Do we need a recession?
People are talking insistently about recession in New Zealand. Driving the recent spate of concerns is the deterioration in consumer confidence over the last three months. All three of the indicators we follow (Colmar Brunton, Roy Morgan, and Westpac McDermott-Miller) have shown a significant deterioration in consumer sentiment since the start of 2008.
Now a small part of this decline is seasonal – however even taking this into account, there has been a worsening in consumers current financial situation and a significant fall in consumer expectations of their financial situation over the next 12 months.
Both the Hive and Roy Morgan state that the Reserve Bank needs to look at cutting rates, in order to avoid a recession we don’t need. However this raises the question, do we need a recession?
People appear to be viciously scared of a potential recession, viewing a slowing in economic growth (or even a slight contraction as BNZ sees it) as the end of the world. While this could be some form of extreme loss aversion from people in the community, I expect that people have asymmetric information, and the media is in turn exaggerating what a recession implies.
A recent article by Robert Samuelson covers the same types of issue (h.t. Mankiw). Thinking about the New Zealand situation, we have record low unemployment, the strongest terms of trade since June 1974, and a strong fiscal situation. Say that consumption tanks, interest rates swell, unemployment is unlikely to go past 5% – only 5%. If you had told me back in 2002, or even better 1992, that 5% was a high rate of unemployment I would have been perplexed to say the least.
Even in the RBNZ forecasts imply consumption growth of only 0.8%pa over the year to March 2009 – suggesting that there will be a massive slowdown in domestic economic activity from the est. 3.1%pa growth in consumption over the year to March 2008 (although not a recession). They are talking about 10% reductions in house prices, interest rates elevated until late-2009, and a reversion in commodity prices – and they still expect that they will have to keep the OCR elevated until late-2009.
If the Bank believes that, even skirting a recession we need a high OCR to suppress inflationary pressure and support long-term growth, then I believe that a recession may even be necessary in order to control the inflation problem. (Note: People love to blame tradable inflation, but non-tradable inflation is over 3% while inflation expectations are touching the top of the RBNZ target band – implying that we are at a point where “looking past” short term inflationary pressures is becoming inappropriate).
But again, what is a recession – a couple of quarters of negative economic growth. If thats the cost of ensuring a stable environment for future investment and trading decisions I think it is worthwhile.
No, we don’t need a recession at all.
Hmm, I agree that people are probably more scared of a recession than they should be, relative to the likely impact on their lives.
But I don’t accept your case for recession. It doesn’t seem consistent to say that a recession will have little impact (on people), while having a large impact on inflation (which I presume is the sole basis for the claim that a recession will ensure “a stable environment for future investment and trading decisions”).
Are you making any stronger claim that that the the economy needs slightly higher unemployment/lower output gap to ensure that inflation remains stable? Or do we “need” a recession to lower the inflation rate? Either way, do you have a reason to prefer a short sharp correction (recession) as opposed to a period of sub-trend growth?
I see some merit in a housing price correction, if only to because people’s expected returns for housing investments have deviated so far from reality. But apart from this, I’m not certain what benefits a recession could reasonably be expected to bring.
“Or do we “need” a recession to lower the inflation rate?'”
I’m not sure if we need a recession to lower the inflation rate – however, I’m not confident that inflationary pressures are going to disappear without some loosening in the labour market. So even if growth stalls, a sticky labour market may leave us in trouble.
I like this link: http://www.voxeu.org/index.php?q=node/995
“Either way, do you have a reason to prefer a short sharp correction (recession) as opposed to a period of sub-trend growth?”
I’m not sure if I have a definite preference – however I am uncertain why people are so scared of a recession vs a long period of sub-trend growth.
To some degree it comes down to uncertainty. A short-sharp recession would see prices clear and reduce uncertainty, which in itself is costly. A long draw out slowdown would be the result of highly sticky prices, and would imply that uncertainty cost remains for a lot longer. As a result, a short-sharp change may be preferable.
“I’m not certain what benefits a recession could reasonably be expected to bring”
A reduction in inflation expectations – thats what I’m after. Ultimately I want to get control of inflation expectations with the smallest possible cost (in terms of growth) as possible. In this post I was merely saying that it may only be possible to drag down inflation expectations through a recession (or possibly a long period of sub-trend growth of course).
My concern is that we already came within a whisker of technical recession this cycle without much of an impact on inflation expectations in Sep & Dec 2005 (although I see revisions have made GDP growth 0.4% and -0.3%, the original vintage data was 0.1% and -0.1%).
I do tend to think the economy occasionally needs resources to be reallocated between sectors (e.g. construction to exports right now), but short and sharp seems a wasteful way to do this. But if the problem is purely central bank credibility, then maybe pushing the economy into recession is more effective than slow and steady.
