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Risks to the Expansion
John B. Taylor
Stanford University
(Notes for White House Conference
presentation, April 2000)
The best way to understand the risks
to the current expansion is to look at
the ends of previous expansions.
• What you find is striking.
• Every expansion in modern American
history—certainly since World War II—has
ended with a run-up of inflation.
– The 1960s expansion ended that way, and so
did the other four recessions in the 1970s
through the early 1980s.
The story was similar in each case.
• As inflation increased the Fed had no choice
but to raise interest rates in order to reduce
the inflationary pressures.
• These higher interest rates then led to a
sharp slowdown or to a recession,
depending on what else was happening in
the economy.
All this changed in the early 1980s
• The Fed tamed inflation and then adopted a
policy that would keep inflation low.
• Since the change in policy we have had two
of the three longest expansions in American
history—the 1980s and 1990s—back to
back.
The 18-year span from 1982 to
the present is unprecedented in
U.S. history.
• Think of it this way.
– Before 1982 the U.S. economy was in recession
more than 35 percent of the time.
– Since 1982 the U.S economy has been in
recession less than 4 percent of the time.
• Expansions are getting longer
In sum, a sensible monetary
policy, more than anything else,
has kept expansions long.
• But the risk is still there.
– Keeping demand in line with potential GDP, so
as to prevent inflation from getting started, is
not easy,
– Even a well-intentioned Fed could let inflation
run up significantly again.
The most likely reason that the
current expansion will end is
another increase in inflation.
• This would force interest rates to rise by
more than people now expect.
• Inflation is still pretty low, but there are
signs that it is increasing in the U.S. and in
other countries.
Such an inflation scare is not the
only risk.
• A stock market crash, a sudden drop in
confidence, and even an oil price shock
could do damage.
• But unless there are inflationary pressures
forcing interest rates up at the same time, or
at least preventing easing by the Fed, these
will be enough on their own to end the
expansion.
In addition to continuing with a
good monetary policy, there are
other policies that will reduce risks
• Policies
– to increase government saving and private saving
– to lower marginal tax rates,
– to improve education,
• will help keep the economy’s potential supply
from falling below the growth of demand
• and keep expansions strong as well as long.