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.