While the reduction in inflation expectations is a key factor in getting back to a more comfortable interest rate, that begs the question of what is driving inflation expectations. Obviously there are things such as oil prices which are beyond the control of any policymaker in NZ. But there is a good argument to be made that the level of/growth in domestic demand is simply too high.
We are less likely to see a dramatic loosening of the labour market of the type seen previously (e.g. the reform period or even earlier when prices were more rigid and the adjustment fell heavily on output). While workers may see fewer job opportunities (and watch the upcoming Q1 Westpac McDermott Miller Employment Confidence for signs of this) they are not going to be fearing mass lay-offs or real wage contraction. The slowdown in consumer spending is likely to be modest and thus would not generate the conditions necessary to see a sharp fall in inflation expectations.
Thus I agree that in some sense a recession is “needed”. However, I think that without a much greater level of pessimism, we are not going to see a return of more circumspection (especially needed on the housing front but that’s another story) on a permanent basis. The worst case scenario is that we muddle through, setting ourselves up for yet another bout of “irrational exuberance”. It’s like the drunk who never sobers up – with no fear of a hangover, it’ll only be liver failure that ultimately stops him.
“I do tend to think the economy occasionally needs resources to be reallocated between sectors (e.g. construction to exports right now), but short and sharp seems a wasteful way to do this. But if the problem is purely central bank credibility, then maybe pushing the economy into recession is more effective than slow and steady.”
I think it is also important to ask why the transition is either slow and steady or sharp. As I believe that we have an issue with relative prices in the economy I would prefer a sharp jolt to put these back into line – or else the allocation of resources in the economy will be screwed and the potential rate of growth will be lower than it needs to be.
However, we can’t do much about that. If we do have a recession it will merely tell me that prices are more responsive in New Zealand than they are in the case when we have a slow and steady correction – which implies to me that if we don’t have a sharp correction in growth our potential output level is likely to be lower.
Ultimately, I’m not saying that we a recession is definitely what we want, I can just imagine a situation where relative prices are so out of whack that I would like one
“The worst case scenario is that we muddle through, setting ourselves up for yet another bout of “irrational exuberance”. It’s like the drunk who never sobers up – with no fear of a hangover, it’ll only be liver failure that ultimately stops him.”
Dismal, that is an awesome analogy 😉
Matt, I guess the difference is between reallocating capital (because former investment is often sunk) where you want it going to the right sectors as quickly as possible, and reallocating labour (because retraining and creating new jobs is time consuming) and you don’t necessarily want a spike in unemployment by doing it all once.
I’d still be curious what specific adjustments you and Dismal think are required. It’s very easy to conceive of a negative oil price shock, for example, that lowers inflation and inflation expectations by around 0.5%, but leaves relative prices unchanged – would this solve all New Zealand’s economic problems? The RBNZ’s output gap estimate would imply we just need growth to be about 1% below trend (in aggregate) over the next 2-3 years to stop inflation accelerating.
“It’s very easy to conceive of a negative oil price shock, for example, that lowers inflation and inflation expectations by around 0.5%, but leaves relative prices unchanged – would this solve all New Zealand’s economic problems”
It’s an increase in aggregate supply, so of course it would be useful – it should increase potential output. However this isn’t a policy it is just an external shock.
“The RBNZ’s output gap estimate would imply we just need growth to be about 1% below trend (in aggregate) over the next 2-3 years to stop inflation accelerating”
As I believe I said in the post, I’m not advocating that we should have a recession, I’m just saying that if that is where we head with current monetary policy then I think it is appropriate. Saying that we can’t have a recession is like ignoring the business cycle exists – we’ve been above trend for so long we have to go below it to reduce capacity pressures.
Ultimately I would prefer below trend growth to a recession all other things equal, but I still think the ultimate goal should be to limit inflationary pressures.
Currently we have a number of negative supply shocks (drought, oil and food prices) – our potential rate of output is lower and as a result individuals and firms are rationally re-evaluating there position and adjusting output/prices. If this causes a recession then thats fine, real business cycle theory tells us that any output focused intervention will be distortionary – we just need to maintain credibility over inflation, so that we can keep expectations anchored. Of course in the face of price stickiness there could be reasons to intervene (eg, why people say we should allow inflation to rise so that nominal house price falls will be smaller), however I’m not entirely sold on that yet.
I wonder whether another reason to ‘need’ a recession is whether adjusting consumer spending (and perhaps Blue Chip/Bridgecorp style property investment) down to a level nessesitated by the tighter credit environment.
“I wonder whether another reason to ‘need’ a recession is whether adjusting consumer spending (and perhaps Blue Chip/Bridgecorp style property investment) down to a level nessesitated by the tighter credit environment.”
Ultimately, with income growth of 5%pa and tax cuts on the way, I don’t think that consumer spending will fall. However, higher interest rates, tighter credit, and lower house prices will see consumer spending growth remain low (Note: Consumer spending growth has sucked since about May)