Oil and the Great Moderation

Another interesting paper presented at the Society for Nonlinear Dynamics and Econometrics Symposium that I attended last week was by Anton Nakov of the Bank of Spain and Andrea Pescatori of the Federal Reserve Bank of Cleveland on the role that changes in energy markets may have played in the reduction in GDP and inflation volatility observed since 1984. (Click to enlarge images.)

Source: Nakov and Pescatori (2007)

One of the features that has to strike you if you look at a plot of U.S. real GDP growth rates over the last half century is the fact that its volatility (the magnitude of deviations above or below the average growth rate) has dampened considerably since the mid 1980s. No less striking is the apparent reduction in the level and volatility of inflation.

Source: Nakov and Pescatori (2007)

One sometimes can get the impression from discussions in the popular press that an investigation into what's behind these changes is somehow ideological or agenda driven. But to most economists studying this matter, it is simply an objective feature of the data for which an explanation should be sought. Margaret McConnell and Gabriel Perez-Quiros were the first to document that the reduction in GDP volatility is a statistically significant development. Since their study, there have been a number of academic papers documenting this phenomenon and investigating the possible factors behind it.

I found the latest study by Nakov and Pescatori particularly interesting, in that it looked among other things at the role that changes in oil markets may have played in these trends. We saw three major disturbances in global oil supplies in the 1970s and early 1980s, associated with the 1973-74 oil embargo by the Organization of Arab Petroleum Exporting Countries, the 1978 Iranian revolution, and the subsequent war between Iran and Iraq, which many economists believe contributed to the recessions that followed each of these events. Since 1984, however, we have been more fortunate in only seeing one such big disturbance (the one associated with the 1990-91 Persian Gulf War). Moreover, many economists argue that the decreasing dollar share of energy expenditures in total value added may have made the economy less vulnerable to effects of oil supply disruptions.

One of the interesting features of Nakov and Pescatori's new paper is that they try to distinguish between supply and demand factors in influencing the determinants of oil prices. They use a model in which part of the world oil market is controlled by an OPEC monopoly while the rest of the market is competitive. According to such a view, one transmission mechanism whereby oil supply disruptions may influence the economy is through inducing variations in the economic distortions induced by monopolizing markups. I am not persuaded that this is the best way to interpret global oil markets, but I found the effort thoughtful and well done.

The authors then infer estimates of the magnitudes of pre- and post-1984 disruptions in oil supplies on the basis of the the observed variability in relative oil prices, and calibrate the reduced share of oil in total expenditures directly from the observed magnitudes. Their effort also examines a number of the other main competing explanations for the moderation in output and inflation. Most prominent among these are first the idea that monetary policy has become both more predictable and more aggressive in responding to deviations of inflation or output from the intended targets, and second the "good luck" hypothesis-- the economy has simply been subject to less year-to-year variation in productivity growth, for unknown reasons.

Fraction of predicted decline in volatility of GDP and inflation that would be attributed to improvement in indicated category (in percent):

Nakov and Pescatori's simulation predicts that a combination of the above factors could account for a 52% reduction in the volatility of GDP growth and a 58% reduction in the volatility of inflation since 1984, both of which are quite close to what is actually observed. The table above shows how big a contribution the various factors they studied would be predicted to make to these totals. They conclude that although improved monetary policy is the biggest single factor in the reduced volatility in inflation since 1984, changing oil markets have also helped, with the reduced reliance on oil accounting for 1/3 of the reduction and the reduced prevalence of major oil supply shocks accounting for an additional 9% of the reduction in the volatility of inflation.

By contrast, the authors conclude that neither monetary policy nor oil markets are the main explanation for the reduced volatility of GDP. According to their calculations, the reduced reliance on oil and increased stability in oil markets might account for about 1/5 of the reduction in GDP volatility, while monetary policy mattered very little. Instead, the biggest factor seems to be unexplained changes in productivity-- the reduced volatility of real GDP may be largely a matter of having had some better luck.

Although it may be a little frustrating intellectually to conclude that "good luck" is the main explanation for the reduced volatility of GDP, that's the same conclusion reached in many of the previous investigations of this question, such as those by James Stock and Mark Watson and Sylvain Leduc and Keith Sill.

Comments

[Mr. Math]

"lucky": Non-supply-side economists will go to almost any lengths to avoid giving credit to Reaganomics for changing the world.