Tomasz Wieladek has an explanation for recent macroeconomic puzzles

THE CURRENT business cycle has revealed a number of puzzles. Although in America the real economy seems immune to very large monetary tightening, inflation is still falling from historically high levels. In Europe, even after a huge energy-price shock and record tightening by the European Central Bank, the economy so far is suffering only stagnation, where most economists would have predicted a deep recession. Labour markets appear to have decoupled from the real economy. These developments are in stark contrast to what one would expect in a normal business cycle.

I argue that the nature of the economic recovery from the covid-19 pandemic can explain this puzzling business-cycle behaviour. Historical rules of thumb do not apply to this type of recovery.

There are two types of economic recoveries. In a so-called Hamilton recovery—first modelled by James Hamilton in 1989—the economy recovers after a recession, but never reaches the level of output that would have been obtained if it had kept growing instead. In a Friedman recovery—posited by Milton Friedman in 1993—the economy grows very quickly following the recession and returns to the level of output that would have been reached had it not contracted. This distinction is not just of interest to aficionados, but relevant to explaining the macroeconomic puzzles of the past couple of years.

Friedman recoveries are very rare. In their analysis of recoveries across 192 countries between 1960 and 2001, Valerie Cerra and Sweta Chaman Saxena found only three complete and six partial Friedman recoveries. All other recoveries were of the Hamilton type. Indeed, before the pandemic, no developed economy had experienced a Friedman recovery since at least as far back as the second world war. Standard business-cycle rules of thumb are therefore all based on Hamilton recoveries.

“This time is different” are said to be the most dangerous words in economics. But this time really is different, because the recovery from the covid-19 recession has been Friedmanesque. This is true in America, but also in European countries before they were hit by the energy-price shock following Russia’s invasion of Ukraine. The business-cycle rules of thumb about when an economy goes into recession, how labour markets react and what is needed to bring inflation back down therefore don’t apply.

A Friedman recovery is not just a statistical curiosity: there is an important economic difference with the Hamilton type. In a Hamilton recovery, the supply side of the economy is left scarred by recession. This is an important reason why job markets weaken. Inflation can be brought down only through demand-side policies, since demand needs to fall below supply. But in the Friedman version, the supply side is unaffected. This important economic distinction can help explain several aspects of the recent recovery which have puzzled many economists.

One of those puzzles is that despite significant monetary tightening, economies have been surprisingly resilient. The American economy recorded an annualised growth rate of 5.2% in the third quarter of 2023. In Europe, economies are mostly stagnating, but even that is an impressive outcome considering the brutal energy-price shock they endured.

A second puzzle is that labour markets have held up, even as growth slowed. History suggests that unemployment rates should be rising significantly by now. Indeed, in 2022 Alex Domash and Lawrence Summers estimated that the 20% reduction in vacancies observed in the American economy over the previous year should have led to an unemployment rise of a couple of percentage points—a much bigger increase than actually seen in the data thus far. Even in the euro area, where the unemployment rate has been very sensitive to monetary policy in the past, the rate hasn’t risen yet.

A third puzzle is “immaculate disinflation”: high, demand-driven inflation in America has come down substantially, without a weak real economy or labour market, despite significant monetary tightening. Similarly, inflation is falling in the euro area, yet the unemployment rate remains at a record low.

These puzzles can be explained by the Friedman recovery: the economy grows significantly above trend in the recovery phase; the supply side doesn’t experience scarring, so there is no need to shed labour; and supply can expand over time to meet higher demand, which helps to reduce inflationary pressure without demand having to fall substantially.

Policymakers and financial markets need to take this distinction between the Hamilton and Friedman types of recovery into account. If policymakers act in response to a Hamilton recovery, they will interpret strong growth as a sign of excess demand and therefore future inflation. But in the Friedman recovery, the rapid growth rate signals not excess demand, but rather that the supply side hasn’t been affected. The opposite monetary-policy response is required. Strong growth in a Hamilton recovery is a sign of excess demand, which calls for more monetary tightening. But in a Friedman recovery it is a sign of the supply side accommodating demand, meaning policy should ease to prevent inflation from running below target.

Clearly, distinguishing which recovery economies are experiencing is difficult in real time, not least because the relevant data can be subject to large revisions, even a long time after the initial release. Nevertheless, macroeconomic facts show that a Friedman recovery is under way. If policymakers and markets have instead concluded that it is Hamiltonian, there is a risk that monetary policy and financial conditions will tighten too much—which could eventually trigger an unnecessary recession.■

Tomasz Wieladek is chief European economist at T. Rowe Price.