Shock Value

From manic muddle to melancholic mess. 


Listener: 23 August, 2008. 


Keywords: Macroeconomics & Money;  


Suppose a volcano erupted in Auckland, a tsunami drowned the Bay of Plenty, a major earthquake shook Wellington, or foot-and-mouth disease broke out in the South Island. Would you expect the Reserve Bank to tighten its monetary stance (raise interest rates) to deal with any resulting inflation from these supply-side shocks? 


Before you say that is absurd, that there are things the Reserve Bank should not try to deal with, and that the Reserve Bank Act is robust enough to avoid an overreaction, consider the following: 


Suppose that drought reduced the productivity of farming; that the rains missed the hydro lakes so we had to burn more fuel to supply electricity; that oil prices rose sharply; and that international food prices raised the price of food. These are all inflationary supply-side shocks, too. Should the Reserve Bank tighten its monetary stance for them? 


Because they are smaller, it is harder to disentangle their effects on price levels. But the consistent answer is that we should expect the inflation target range to be temporarily breached because of supply-side shocks. (I’m not sure how long “temporary” is, though.) 


You will notice at least two of those shocks are productivity-decreasing, with the effect of lowering net output, which is what GDP measures. Farm net output is down and so is energy net output. (I leave aside the complicated argument about the effect of higher international prices on GDP for another column, but in this context they lower effective GDP.) 


Undoubtedly, production has been slowing down, with the building, real estate and fringe financial sectors contracting (with knock-on effects on other sectors). We are in a “recession”, which is the slowing-down phase of a business cycle. A number of commentators have defined a recession as two successive quarters of falling real output. They have uncritically borrowed a US definition. If we accept that definition, we are in a recession only because of those supply-side shocks. When they unwind – perhaps in a quarter or two – we may move out of the recession on this mechanical -definition, but there will still be economic difficulties. For instance, don’t expect the Reserve Bank to immediately tighten its monetary stance. 


I cheated a little earlier when I described the international food price hikes as supply-side shocks. They are, but although they are down-shocks for consumers, they are up-shocks for farmers. So, there can be positive supply-side shocks as well as negative ones. At the moment we are suffering three-and-a-half downs and half an up, as well as international demand-side shocks from a world liquidity squeeze together with a slowdown in some of our key markets. I don’t think the world economy is in a bigger muddle than it was a couple of years ago, but this time it is a melancholic mess rather than a manic one. 


Positive supply-side shocks make monetary policy easier. There is increasing widespread criticism of Alan Greenspan, the chairman of the American Federal Reserve from 1986 to 2007, for his failure to regulate the American financial system properly. While he presided over low inflation, he had the good luck that the world economy was experiencing favourable supply-side shocks. His successor, Ben Bernanke, may be no less competent, but it looks as though his world economy is getting unfavourable shocks, some of which he inherited from Greenspan. 


Economic policy is going to be a lot harder in the near future. The US financial system appears to be in a deeper mess than we feared; the American taxpayers will continue to reach into deep pockets to bail it out, to keep their payments system intact. 


The rest of the world will probably be affected. The international liquidity squeeze is one cause of some of our fringe financial institutions collapsing. Our core financial institutions seem sound, but we must not ask more of the Reserve Bank than it can reasonably deliver. 


<>Getting through the mess will need a co-ordinated response from fiscal policy and other policy instruments as well as monetary policy – and our understanding.