Great Moderation

The Great Moderation is the name economists give to the period from roughly the mid-1980s to 2007 during which the ups and downs of output growth and inflation in the United States, and in many other advanced economies, became markedly smaller. Recessions were rare and mild, inflation was low and stable, and the business cycle seemed to have been tamed.

The term was popularized by economists James Stock and Mark Watson in 2002 and by Ben Bernanke, then a Federal Reserve governor, in a February 2004 speech. The Federal Reserve's own history dates the period from 1984 to mid-2007. It ended with the 2008 financial crisis, which prompted a hard look at whether the calm had itself bred hidden risks.

Imagine a road that used to be full of potholes and sharp bends, where drivers were thrown around on every trip. Then, for two decades, the road seems smooth: journeys are steady and predictable, and drivers start going faster and carrying heavier loads. Nobody is quite sure whether the road was repaved, the cars got better suspension, or the weather was simply kind.

That is the Great Moderation. Economies grew more steadily and prices rose more gently than in the turbulent 1970s. Economists still argue about why, and the 2008 crash showed that a smooth stretch of road does not mean the potholes are gone for good.

Volatility is usually measured as the standard deviation of quarterly growth rates over a period:

• $\sigma$ is the standard deviation of growth.
• $g_i$ is growth in quarter $i$, and $\bar{g}$ is the average growth over the period.
• $n$ is the number of quarters.

For example, quarterly growth rates of 1%, 3%, −1% and 5% average 2%, with squared deviations of 1, 1, 9 and 9; their sum, 20, divided by 3 gives about 6.67, and its square root is about 2.6 percentage points. Repeating that calculation for US real GDP shows a sharp drop around 1984. In his 2004 speech, Bernanke said the variability of quarterly output growth had roughly halved since the mid-1980s and the variability of quarterly inflation had fallen by about two-thirds. Similar declines appeared in the UK, Canada, Japan and much of Europe.

Three broad explanations were offered, and most economists accept some role for each:

• Better monetary policy. After Paul Volcker's Federal Reserve brought inflation down from double digits in the early 1980s, central banks focused on price stability, gained independence and in many countries adopted inflation targeting. Policy that followed systematic rules, often summarized by the Taylor rule, kept inflation expectations anchored. Bernanke argued this was an important source of the calm.
• Structural change. Better inventory management, a shift from manufacturing toward services, deregulated financial markets that let households smooth spending, and more flexible labour markets may all have damped swings.
• Good luck. Stock and Watson's statistical work suggested that much of the decline came from smaller shocks, notably the absence of 1970s-style oil-price spikes. The Fed's own history notes, however, that the period still contained large shocks, from the 1987 stock market crash to the dot-com collapse.

The US housing bust and the global banking crisis of 2007–2009 produced the deepest recession since the Great Depression, ending talk of a permanently tamer cycle. Critics argued that the Great Moderation contained the seeds of its own end. Economists in the tradition of Hyman Minsky, and researchers at the Bank for International Settlements, contend that long periods of stability encourage investors and lenders to take more risk, raise leverage and underprice danger, building up systemic risk that eventually erupts in a Minsky moment. Others noted that monetary policy during the period paid little attention to credit growth and asset prices; the Fed's history quotes Bernanke observing in 2013 that financial stability did not figure prominently in monetary policy discussions during those years.

The experience changed central banking. Policymakers added a financial-stability lens through macroprudential policy, and the episode fuelled debate about whether central banks should "lean against" asset-price booms or "clean up" afterwards. Low and stable inflation during the Great Moderation also pushed interest rates lower, which, combined with weak demand after 2008, left many central banks at the zero lower bound and reliant on quantitative easing. The surge in inflation in 2021–2022, driven by pandemic disruption, energy shocks and strong demand, showed that the stable-inflation environment of the Great Moderation could not be taken for granted. Some economists described the post-2008 years of weak growth as economic stagnation, while others pointed to rising inequality that had been building beneath the calm surface.

• Federal Reserve Board: Remarks by Governor Ben S. Bernanke, "The Great Moderation" (2004)
• Federal Reserve History: The Great Moderation