Stall speed and mini-recessions
By Scott Sumner
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.