Over the past few years, I’ve done a number of posts discussing the mystery of “mini-recessions”. The mystery is the complete lack of mini-recessions in the US. After all, mini-earthquakes are much more common that big earthquakes, so why isn’t the same true of recessions? Why is it that when the unemployment rate jumps by more than a very small amount, it eventually rises by more than 2%. Why not increase by 1%, or 1.5%?
As far as I know, none of the major macro theories can explain the absence of mini-recessions. Indeed I have trouble even getting people interested in the topic. And then there’s the mystery of why other countries do have mini-recessions.
Former NY Fed President Bill Dudley has an article warning of the danger of the economy slowing to a “stall speed”.
Don’t Let the U.S. Economy Hit Stall Speed
The Fed should take out some insurance against a recession.
As soon as I saw that headline, I immediately thought of the absence of mini-recessions. If the economy slows to a certain point, then things get much, much worse before getting better. Dudley has the same intuition:
To understand the risk, consider the historical behavior of the unemployment rate. Looking at a three-month average (to eliminate month-to-month noise), a remarkable pattern appears: When the rate rises, it moves either trivially or a lot. That is, either it goes up by less than a third of a percentage point, or it goes up by 2 percentage points or more and the U.S. economy falls into recession. Since World War II, there has never been anything in between.
So how does Dudley explain this mystery?
Why the gap? The answer probably lies in a dynamic that Yale economist Robert Shiller describes in his new book, “Narrative Economics.” Suppose some minor economic shock, such as heightened uncertainty about trade policy, precipitates modest job losses. When other workers hear that their acquaintances, or their acquaintances’ acquaintances, have been laid off, they worry that they could be next. So they tighten their belts a bit, eat out less, hold off on that kitchen remodeling. This reduces demand further and leads to more layoffs. Pretty soon the negative narrative is pervasive and self-reinforcing, with the unemployment rate rising persistently. The Fed can’t respond in time because definitive data take a while to appear, and because it takes time for monetary easing to stimulate economic activity.
I’ve also argued that monetary policy plays a role in the lack of mini-recessions. My view is that our interest rate targeting regime imparts a procyclical bias into policy. A negative shock lowers the equilibrium interest rate, and the Fed is slow to respond. Money gets (effectively) tighter. Eventually the Fed catches on to the problem, but by that time it’s too late to prevent a full-blown recession. In my view, this problem could be solved if we switched from interest rate targeting to the targeting of market expectations of NGDP, and also engaged in level targeting. In that case, we’d have many fewer recessions and a few more mini-recessions.
READER COMMENTS
P Burgos
Oct 29 2019 at 10:07pm
Could the size of the US economy have anything to do with the lack of mini recessions? Or perhaps the US economy is more insular? Maybe the role of the US dollar as a reserve currency prevents the US economy from reorienting towards exports and import substitution in a way that isn’t the case for other countries?
Nick
Oct 30 2019 at 7:41am
the reasons given dont seem to offer any hint of why other countries can have mini recessions.
having a quick look at the data, europe as a whole has the same feature as the US, no mini recessions, but individual european countries do have mini recessions. do us states have mini recessions whilst the us as a whole doesnt?
if true, this could suggest there are no medium sized shocks, either shocks are so small that they are practically unnoticeable in a large economic zone (though noticeable in more concentrated smaller economic zones), or large that they affect the whole world.
Nick
Oct 30 2019 at 2:23pm
forgot to mention also, it’s the case that the US consumer has a much higher percentage of wealth in equities than the average european. so that is certainly a source of feedback that could exacerbate recessions.
Scott Sumner
Oct 30 2019 at 7:11pm
Do you have a long time series for European unemployment?
Nick
Oct 31 2019 at 8:36am
IMF data here seems to go back to 1980
https://www.imf.org/external/datamapper/LUR@WEO/FRA/ITA/ESP/FIN/DEU/AUT/NLD/BEL
World bank data goes back further but is patchy
https://data.worldbank.org/indicator/SL.UEM.TOTL.NE.ZS?locations=AT-BE-FI-FR-DE-IE-IT-ES
https://www.quandl.com/is often good, but didnt find anything further back yet.
Alan Goldhammer
Oct 30 2019 at 8:10am
With the usual caveat that I am not an economist, I would side with P Burgos’s points above. Certainly there are sectors of the economy that are exhibiting signs of trouble largely because of the tariff situation. Some manufacturers are laying off workers as things are slowing down. Agricultural exports are problematic and perhaps farm bankruptcies will rise. Another coal company just declared bankruptcy yesterday (though that is a result of alternative energy choices).
The one bright spot is some very good corporate earnings coming out but that’s reflective of the past and not the future. There is just a lot of weirdness out there to paraphrase Hunter Thompson.
jj
Oct 30 2019 at 10:35am
The problem has been understood for at least 90 years. Shiller was describing what Keynes called Animal Spirits. I haven’t read Shiller’s book, but I would expect he referenced that.
The solution (rather a solution — but a good, achievable one) is more recent: NGDP targeting.
