Economists can't tell you when the next downturn is coming [...]. Expansions don't die of old age: They're murdered by bubbles, central-bank mistakes or some unforeseen shock to the economy's supply (e.g., energy price spike, credit disruption) and/or demand slide (e.g., income/wealth losses).
—Jared Bernstein, Washington Post, 7/5/2018

Economists cannot predict the timing of the next recession because forecasting business cycles is hard. For example, at the onset of the 2001 recession, the median forecaster in the Survey of Professional Forecasters (SPF) expected real U.S. gross domestic product (GDP) growth of 2.5 percent over the next year, while in reality output barely grew. Again, on the eve of the Great Recession, forecasters were expecting GDP to grow 2.2 percent over the next four quarters, and we all know how that worked out.1 Why is it so hard to predict downturns—even while they are happening?

Most economists view business cycle fluctuations—contractions and expansions in economic output—as being driven by random forces—unforeseen shocks or mistakes, as Bernstein writes. As I will show, a model in which purely random events interact with economic forces can resemble U.S. business cycles. This randomness of economic ups and downs poses a challenge for macroeconomic forecasters because random events, by their very nature, are unpredictable.

One might be tempted to conclude that if the origins of business cycles are random forces, then analyzing business cycles must be a pointless endeavor. However, not all random forces are alike. For our purposes, economists distinguish between two main types of random forces—demand shocks and supply shocks.2 As the term implies, shocks are surprise events that, when put into a mathematical model of the economy, generate patterns in economic variables that resemble those of business cycles.

This article appeared in the First Quarter 2019 edition of Economic Insights. Download and read the full issue.

[1]In the first quarter of 2001, forecasters expected cumulative GDP growth of 2.5 percent over the next four quarters, whereas actual growth (according to the first releases) averaged 0.5 percent. In the fourth quarter of 2007, forecasters expected cumulative GDP growth of 2.2 percent over the next four quarters, whereas actual growth (according to the first releases) averaged 0.6 percent.

[2]Bernstein's “central-bank mistakes,” labeled monetary policy shocks later in this article, withdraw demand from the economy and are thus also demand shocks. “Bubbles” could affect the credit supply by easing collateralized borrowing, and their emergence or bursting would then be a supply shock in financial markets.


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