The Federal Reserve (the Fed) is widely expected to announce another interest rate hike on Feb. 1. The Federal Open Market Committee (FOMC) statement and Chairman Jerome Powell’s post-meeting press conference will be parsed closely, and an interminable debate regarding future Fed actions will start all over again.
While the media circus surrounding short-term policy changes makes for good theater, it is time to consider the longer-term challenges facing central bankers. Debating whether the terminal rate in the current rate hike cycle should be slightly above or slightly below 5 percent is a moot exercise. It should suffice that the Fed is fast approaching the end of its rate hike cycle. (Frankly, the duration over which rates are maintained at elevated levels is of greater consequence.)
In the long run, the growing possibility that the Fed and other major central banks may face a fundamentally more unstable environment in the coming years than the one they experienced over the prior four decades should be a matter of great concern.
Between 1984 and early 2020, the degree of volatility associated with output growth and inflation was, for the most part, quite low. Even the 2008-09 financial crisis and the accompanying Great Recession caused only a brief spike in macroeconomic volatility. In fact, the period between June 2009 and February 2020 saw the U.S. experience its longest economic expansion, albeit one characterized by subpar growth and muted inflationary pressures.
The underlying causes of the so-called “Great Moderation” are still debated by economists. Broadly, three main candidates have been highlighted in the economics literature: structural changes, improved monetary policy and good luck (smaller/fewer exogenous shocks and favorable supply-side developments).
Globalization and technological changes, along with institutional shifts and evolving business practices, played a role in bringing about a structural transformation in both the U.S. and the global economy during the Great Moderation era. Globalization contributed to the easing of macroeconomic volatility in several advanced economies as it was able to act as a massive shock absorber.
The establishment of an efficient global supply chain that was able to integrate capital from the West with surplus labor from China and other emerging economies using modern information and communication technologies (ICT) allowed for a dramatic expansion in global productive capacity. Information technology-based outsourcing/offshoring to low-cost destinations also generated significant cost savings for Western multinationals.
Furthermore, as a Federal Reserve essay notes: “Changes in the structure of the economy can reduce volatility. For example, since manufacturing tends to be volatile, the shift that occurred from manufacturing to services would tend to reduce volatility. Another structural change would be the adoption of ‘just-in-time’ inventory practices, which reduces the volatility of the inventory cycle. Similarly, advances in information technology and communications may have allowed firms to produce more efficiently and monitor their production processes more effectively, thereby reducing volatility in production—and thus in real GDP.”
Meanwhile, many central bankers endorsed the notion that better monetary policies were a key contributor as well. Following the debacle of the 1970s and early 1980s, there was widespread policy consensus that favored enhancing central bank independence and establishing (formally or informally) a hierarchical mandate that prioritized the maintenance of price stability through the adoption of explicit or implicit inflation targeting regimes. Some, however, are skeptical of the notion that improved monetary policy was chiefly responsible for the Great Moderation.
The European Central Bank’s Isabel Schnabel recently highlighted the role of energy supply: “Following the oil price shocks of the 1970s, the distribution of global oil supply changed drastically. OPEC’s global market share fell from 53% in 1973 to 28% in 1985 as Mexico, Norway and other countries started producing significant amounts of oil. The ‘Shale Revolution in the United States, which started at the turn of the century, changed the oil market once again. It is estimated to have resulted in a significant increase in the price elasticity of oil and gas supply … the emergence of the United States as a large net exporter of energy buffered the impact of demand shocks on oil and gas prices over the past 15 years.”
Even as economists continue to debate the underlying causes of the Great Moderation, we may be headed into a new era that is highlighted by a return of macroeconomic volatility. The major forces responsible for the Great Moderation are all now starting to either reverse or dissipate.
The geopolitical landscape has shifted radically, and a sustained period of heightened uncertainty and volatility may lie ahead. America and its closest allies are re-orienting economic priorities to emphasize strategic autonomy and supply chain resilience. Reappraisal of global supply chains and the growing reliance on economic sanctions and trade protectionism raise the possibility of partial de-globalization and reemergence of economic blocs.
Increased economic turbulence may also be driven by more frequent and more severe weather-related shocks. Furthermore, the green transition, though necessary, is likely to be a costly endeavor in the short-to-medium run, and insufficient energy buffers will leave the global economy exposed to sudden supply-side shocks.
We can no longer rely on favorable structural shifts, and geopolitical tensions are rising and climate threats are growing. Consequently, central bankers will face considerable challenges in their attempts to attain monetary policy normalization. Furthermore, an ultra-accommodative monetary policy stance in the past (and the resultant financial distortions) has led to a massive increase in the global debt load. This will further restrict central banks’ ability to maneuver in the years ahead.
Vivekanand Jayakumar is an associate professor of economics at the University of Tampa.