27 January 2010

Aruoba and Diebold describe and explain recession


In their new NBER working paper "Real-time monitoring: real time macroeconomic activity, inflation, and interactions," S. Boragan Aruoba and Francis X. Diebold summarize their methodology and use two resulting indices to describe and explain the recent recession.

The authors (develop a state space framework with multiple indicators and a single latent factor extracted via a Kalman filter to) construct a real activity index and an inflation index.

For activity, they use five indicators: payroll employment, industrial production, real personal income less transfers, real manufacturing and trade sales, and real GDP.

For inflation, six: CPI, finished-goods PPI, a non-energy commodity prices index, spot oil prices, the GDP deflator, and hourly compensation.

With regard to the recent U.S. recession, they conclude the following:
  1. The Great moderation was no illusion—volatility in real economic activity moderated notably from 1985 to 2007.
  2. Real activity troughed in January 2009.
  3. The recession ended in July 2009. (The authors define the end of a recession as a return in their activity index to its historic average of zero.)
  4. Compared with past recessions, the recession was quite deep. But, more notably, it was long (19 months).
  5. Disinflation started later (in the summer of 2008) and was shorter than the recession (six months). But, according to the authors, because inflation and activity both dropped, the cause of the recession seems to have been a demand shock, not a supply shock.
I have five comments:
  1. The demand shock to which the authors allude is clearly the financial crisis.
  2. The authors are working on a global version of their index. I do hope that their definition of "global" includes emerging economies such as Mexico.
  3. What is a Mexico analyst supposed to use in lieu of a real personal income less transfers? I yearn for such an indicator in Mexico! (INEGI, are you listening?)
  4. Commodity prices blew up until the summer of 2008, even as activity began to slow down. Perhaps because for the first seven months of the recession the U.S. economy was experiencing a supply and a demand shock both.
  5. Macroeconomists speak of inflation as a general rise in prices, not a change in relative prices. Both phenomena move average prices. So why do all our inflation measures consider averages and ignore how broadly prices are changing? This confuses the public both about inflation and monetary policy, and the confusion unjustly erodes central bank credibility. Central banks such as Banxico can counteract by better educating the public about the difference between the two phenomena.
In my next blog entry, I'll expand on comment 5.

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