TheGreat Moderation is a period of macroeconomic stability in theUnited States coinciding with the rise ofcentral bank independence beginning with theVolcker shock in 1980 and continuing to the present day.[1][2] It is characterized by generally milderbusiness cycle fluctuations indeveloped nations, compared with decades before. Throughout this period, major economic variables such asreal GDP growth, industrial production,unemployment, andprice levels have become lessvolatile, whileaverage inflation has fallen and recessions have become less common.[3]
The Great Moderation is typically attributed to the adoption of standards for macroeconomic targeting such as theTaylor rule andinflation targeting.[3][4] However, some economists argue technological shifts also played a role.[5]
The term was coined in 2002 byJames H. Stock andMark Watson to describe the observed reduction in business cycle volatility.[6] There is some debate as to whether the Great Moderation ended with the2008 financial crisis and theGreat Recession, or if it continued beyond this date, with the crisis being an anomaly.[7]
The term "Great Moderation" was coined byJames Stock andMark Watson in their 2002 paper, "Has the Business Cycle Changed and Why?"[8] It was brought to the attention of the wider public byBen Bernanke (then member and later chairman of theBoard of Governors of the Federal Reserve) in a speech at the 2004 meetings of the Eastern Economic Association.[3][9]
Since theTreasury–Fed Accord of 1951, theUS Federal Reserve was freed from government and gave way to the development of modern monetary policy. According to John B. Taylor, this allowed the Federal Reserve to abandon discretionary macroeconomic policy by the US Federal government to set new goals that would better benefit the economy.[10]
TheTaylor rule results in less policy instability, which should reduce macroeconomic volatility.[2] The rule prescribed setting thebank rate based on three main indicators: thefederal funds rate, theprice level and the changes inreal income.[11] The Taylor rule also prescribes economic activity regulation by choosing thefederal funds rate based on the inflation gap between desired (targeted) inflation rate and actual inflation rate; and the output gap between the actual and natural level.
In anAmerican Economic Review paper, Troy Davig and Eric Leeper stated that the Taylor principle is countercyclical in nature and a "very simple rule [that] does a good job of describing Federal Reserve interest-rate decisions". They argued that it is designed for "keeping the economy on an even keel", and that following the Taylor principle can produce business cycle stabilization and crisis stabilization.[12]
However, since the 2000s the actual interest rate inadvanced economies, especially in the US, was below that suggested by the Taylor rule.[13]
A change in economic structure shifted away from manufacturing, an industry considered less predictable and more volatile.The Sources of the Great Moderation by Bruno Coric supports the claim of drastic labor market changes, noting a high "increase in temporary workers, part time workers and overtime hours".[5] In addition to a change in the labor market, there were behavioral changes in how corporations managed their inventories. With improved sales forecasting and inventory management, inventory costs became much less volatile, increasing corporation stability.[citation needed]
Advances in information technology and communications increased corporation efficiency. The improvement in technology changed the entire way corporations managed their resources as information became much more readily available to them with inventions such as the barcode.[14]
Information technology introduced the adoption of the "just-in-time" inventory practices. Demand and inventory became easier to track with advancements in technology, corporations were able to reduce stocks of inventory and their carrying costs more immediately, both of which resulted in much less output volatility.[5]
Researchers at the US Federal Reserve and theEuropean Central Bank have rejected the "good luck" explanation, and attribute it mainly to monetary policies.[3][15][16] There were many large economic crises — such as theLatin American debt crisis, the failure ofContinental Illinois in 1984,Black Monday (1987), the1997 Asian financial crisis, the collapse ofLong-Term Capital Management in 1998, and thedot-com bubble in 2000 — that did not greatly destabilize the US economy during the Great Moderation.[17]
Stock and Watson used a four variable vector autoregression model to analyze output volatility and concluded that stability increased due to economic good luck. Stock and Watson believed that it was pure luck that the economy didn't react violently to the economic shocks during the Great Moderation. While there were numerous economic shocks, there is very little evidence that these shocks are as large as prior economic shocks.[5]
Research has indicated that the US monetary policy that contributed to the drop in the volatility of US output fluctuations also contributed to thedecoupling of the business cycle from household investments characterized the Great Moderation.[4] The latter became the toxic assets that caused theGreat Recession.[18][19]
According toHyman Minsky the great moderation enabled a classic period of financial instability, with stable growth encouraging greaterfinancial risk taking.[20]
It is now commonly assumed that the2008 financial crisis and theGreat Recession brought the Great Moderation period to an end, as was initially argued by some economists such asJohn Quiggin.[21]Richard Clarida atPIMCO considered the Great Moderation period to have been roughly between 1987 and 2007, and characterized it as having "predictable policy, low inflation, and modest business cycles".[22]
However, before the COVID-19 pandemic, the US real GDP growth rate, the real retail sales growth rate, and the inflation rate had all returned to roughly what they were before the Great Recession. Todd Clark has presented an empirical analysis which claims that volatility, in general, has returned to the same level as before theGreat Recession. He concluded that while severe, the 2007 recession will in future be viewed as a temporary period with a high level of volatility in a longer period where low volatility is the norm, and not as a definitive end to the Great Moderation.[23][24]
However, the decade followingGreat Recession had some key differences with the economy of the Great Moderation. The economy had a much larger debt overhead. This led to a much slower economic recovery, the slowest since theGreat Depression.[25] Despite the low volatility of the economy, few would argue that the 2009-2020 economic expansion, which was the longest on record,[26] was carried out underGoldilocks economic conditions. Andrea Riquier dubs the post-Great Recession period as the "Great Stability".[27]