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Three Funerals and a Wedding

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Three Funerals and a Wedding Three Funerals and a Wedding James B. Bullard This article is a modified and updated version of a speech presented at the Regional Economic Summit, Evansville, Indiana, November 20, 2008. Federal Reserve Bank of St. Louis Review, January/February 2009, 91(1), pp. 1-12. he U.S. economy continues to face be taking on a new life. I will keep you in suspense substantial turmoil. Financial markets about what ideas I have in mind. are under unusual stress. Wall Street As always, any views expressed here are my has been racked by seismic change. own and do not necessarily reflect the official TUncertainty over the future prospects for the U.S. views of other Federal Open Market Committee economy has caused consumers and businesses members. to pull back on discretionary consumption and investment spending. Doubts concerning the true value of complex securities continue to weigh THE FATE OF THE GREAT heavily on financial markets worldwide. The still- MODERATION uncertain fate of housing markets has kept the value of the underlying mortgage assets obscured. A common description of current events is The Federal Reserve has been active and that some cherished theories about the macro- innovative in responding to the evolving turmoil economy have been shattered. One idea is that during 2008. In addition to deploying interest rate the fabled resiliency of the U.S. economy over cuts, the Fed has implemented a series of new and the past several decades is being called into ques- unconventional tools. This innovation has inten- tion. Policymakers and academics alike have sified in response to evolving market events. described the period since the mid-1980s as the There may be many more twists and turns in the Great Moderation, meaning that the volatility of policy response going forward. the economy has been markedly lower during I will discuss the challenges my Federal recent decades than it was in the earlier part of Reserve colleagues and I face as we strive to imple- the postwar era, and certainly much less than ment a policy that is designed to deliver low and during the interwar period during the 1920s and stable inflation along with maximum sustainable 1930s. Now, that moderation and resiliency may employment. I will describe three funerals and a be coming unraveled. If so, it would be a funeral wedding—that is, three ideas about the U.S. for the Great Moderation. economy that may be going to their final resting Is it really true that the Great Moderation is place and one idea that, once left for dead, may coming to an end? My sense is that it is too early to James B. Bullard is president of the Federal Reserve Bank of St. Louis. The author appreciates the assistance and comments provided by colleagues at the Federal Reserve Bank of St. Louis. Marcela M. Williams, special research assistant to the president, provided assistance. © 2009, The Federal Reserve Bank of St. Louis. The views expressed in this article are those of the author(s) and do not necessarily reflect the views of the Federal Reserve System, the Board of Governors, or the regional Federal Reserve Banks. Articles may be reprinted, reproduced, published, distributed, displayed, and transmitted in their entirety if copyright notice, author name(s), and full citation are included. Abstracts, synopses, and other derivative works may be made only with prior written permission of the Federal Reserve Bank of St. Louis. FEDERALRESERVEBANKOFST. LOUIS REVIEW JANUARY/FEBRUARY 2009 1 Bullard Figure 1 Real GDP Growth, 1950:Q1–2008:Q3 Percent Change, Annual Rate 20 15 10 5 0 –5 –10 –15 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 SOURCE: Bureau of Economic Analysis and National Bureau of Economic Research. tell. Let’s begin with a description of why policy- often the case when the data show a clear pattern, makers and academics started talking about mod- theories abound about the causes of this phenom- eration and resiliency in the first place. The main enon. But all the theories have a common theme— idea is simple: Our primary measures of macro- namely, that some important macroeconomic economic performance have been a lot less volatile event triggered a more stable, more resilient than they were before 1984. In particular, quarterly American economy over the past 25 years. gross domestic product (GDP) growth rates for the Understandably, many are yearning for a U.S. economy since 1945 show a clear change in sense of stability today, and many are questioning behavior beginning in the middle 1980s. After what happened to the resiliency and moderation 1984, these