The DWL Cycle

Deepest (contraction) Weakest (recovery) and (soon to become) Longest (expansion).

There are some interesting features to the DWL cycle.

As the chart below indicates, the DWL cycle started off very mild, being one of the mildest three quarters into the recession. Then, when many of the other cycles were beginning their expansion phase, the DWL cycle turned markedly “south”.

Why? That´s the moment the Fed, having tightened monetary policy on account of a misguided worry about headline inflation, which was being buffeted by the ongoing oil shock, decided to “micromanage” the economy by providing “rescue services”, mostly to the financial sector.

With those actions, the Fed let go of the nominal stability that had sustained the economy with low inflation, low unemployment and robust growth during the “Great Moderation”

Afraid that the provision of “rescue services” could undesirably impact inflation, monetary policy tightened further, as illustrated by the rapid drop in nominal spending (NGDP) growth.

That has Bernanke´s “signature” all over it, being a straightforward application of his “Magna Carta” from 1983 “Non Monetary Effects of the Financial Crisis in the Propagation of the Great Depression”.

In March 2009, likely surprised by depth of the drop in real output, the Fed decide to provide some monetary stimulus under the guise of QE.

That was sufficient to brake the output fall, but quite insufficient to generate the required recovery, in practice keeping the economy evolving along a “depressed floor”.

Is this, as the Fed thinks, the best that can be done? Nominal stability has been restored, again with low inflation and low unemployment, albeit with weak growth.

Is it possible to drive the level of output higher, in other words, regain a higher (even if still lower than previously) path of output?

Given the experience of history (including the Great Depression), we believe it is. The major factor constraining such an outcome is the Fed´s undeniable fear of a return of the “inflation monster”.

 Back in the day, the time it took to conquer high inflation was associated with the fear of high unemployment. While that fear lasted, inflation went untamed. To get inflation under control, the Volcker Fed “accepted” temporarily high unemployment.

Maybe now we should “accept” (and that´s not a given) temporarily high inflation (4%-5%?) to put the economy back on a more desirable track (level path).

Unfortunately, that´s unlikely, with the expected changes at the Fed to take place in the near future, dubious.


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