Sunday, October 26, 2008

Roubini: "Negative Demand Shock"

“…unlike a true negative supply side shock – that reduces growth while increasing inflation - a US recession followed by a global economic slowdown is a negative demand shock that has the effect of reducing US and global growth while at the same time reducing US and global inflationary pressures. Specifically such a negative demand shock will reduce inflation across the world because of a variety of channels.

First, a US hard landing will lead to a reduction in aggregate demand relative to the aggregate supply as a glut of housing, consumer durables, autos and, soon enough, other goods and service takes places. Such reduction in aggregate demand tends to reduce inflationary pressures as firms lose pricing power and then to cut prices to stave off the fall in demand and the rising stock of inventories of unsold goods. These deflationary pressures are already clear in housing where prices as falling and in the auto sector where the glut of automobiles is leading to price discounts and other price incentives. Obviously, inflation tends to fall in recession led by a fall in aggregate demand.

Second, during US recessions you observe a significant slack in labor markets: job losses and the rise in the unemployment rate lead to a slowdown in nominal wage growth that reduces labor costs and unit labor cost, thus reducing wage and price inflationary pressured in the economy.

Third, the same slack of aggregate demand and slack in labor markets will occur around the world as long as the negative US demand shock is transmitted – through trade, financial, exchange rate and confidence channels – to other countries leading to a slowdown in growth in other countries (the recoupling rather than decoupling phenomenon). The reduction in global aggregate demand – relative to the global supply of goods and service – will lead to a reduction in inflationary pressures.

Fourth, during any US hard landing and global economic slowdown driven by a negative demand shock the US and global demand for oil, gas, energy and other commodities tends to fall leading to a sharp fall in the price of all commodities. A US hard landing followed by a European, Chinese and Asian slowdown will lead to a much lower demand for commodities pushing down their price. The fall in prices tends to be sharp because – in the short run – the supply of commodities tends to be inelastic; thus any fall in demand leads to a greater fall in price – given an inelastic supply curve – to clear the commodity prices.

The four factors discussed above suggest that – conditional on the negative global demand shock (US hard landing and global economic slowdown) materializing even the risks of stagflation-lite are exaggerated; rather US and global inflationary force would sharply diminish in this scenario and, if anything, concerns about deflation may reemerge again.”

- Nouriel Roubini,

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