The Great Moderation

Very Interesting article from Financial Times. Notice the debate over what has cause “The Great Moderation” in output fluctuations and inflation rates! What has caused the last two decades of mild business cycles and mild inflation. Is it:

1 Better monetary policy (Feds controlling supply of money)

2 Increased productivity (Technology)

3 Globalization

4 Or a combination of all three.

So the interesting questions is: will these positive drivers continue? Greenspan says no, Taylor says yes, Rogoff says no, Blinder says yes. What do you all think?

BTW, Great Moderation is the period between 1980s and 2002 or so, during which US economy grew rapidly with little or no inflation.

Fed treads a fine line between perils

By Krishna Guha in Washington

Published: September 18 2007 03:00 | Last updated: September 18 2007 03:00

If Alan Greenspan is right, Ben Bernanke and his colleagues at the Federal Reserve - who meet today to set interest rates - have an even tougher decision to make than most people think.

Not only do they have to worry a lot about easing policy too little - and allowing the economy to slide into possible recession - but they also have to worry seriously about easing too much, and letting inflation out of the bag.

This is because MrGreenspan believes that the fundamental forces that have subdued inflationary pressure for more than a decade - high productivity growth and an increasing pace of globalisation - are set to abate.

If this is correct, it would be a very bad moment to make a policy mistake on inflation.

However, not all economists agree with Mr Greenspan's analysis, which emphasises the link between price changes and the rate of change of global economic integration. John Taylor, a professor at Stanford and former under-secretary for international affairs at the US Treasury, says: "The change in the behaviour of inflation over the last few decades cannot be explained at least in any great degree by changes in globalisation.

"By far the main thing is how central banks have behaved in terms of providing money growth and setting interest rates," he says.

Mr Taylor argues that there was a dramatic improvement in the conduct of monetary policy in the US and elsewhere from the early 1980s onwards. The increased credibility of central banks in turn reduced the expected rate of inflation.

He accepts that the trade-off between growth and inflation may have deteriorated due to lower productivity gains. But he sees little danger of today's low inflation rates being jeopardised by changing global economic trends.

"There is still this idea of monetary policy being conducted in a good way," he says.

However, Ken Rogoff, a professor at Harvard and former chief economist at the International Monetary Fund, says the improvements in inflation worldwide since the early 1980s cannot be simply attributed to better central banking.

Like Mr Greenspan, he believes the economic context was unusually favourable for a while, and may now be turning for the worse, though his specification of the processes differs.

Mr Rogoff says the rise of China has been changing relative prices - not the overall level of prices.

But he says that increased global competition may have made it more difficult for classic wage-price spirals to take off, and thus buttressed the credibility of central banks.

Mr Rogoff also says that many productivity gains were linked to opportunities created by global integration.

"Central banks have had the wind at their backs," he says.

"It has made it easier for them to deliver strong growth and low inflation at the same time. Now the parameters are changing."

He says that it will be much harder for the Fed to stay focused on inflation in an era of lower US growth.

"There will be pressureon it to inflate a little -and I bet it does," he says.

By contrast, Alan Blinder, a professor at Princeton and a former vice-chairman of the Fed, agrees with Mr Greenspan that globalisation has held down price pressures - but disagrees that the rate of change of this process is peaking.

Mr Blinder says the integration of China and India added much more to global supply than demand.

Technically, he says, this changes the world price level, not the inflation rate. But because this effect is spread out over many years, it looks like a lower inflation rate.

Mr Blinder says: "We are only beginning to exploit the opportunities for global economic integration inservices."

If he is right, the favourable tailwinds that benefited Mr Greenspan may also aid his successors for years to come.