Thaomas
Oct 31 2019 at 10:26am
Or actually acting on the targets that the Fed already has, maintaining average inflation at 2% and maximizing employment. I’m not entirely persuaded that the Fed’s problem has not been reluctance (perceived constraint) to use all the instruments it has rather than that it’s targets being wrong. [Admittedly, it is hard to distinguish the former from an inflation rate ceiling target.]
jj
Oct 31 2019 at 3:12pm
Yes the larger problem is their instruments and willingness to use them, but much of this is addressed by level targeting (which mitigates the unwillingness) and NGDP targeting (which has no zero bound).
Thaomas
Oct 31 2019 at 8:49pm
But average inflation targeting is price level targeting and maximum employment has no upper bound. Conceivably one might need to stimulate the economy when the price level trend was on target but unemployment was had risen, but I suspect this would not happen frequently or for long. I’ll bet that one would be hard pressed to deduce which central band was following which rule if one targeted NGDP and the other PL + employment.
Thaomas
Oct 30 2019 at 11:26am
There is a lot in this, but it does not explain why the Fed chooses to target interest rates rather that prices and employment as is their mandate. That the price level is above or below their target or that unemployment is above target. are easily observed phenomena; the “equilibrium” level of “the” interest rate is not.
Now it is understandable that one does not necessarily move the instrument to every quiver in the price level or unemployment rate, but many central banks use short term interest rates as their policy instrument without allowing their economies to fall into recession and and remain there for years.
Michael Rulle
Oct 30 2019 at 11:37am
Prof Shiller’s CAPE is useful, I think. Meaning it is one of a number of ways to look at market valuation.
But a recent interview he gave–or “narrative”—- (which at first I wondered if it was some form of sarcasm) on the positive impact Trump has had on the economy was amazing. He seemed to say that Trump’s policies, personality, and our alternatives (e.g.,Warren et.al) will continue to have positive impacts on markets and the economy if he is re-elected. It felt —–bizarre may be too strong a term—but something close to it. Even though I did not necessarily disagree (!)
“Narratives” are just impressions—maybe they are real—but we will never know. It was his emphasis on “personality” I found most astonishing. This comment has nothing to do with my views on Trump, just my observation of Shiller.
He appears to literally make Trump the cause, not only of current success, but future success. I cannot think of a thought process more different than yours.
I read your title—-and I immediately predicted your answer, wasn’t too hard—-Fed tightens to create a worse outcome (why just our central bank?) and we need to go to NGDP. I have said in the past, not critically—(am not knowledgeable enough to be “critical” ), but observationally, that this is very often your answer to complex questions.
My point, which you may correct, is I cannot think of more different views of how the economy “works” than you and Shiller.
Cloud
Oct 31 2019 at 1:57am
Have you read, or will you, Shiller’s Narrative Economics?
I mean, after all, the Midas Paradox is itself based “narrative” study of your reading of newspaper back in the 30s. I would love to know if you have any thought on Shiller’s framework, as a long term practitioner of similar method.
Scott Sumner
Oct 31 2019 at 12:21pm
Cloud, Probably not.
Thaomas
Nov 1 2019 at 12:31pm
Here is the explanation!
https://blogs.uoregon.edu/timduyfedwatch/2019/10/31/fed-attempts-to-conclude-their-mid-cycle-adjustment/
The Fed has pretty much admitted that it is NOT targeting average inflation at 2%. So what kind of a “stable prices” target DO they have? They say, obviously, that that they will react to (how large?) increases in unemployment. But on the whole it leaves everyone in the dark about what their targets actually are. That means that anyone making a business decision has not one thing to try to forecast, events that affect business conditions — a new trade war, hard Brexit, German recession, etc. — but two things, changes in business conditions and how the Fed will react to those conditions.
And the problem with reacting only to unemployment is that unemployment increases only after things are getting worse.
Jake W.
Nov 7 2019 at 3:37pm
Isn’t this exactly the Austrian school’s “cluster of errors” critique resulting from centralized monetary policy?
Dallas Weaver Ph.D.
Nov 7 2019 at 4:53pm
Sorry, the aerodynamic stalling metaphor is not very good for an economy. Dynamic effects are best described by differential equations. I know the math is harder than economists like, but control theory and electrical engineers have done all the math relative to supply/demand systems where an increase in demand drives an increase in supply through price signals like in normal markets (aka. a feedback control system).
Real economic systems have inertial type properties where some things keep going for some time before changing. For example, building new housing that is 90% complete will go to completion even after the market dropped. The dynamic effects of these slow to change components eliminates the mini-recessions.
Stalling is going from one stable condition to another with a loss of lift. No relevant inertial effects just a radical change in the boundary layers.
spencer
Nov 8 2019 at 11:54am
The pattern of US recessions has changed since 1980. Prior to 1980 the four year cycle was the norm but since 1980 the (only) two recessions have been about a decade apart.
Part of the change is the technology company managements now have to monitor their business in a real time basis. They can now adjust their output much faster in reaction to a shift in demand than they did in the old days, so the necessary adjustment is much smaller. Moreover, now when firms find themselves with excess inventories more of the change shows up as a change in imports rather than a change in domestic production. Consequently, the international leakages of economic adjustments is much larger now.
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