Wednesday, October 10, 2012

What Trend? 1991 or 1985?

During the Great Moderation, Nominal GDP remained on a remarkably stable growth path.   Generally, I have been calculating a log linear trend from the first quarter of 1985 to the last quarter of 2007.    Why not start at the beginning--1984?    I used to, but the 10 percent growth in the second quarter of 2004 caused me to place that year as part of the Reagan-Volcker nominal reflation.

Others have instead started their trends in the next decade.    As far as nominal GDP is concerned, it makes little difference.   The trend starting in 1985 has a 5.38 percent growth rate and the trend starting in 1991 has a 5.28 percent growth rate.    While the fit is a bit better for 1985 to 2007, the 1991 to 2007 trend does almost as well.

Not much difference to be seen at this scale.  Still, for the second quarter of 2012, the gap between current nominal GDP and trend is 15.2 percent for the 1985 trend and only 14.1 percent for the 1991 trend.    A difference of one tenth of a percent in growth rates adds up over the years.

No doubt it was due to my Market Monetarist priors that I have always fit all the other macroeconomic variables to the same trend--1985 to 2007.    The trend inflation rate using the GDP chain-type deflator is 2.3 percent and in the second quarter of 2012, the price level was 2.42 percent below trend.   

Using 1991, on the other hand, provides a trend inflation rate of 2.05 percent.   And the price level was not below trend in the second quarter of 2012, it was .3 percent above trend!    This is as close to being on trend as can be expected.     As Bullard and also Davies (at all) have pointed out, the Fed is doing a great job in targeting a 2 percent growth path for the price level.  (At least last quarter.)

The 1991 trend fits the first part of the nineties (up until 1997) very well.   It also fits the Great Recession.     The 1985 trend fits just about nothing other than the peak of the "Housing boom," maybe 2006 and 2007.   

Of course, from a Market Monetarist perspective, the price level should vary with "supply shocks."   All that is important is for nominal GDP to remain on trend.   

Here is the price level again with the 1991 trend.

After the 2 percent targeting regime was established in the nineties, everything goes well until 1997 when inflation falls below 2 percent and the price level begins to fall below trend.    The gap between the price level and its trend grows and reaches 1.5 percent in 2002.   It only really starts shrinking in 2004 and has returned to trend by 2005.    However, it overshoots, and reaches 2.8 percent above trend in the second quarter of 2008.   Then it begins to shrink (should I add, "because the Fed took action?")   By the middle of 2009, it was back to one percent above trend, and has continued to gently return to trend, nearly reaching it by the middle of 2012.

Of course, because the trend for nominal GDP using the 1991-2007 period is approximately the same as for the longer 1985 to 2007 period, the deviations from trend are about the same.   During the late nineties, when the price level was below the 1991 trend, nominal GDP was above trend, reaching 2.59 percent in the third quarter of 2000 using both the 1985 and the 1991 trend.    At that point of "high" spending on output, the 1985 trend for the price level is about one percent "too high," while the 1991 trend for the price level was about 1 percent "too low."

And what about the "Housing Boom?"   Using the 1991 trend, nominal GDP is above trend from the third quarter of 2005 to the third quarter of 2007 and it reaches .8 percent above trend during the first and second quarter of 2006.    Looking at the longer, 1985 trend, only the first and second quarters of 2006 are above trend at all, and only about .2 percent.    

So nominal GDP trends and deviations from trend are about the same, but the price level trends and deviations from trend are very different.   Obviously, the difference must be in real GDP.

The 1985 trend tracks real GDP very close from 1984 to 1987, then it rises above trend a bit before falling below trend for a recession in 1989.   There is a very slow return to trend and then a pronounced Dot.Com boom.  The 2000 recession is just a return to trend and then real GDP remains on the trend until the Great Recession.

The 1991 trend starts with real GDP above trend in 1984 and the gap grows reaching nearly 4.2 percent in the first quarter of 1989.   The "recession" was simply a return to trend, which was reached in 1991.   This begins the long period of real GDP remaining very close to trend until the Dot.Com boom begins.    Just like the trend from 1985, the recession of 2000 was just a return to trend.   And then both remain at trend until the Great Recession begins.   Interestingly, real GDP is below the 1991 trend exactly like nominal GDP by the second quarter of 2012.  This, of course, follows from the price level being approximate at trend.

Here is real GDP and the 1991 to 2007  trend for real GDP:

The "Reagan Boom" is clear on this diagram, along with the Dot.Com boom.  There is really no "housing boom."

Consider the CBO estimate of potential output.   How does that compare?

There is no "Reagan Boom" in the late eighties according to the CBO, and the recession in the early nineties involved real output less than potential. While both the 1985 and 1991 trend show real GDP above trend, the 1991 shows a very large gap before the recession, and at least the 1985 trend shows real GDP below trend when real GDP is below the CBO estimate.    

Both the 1991 and the 1985 trends show real GDP above trend during the Dot.Com boom, and the CBO has real GDP above potential.   Interestingly, both the 1991 and 1985 trends have real GDP almost exactly on trend during the "Housing Boom" and the CBO estimate has real GDP equal to potential.   

Looking at real GDP,. the 1991 trend takes the slow recovery of the nineties to define the trend.   It shows real GDP far above trend during the late eighties.  The 1991 trend shows a huge "boom" in the price level during the "Housing boom" when real GDP remains at trend and real GDP remains equal to potential output.

Is the 1991  trend "best?"   I have my doubts.   


1 comment:

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