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)

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’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.

Dismal, that is an awesome analogy 😉

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

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’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).

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.