Interpreting the Recent Slowdown: Delayed Recovery or Stall Speed?
Economic activity has slowed markedly in recent months. After growing 3.14 percent in 2010, real GDP grew at a rate of only 0.7 percent during the first half of 2011. This unexpected deceleration has raised doubts about the outlook. Are we still to expect a stronger recovery? Or is a double-dip recession on its way?
The answers to these questions will affect the economic decisions that consumers and businesses make going forward. For instance, as we argued in a previous article, an important reason why firms are shying away from investing right now is that they forecast slow growth and weak aggregate demand and they are uncertain about the economic outlook.
In the past, recessions were typically followed by a recovery period of strong growth, and that in turn was followed by an expansion period of more moderate growth close to the long-term trend. Real GDP was temporarily driven below its trend level during the recession; then it grew at a rate faster than trend growth during the recovery, rapidly returning to its trend and closing the gap; after that, it grew along its trend during the expansion period. Growth during the recovery period tended to be stronger after more severe recessions, so the gap between GDP and its trend level tended to close quickly. Average growth during the first year of the recovery tended to be higher than during the following years, especially after recessions with large output losses.
The current cycle, however, has not followed this pattern. Although the recession was the most severe since the Great Depression, there has not been any strong recovery. The average growth rate during the first year of the recovery was only 3.3 percent, not enough to allow GDP to return to its trend level. In the subsequent year, GDP decelerated and grew only 1.55 percent, a rate even lower than trend growth. The path of GDP has remained well below its trend for a much longer period than is typical.
One reason behind the lack of a strong recovery is the financial crisis that hit the economy in the last recession. Research by Carmen Reinhart and Kenneth Rogoff has documented that it takes much longer to recover from recessions associated with financial crises. A related reason has to do with the high level of debt of the household, corporate and government sectors. For all the three sectors, the ratios of debt to GDP have increased over the last 30 years and are now close to their all-time high. When debt is too high, it makes the economy more vulnerable to financial shocks. And it delays the recovery because households and firms need to repair their balance sheets before they are able to spend again. (Click here for more on household debt and the recession). This may explain why economic activity has not rebounded yet and might suggest that a delayed recovery is still coming.
There is, however, another possible interpretation of the current slow growth. As recently emphasized by Jeremy Nalewaik, economic activity tends to decelerate in the year before a recession. After growing along the trend in the expansion period, the economy may enter a state of stall speed, with GDP growing at a rate slower than trend just before the arrival of a recession. Average growth in the year before a recession tends to be lower than during the preceding years. This pattern suggests that the current slowdown in economic activity may signal another recession coming.
However, information from other sources does not support the case for an imminent recession. Part of the economic weakness during the first part of the year has been due to transitory factors, including supply chain disruptions caused by the Japanese earthquake and tsunami, and temporarily high energy prices related to the turmoil in North Africa. Also, the most recent indicators of economic activity, like the monthly data on personal income, personal consumption expenditures, retail sales, new orders for durable goods, and payroll employment, are not pointing to a contraction in economic activity, although they confirm the economic weakness.