Detecting recessions in the Great Moderation: a real-time analysis

The nature of the business cycle, particularly in the United States, has changed dramatically over the past several decades. In the 1970s and early 1980s, the U.S. economy often whipsawed up and down. Since then, real economic activity stabilized considerably, entering a period economists call the “Great Moderation.” With the ups and downs of the economy becoming less dramatic, it has become harder to determine in real-time when the economy dips into recession. ; Economists have a variety of methods to determine when the economy is entering a recession. These methods range from directly analyzing a broad spectrum of data to the formal use of recession prediction models. The National Bureau of Economic Research (NBER) uses the first approach, relying on several data series to make a determination of when the economy enters or exits a recession. Their decisions are intended to be accurate, not timely. More formal recession prediction models are designed to send a timely signal, but often do not take account of how the Great Moderation has altered the business cycle. ; Davig uses a framework that efficiently uses a large set of data in a “business cycle tracking” model. The model accounts for shifts in overall economic volatility – to capture the Great Moderation – and sends a signal when the economy is shifting between periods of low and high economic activity. The model can be used in different ways to extract a signal regarding whether the economy is likely heading for an NBER recession.

What is the effect of financial stress on economic activity

Despite the apparent risk that financial stress poses to the real economy, the relationship between financial stress and economic activity is complex and not well understood. The experience of the United States and other countries has shown that businesses and households often pull back on new investments and purchases in response to the tighter credit conditions and greater uncertainty caused by financial stress. Yet important gaps remain in our understanding of this critical relationship. ; One potential complication is that the relationship may change when financial stress is elevated and the economy is in a recession. Over the last 20 years, the U.S. economy has shown a tendency to switch between two very distinct states—a normal state in which economic activity is high and financial stress is low, and a distressed state in which economic activity is low and financial stress is high. Does the impact of financial stress on economic activity depend on which of these two states currently prevails? And how do changes in financial stress and economic activity affect the likelihood of switching from one state to the other? ; Davig and Hakkio examine these questions. A key finding is that, over the last two decades, increases in financial stress have had a much stronger effect on the real economy when the economy is in a distressed state. In addition, rising financial stress plays a role in eventually tipping a strong economy into a distressed state. As a result, policymakers should monitor financial conditions closely, both in good as well as bad times.

Endogenous monetary policy regime change

This paper makes changes in monetary policy rules (or regimes) endogenous. Changes are triggered when certain endogenous variables cross specified thresholds. Rational expectations equilibria are examined in three models of threshold switching to illustrate that (i) expectations formation effects generated by the possibility of regime change can be quantitatively important; (ii) symmetric shocks can have asymmetric effects; (iii) endogenous switching is a natural way to formally model preemptive policy actions. In a conventional calibrated model, preemptive policy shifts agents’ expectations, enhancing the ability of policy to offset demand shocks; this yields a quantitatively significant “preemption dividend.”Monetary policy ; Taylor's rule

EXPECTATIONS AND FISCAL STIMULUS

Increases in government spending trigger substitution effects—both inter- and intra-temporal—and a wealth effect. The ultimate impacts on the econ- omy hinge on current and expected monetary and fiscal policy behavior. Studies that impose active monetary policy and passive fiscal policy typically find that government consumption crowds out private consumption: higher future taxes cre- ate a strong negative wealth effect, while the active monetary response increases the real interest rate. This paper estimates Markov-switching policy rules for the United States and finds that monetary and fiscal policies fluctuate between ac- tive and passive behavior. When the estimated joint policy process is imposed on a conventional new Keynesian model, government spending generates positive consumption multipliers in some policy regimes and in simulated data in which all policy regimes are realized. The paper reports the model’s predictions of the macroeconomic impacts of the American Recovery and Reinvestment Act’s implied path for government spending under alternative monetary-fiscal policy combina- tions.

Monetary-fiscal policy interactions and fiscal stimulus

Increases in government spending trigger substitution effects both inter- and intra-temporal and a wealth effect. The ultimate impacts on the economy hinge on current and expected monetary and fiscal policy behavior. Studies that impose active monetary policy and passive fiscal policy typically find that government consumption crowds out private consumption: higher future taxes create a strong negative wealth effect, while the active monetary response increases the real interest rate. This paper estimates Markov-switching policy rules for the United States and finds that monetary and fiscal policies fluctuate between active and passive behavior. When the estimated joint policy process is imposed on a conventional new Keynesian model, government spending generates positive consumption multipliers in some policy regimes and in simulated data in which all policy regimes are realized. The paper reports the model's predictions of the macroeconomic impacts of the American Recovery and Reinvestment Act's implied path for government spending under alternative monetary-fiscal policy combinations.

State-Dependent Stock Market Reactions to Monetary Policy

This paper presents a test of the response of stock prices to Federal Reserve policy shocks using a Markov-switching framework. The framework endogenously identifies two distinct regimes. The first is a state where the S&P 500 index exhibits a significantly negative response to unexpected changes in the target federal funds rate in the thirty-minute window bracketing FOMC announcements, a result consistent with previous work. However, the model identifies a second regime from September 1998 to September 2002, in which the response of stock prices to policy shocks is insignificant and over ten times more volatile relative to the other regime.�

Decomposing the declining volatility of long-term inflation expectations

The level and volatility of survey-based measures of long-term inflation expectations have come down dramatically over the past several decades. To capture these changes in inflation dynamics, we embed both short- and long-term expectations into a medium-scale VAR with stochastic volatility. The model documents a marked decline in the volatility of expectations, but also reveals a shift in the factors driving their movement. Throughout the 1980s and early 1990s, the majority of the variance in long-term expectations were driven by 'own' shocks. Beginning in the mid-1990s, however, the factors explaining the variance of long-term expectations began shifting amidst an overall decline in volatility. At the end of the sample in 2008, innovations to measures of inflation and output account for the majority of the remaining low-level of volatility in long-term expectations. We document a shift in monetary policy towards more systematic behavior that precedes the shift in the factors driving long-term expectations.

Generalizing the Taylor Principle

The paper generalizes the Taylor principle—the proposition that central banks can stabilize the macroeconomy by raising their interest rate instrument more than one-for-one in response to higher inflation—to an environment in which reaction coefficients in the monetary policy rule evolve according to a Markov process. We derive a long-run Taylor principle that delivers unique bounded equilibria in two standard models. Policy can satisfy the Taylor principle in the long run,even while deviating from it substantially for brief periods or modestly for prolonged periods. Macroeconomic volatility can be higher in periods when the Taylorprinciple is not satisfied, not because of indeterminacy, but because monetary policy amplifies the impacts of fundamental shocks. Regime change alters the qualitative and quantitative predictions of a conventional new Keynesian model, yielding fresh interpretations of existing empirical work.regime change, indeterminacy, monetary policy