SINCE THE EARLY 1980S the U.S. economy has gone through two long expansions. The first, from 1982 to 1990, lasted thirty-one quarters. The second started in 1991 and, although showing signs of faltering, has recorded its fortieth quarter as this volume goes to press and is already the longest U.S. expansion on record.
One view is that these two long expansions are simply the result of luck, of an absence of major adverse shocks over the last twenty years. We argue that more has been at work, namely, a large underlying decline in output volatility. Furthermore, we contend, this decline is not a recent development--the by-product of a "New Economy" or of Alan Greenspan's talent. Rather it has been a steady decline over several decades, which started in the 1950s (or earlier, but lack of consistent data makes this difficult to establish), was interrupted in the 1970s and early 1980s, and returned to trend in the late 1980s and the 1990s.(1) The magnitude of the decline is substantial: the standard deviation of quarterly output growth has declined by a factor of three over the period. This is more than enough to account for the increased length of expansions.
Having established this fact, we reach two other conclusions. First, the decrease in volatility can be traced to a number of proximate causes, from a decrease in the volatility of government spending early on, to a decrease in consumption and investment volatility throughout the period, to a change in the sign of the correlation between inventory investment and sales in the last decade. Second, there is a strong relationship between movements in output volatility and movements in inflation volatility. The interruption of the trend decline in output volatility in the 1970s was associated with a large increase in inflation volatility; the return to trend is associated with the decrease in inflation volatility since then.
This paper is organized as follows. We start by documenting our basic fact, namely, the secular decrease in output volatility. We then look at the stochastic process for GDP and show that this decrease in volatility can be traced primarily to a decrease in the standard deviation of output shocks, rather than to a change in the dynamics of output. Finally, we show how this decrease in the standard deviation of shocks accounts for the increased length of expansions.
We then take up the question of whether recessions are special, in a way that the formalization used earlier does not do justice to. Put another way, we ask whether what we have seen over the last twenty years is simply the absence of large shocks and nothing more. We show that this is not the case. The measured decrease in output volatility has little to do with the absence of large shocks in the recent past.
We then turn to the relationship between output volatility and inflation. We show that there is a strong relationship both between output volatility and the level of inflation, and between output volatility and inflation volatility. Both volatilities went up in the 1970s and have come down since. Correlation does not, however, imply causality. The correlation in both periods may have been due to third factors, such as supply shocks in the 1970s. This leads us to consider evidence from the other members of the Group of Seven (G-7) large industrial countries. Our motivation here is that the different timings of disinflation across these countries can help us separate out the effects of inflation from those of supply shocks. We first show that these other countries have also experienced a decline in output volatility, although with some differences in timing and in magnitude. (An interesting exception is Japan, where a decline in output volatility has been reversed since the late 1980s.) We then show that, even after controlling for common time fixed effects, inflation volatility still appears to be strongly related to output volatility.
As a matter of accounting, the decline in output volatility can be traced either to changes in the composition of output or to changes in the variances and covariances of its underlying components. …