distribution. In other words, as of the end of 2007, the model predicts much less than a 1 in 20 chance of GDP growth falling as much as it did at the height of the Great Recession. It also assesses a similarly low chance of the federal funds rate hitting zero at the end of 2008, although it finds the observed fall in inflation to be less unlikely.

In contrast, under Scenario 2, “we have been here before” (right panel), the higher forecast uncertainty—which reflects the more volatile shocks hitting the economy—increases the estimated chance of low-to-negative GDP growth during the Great Recession. In addition, the 95 percent probability regions under Scenario 2 encompass the observed developments in all variables during this period, although GDP growth and the funds rate are both at the lower edge of these regions, especially in 2009.

In sum, our calculations suggest that the Great Recession was indeed entirely off the radar of a standard macroeconomic model estimated with data drawn exclusively from the Great Moderation. By contrast, the extreme events of 2008-09 are seen as far from impossible—if unlikely—by the same model when the shocks hitting the economy are gauged using data from a longer period (third-quarter 1954 to fourth-quarter 2007). These results provide a simple quantitative illustration of the extent to which the Great Moderation, and more specifically the assumption that the tranquil environment characterizing it was permanent, might have led economists to greatly underestimate the possibility of a Great Recession.

The Great Moderation, Forecast Uncertainty, and the Great Recession
Federal Reserve Bank of New York
May 14, 2012

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