growth rates are only about half as in the U.S. economy. Two areas stand out where 1 volatile as they were during the earlier period. volatility has been particularly high since the cur- So, for the past 25 years, growth rate volatility has rent financial turmoil began in earnest in August dramatically moderated from what it was in the 2007. One is in certain interest rates and interest 1950s, 60s, and 70s (Figure 1). rate spreads, especially in markets that have expe- Furthermore, this phenomenon is not limited rienced severe difficulties since the turmoil began. to real GDP growth rates. Almost all macroeco- The closely watched LIBOR–Overnight Index nomic data have been dramatically less volatile since the mid-1980s, according to academic Swap spread, for instance, peaked at more than research (Stock and Watson, 2003). So the Great 300 basis points before retreating in recent weeks. Moderation is a clear feature of the U.S. macro- In July 2007, this spread was less than 10 basis economic data since the mid-1980s. And, as is points (Figure 2). Another volatile area is the equity markets: The Wilshire 5000 stock price 1 index, one of the broadest measures of equity For a discussion and some theorizing about the Great Moderation, see Bullard and Singh (2007). valuation, has been trading near its lows of 2002 2 JANUARY/FEBRUARY 2009 FEDERALRESERVEBANKOFST. LOUIS REVIEW Bullard Figure 2 LIBOR, OIS, and Federal Funds Target Rate, January 3, 2007–December 10, 2008 Percent 6 5 4 3 2 Federal Funds Target Rate 1 3-Month LIBOR 3-Month OIS 0 01/01/07 04/01/07 07/01/07 10/01/07 01/01/08 04/01/08 07/01/08 10/01/08 SOURCE: Federal Reserve Board, British Bankers’ Association, Reuters. Figure 3 Wilshire 5000 Price Index/Nominal GDP, 1980:Q1–2008:Q3 Ratio 2.0 1.5 1.0 0.5 0.0 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 SOURCE: Wall Street Journal, Bureau of Economic Analysis, and National Bureau of Economic Research. FEDERALRESERVEBANKOFST. LOUIS REVIEW JANUARY/FEBRUARY 2009 3 Bullard Figure 4 Chicago Board Options Exchange VIX, January 3, 2007–December 10, 2008 Index 105 84 63 42 21 0 01/01/07 04/01/07 07/01/07 10/01/07 01/01/08 04/01/08 07/01/08 10/01/08 SOURCE: Wall Street Journal. and 2003 in the past few weeks (Figure 3). The to fall sharply, followed by further but less-severe Chicago Board Options Exchange market volatility contraction in the first quarter of 2009. If that index (VIX) was often above 60 during October scenario materializes, the contour of the current and November of this year; in July 2007 it was recession will look much the same as that of the below 20. The dramatic rise in volatility based 1990-91 recession. As bad as that feels, it is not on numbers like these is clear (Figure 4). enough to undo 25 years of moderated behavior Still, it is far too early to organize a funeral in the U.S. economy. for the Great Moderation. Even though financial market volatility is exceptionally high and the U.S. economy is contracting during the second CHANGES IN THE FINANCIAL half of 2008, the demise of the Great Moderation MARKETPLACE would require much more evidence than currently exists. Real economic variables, in particular, It is no secret that the current financial market would have to swing much more than they have turmoil has brought about once-unimaginable to date, and the increased volatility would have changes on Wall Street. One telling sign of the to continue for a number of years before we could magnitude of these changes is that the U.S. econ- start to compare the current environment with the omy began 2008 with five large investment banks pre-1984 experience and pronounce the modera- but will exit the year with zero. Without question, tion dead. Real GDP has fallen by half a percent financial market turmoil since August 2007 is at an annual rate in the third quarter of this year.2 radically altering the nature of U.S. financial To be sure, fourth-quarter 2008 output is expected intermediation. I think it is fair to say that we are witnessing a funeral for the financial system we 2 The BEA preliminary estimate was released November 25, 2008. have known over the past two decades. 4 JANUARY/FEBRUARY 2009 FEDERALRESERVEBANKOFST. LOUIS REVIEW Bullard A key culprit has been the illiquidity of cial market regulation. In particular, any reform mortgage-backed securities and related financial has to address the question of whether—and how— instruments. Many financial firms simply did not to set up systems to resolve failing non-bank manage risk exposure on these securities well financial firms in an orderly way. The current and as a result have struggled with losses and system—bankruptcy court—is not working.
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