Article

What Comes After the 'Great Moderation'?

question mark sits on top of economic charts going and down
By Scott D. Knapp, CFA

5 minutes

This Q2 market commentary summary from Cuna Mutual Group asks: Is the global economy on the precipice of a regime change? If so, what could it mean for investors?

Discussions about regime change usually occur in a geopolitical context when one country’s leaders seek to replace their counterparts in another. But emergence of regimes and changes associated therewith occur in many settings, including financial markets and the economy. Trends in both can become so dominant and entrenched that they qualify as regimes. Only big, sustained changes in the prevailing trajectory qualify as a regime change.

Is the global economy on the precipice of a regime change? If so, what could it mean for investors?

A Case Study in Economic Regime Change

In the 1970s, inflation rates rose to levels not experienced in several decades. Energy shortages galloped across the land, and rapidly rising consumer prices cast a pall on its people. Tough times led the nation’s exasperated leaders to acknowledge that a malaise had taken hold in the country. Economists and policymakers identified inflation as an insidious problem that was causing more pain than a standard recession. It was clear the inflation dragon had to be slain.

Enter U.S. Federal Reserve Chairman Paul Volcker to save the day. His remedy was simple: Tip the economy into a recession through higher interest rates and much tighter financial conditions. It worked like a charm. Inflationary demand created by too much money floating in the financial system was stopped in its tracks. The unemployment rate shot up, but the intractable inflation-based economic regime had been changed.

The Great Moderation

Starting in the middle 1980s, economic growth slowed to a sustained, albeit modest, pace. Annual real GDP growth of around 2% was nearly as predictable as the sun rising in the east. The dominant regime had changed from rising interest rates and inflation to falling rates and disinflation. Rates across the curve fell for 40 years with only brief periods of tightening financial conditions that mostly trended looser. Economists dubbed the period the “Great Moderation.”

Regime change wasn’t confined to interest rates and the real economy. Financial markets also had a disinflationary tailwind that drove them ever higher. Investors as providers of capital were beneficiaries of the best conditions seen in decades. Their wealth grew and investing became a popular sport among the elite. Laborers and providers of other inputs to production weren’t so fortunate. Wages rose slower than even modest inflation for many years, limiting workers’ participation in the growing economy.

Even so, society benefitted in the aggregate from modest but steady improvements in its standard of living. Investing had also become democratized via employer-based retirement plans, thereby mitigating some of the negative influence of growing wealth disparity. A new regime that favored capital and those who provide it was in place.

What Rhymes With “Malaise”?

History doesn’t repeat itself, but it frequently rhymes. Indeed, the emerging post-pandemic economy is similar in many respects to conditions in the 1970s. Disinflation has been replaced by inflation due to huge amounts of stimulus pumped into the economy by the government and central bank. Reminiscent of the 1973 Arab Oil Embargo, Russia’s invasion of Ukraine is causing shortages of important commodities. Consumer sentiment indicators are also at multi-year lows, leading to flashbacks of 1970s-style malaise.

Labor is also in the running to become the leading input to the production process, potentially eclipsing capital. Worker shortages and demand-driven increases in wages could cause inflation to enter a self-reinforcing spiral. Rumor has it the return of disco and bellbottom jeans will soon complete this back-to-the-future moment.  

The Case for Humility

Has the Great Moderation been replaced by an extended inflationary epoch? Your author doesn’t know and neither does anyone else. Regime changes are only identifiable when they’re small, distant images in the rearview mirror. Investors should avoid overconfidence in their ability to discern the long-term implications of current conditions. It’s just too soon to say anything with confidence.

Even so, investors should assign an increased probability that the economy is indeed experiencing a regime change the will impact the long-term trajectory of financial markets. Substantially higher interest rates are highly likely, and a Volcker-like recession is not out of the question. Expectations for volatility and modest investment returns are justified, perhaps until bellbottoms are out of style again.

Watch the full market commentary.

Scott D. Knapp, CFA, is chief market strategist at CUESolutions provider Cuna Mutual Group. He is responsible for investment philosophy development and program implementation for Cuna Mutual Group’s Institutional Retirement Programs. He regularly speaks at economic and investment forums across the country. Connect with Scott on LinkedIn.

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