Is the Business Cycle Dead?

Recession 101

Business expansions don’t die of old age, they died from excesses. These excesses include asset market bubbles, over-investment in inventories, capital goods and consumer durables like housing, and inflation. The recession comes when one or more of the excesses reverse at the same time and/or there is an external shock.

Inflation is the most important of these excesses. If inflation is under control, then it is much easier for the central bank to ease into an adverse shock. By contrast, if inflation is running too hot, the central bank will either tolerate negative shocks to growth or deliberately try to weaken the economy. Most modern recessions involve some combination of a central bank fighting inflation and some other shock.

A New York Times piece this weekend asked: “Is the Boom-and-Bust Business Cycle Dead?” The piece quotes one analyst, arguing that views of the business cycle are based on “an outdated model of how the US economy behaves.” That is because of the shift in the share of economic activity away from the volatile agricultural and manufacturing sector in favor of the relatively stable service sector.

The Great Moderation

This is not new. Economists have been talking about the moderation of the business cycle for several decades now. The term "great moderation" was coined by James Stock and Mark Watson in their 2002 paper, "Has the Business Cycle Changed and Why?" As an economist at the Fed in the early 1990s I learned that at least four things had moderated the business cycle, The first is the afore mentioned shift to services. The second is the development of shock absorbers like bank deposit insurance and the Fed as lender of last resort. The third is better inventory management, a major swing factor in booms and bust.

The fourth is the shift to pre-emptive monetary policy. After the disastrous Great Inflation of the 1970s policy makers learned that it was better to nip inflation in the bud than to wait until it was established. Preemptive monetary policy not only meant that the required inflation reversal was smaller, but it also increased confidence in central banks. If people believe the central bank will prevent serious inflation, then the inflation process is less likely to feed on itself. In my view, increased faith in the Fed goes a long way in explaining econometric estimates of a flat, stable Philips curve.

The upshot is that expansions have gotten much longer over time. Prior to World War II expansions tended to last two or three years. After the war they tended to be longer, including the then-record 106 month expansion in 1960s. The last four expansions have been consistently long: 92, 120, 73 and 128 months respectively, averaging 103 months.

Dead or sleeping?

We are now at a critical point in the economic outlook. The current expansion is just 48 months or less than half of the “new normal.” A combination of record fiscal stimulus, a late Fed response to inflation and supply-side shocks triggered the worst inflation since the 1970s. The Fed’s aggressive policy of catch up in 2022 created legitimate concerns about recession risk.  Fortunately, last year the data seemed to suggest “immaculate disinflation”—a steady drop in inflation despite a strong economy. Perhaps, it seemed, this expansion would be as long as the last four expansions?

While I do not expect a recession in the next couple years, now is an odd time to declare victory over the business cycle. With strong inflation readings over the last three months, recession risks are back on the radar screen. The risk is not the "long and variable lags" that some economists worry about. The last rate hike was a long time ago and financial conditions remain supportive of growth. Rather the risk is if inflation gets stuck above target, forcing the Fed to hit the brakes harder and deliberately risk a recession. The length of the business expansion is not a constant of nature, but requires dealing with excesses in the economy without causing a recession. Data in the coming months will show whether the business cycle is “dead” or just “sleeping.”