"Inflation is proving more intractable than unemployment"
"Inflation is proving more intractable than unemployment"
Our global economic outlook for 2022 was pushed off track by another exogenous shock in the form of Russia’s invasion of neighboring Ukraine. We were looking for the global economy to move past the Covid pandemic and settle into the new business cycle this year. Instead, we are now faced with a sharp exacerbation of the inflation surge that was already contributing to an expected moderation in economic growth in 2022. This development has further depressed economic sentiment and raised expectations of more aggressive monetary policy tightening, particularly in key developed economies. That, in turn, is driving growing fears of recession that are weighing on global financial markets.
What makes the situation especially challenging for investors is the simultaneous sell-off in both equity and bond markets. The dramatic collapse in crypto assets, often promoted as an inflation hedge, adds to the perception of a major market realignment. But all that is playing out against a fundamental backdrop that hasn’t deteriorated very much. What is flashing red are a number of surveys, especially those tracking consumer and small business confidence in both the US and in Europe. Meanwhile, purchasing managers indices, which are geared more toward larger firms, still signal moderate to strong economic activity in most developed world economies.
What we are to some extent relearning is the simple fact that inflation is a much bigger and more intractable problem for the economy than unemployment. The pandemic has demonstrated that fiscal policy is quite capable of dealing with large-scale joblessness; while not a long-term solution, the pandemic emergency programs successfully built an income bridge that prevented a protracted recession in most developed world economies.
It is also pretty clear that despite confident claims in the past, central banks may not have the tools to deal with a sustained and rapid increase in inflation. That’s especially true for those banks that overplayed the perceived danger of deflation. For the past 10 years, the Federal Reserve, the European Central Bank (ECB), and the Bank of Japan have been telling us that we needed more inflation and devised ever-more fanciful tools to boost the pace of price increases. Looking at the inflation backdrop before the pandemic, we now know those attempts largely failed. And now that the inflation tide has turned, it’s stunning how unprepared central banks have been – not just operationally, in terms of having the right toolkits to address runaway prices, but also intellectually. We don’t see a consistent framework among the major central banks to direct policy, but rather attempts simply to deal with the most pressing issue of the day.
The question now before us as we gauge the direction of the economy is whether central banks will in effect engineer a recession to slow inflation. The Federal Reserve has been telling us for years how important it viewed the goal of maximum employment, and not just on average but across gender, racial, and income divides. It would be stunning if the Fed were now to abandon one of its dual mandates for the sake of the other, essentially establishing a new inflation dominance and relegating maximum employment to “nice-to-have” status – and we doubt this will happen.
So long as US inflation is still accelerating and the Fed, in the absence of a credible policy framework, continues to react to market pressures, the media, and Washington, rates will continue to rise. The other two major developed world central banks, the ECB and the Bank of Japan, are already driving in a different direction. The ECB has painted itself into an even tighter corner than the Fed by refusing to adjust policy last year. Negative interest rates have been largely ineffective, as evidenced by the fact that no other banks, other than those essentially forced to shadow the ECB, such as the Swiss National Bank, have adopted them. The problem for the ECB is that policy tightening rekindles the same forces that caused the 2013 eurozone debt crisis. Already, the focus has turned to Italian and Greek government yield spreads, and the ECB was already forced to adjust its planned stimulus reduction.
And then there is the Bank of Japan, which is holding fast to its policy of yield curve control, attempting to keep the entire government bond yield curve near 0%. But that policy now requires a dramatic increase in bond purchases, which the market expects to be unsustainable.
While there seems to be little coordination of monetary policy across the major central banks, the reporting makes it sound as if they’re all gunning for a recession. It’s true that financial markets react to every change in interest rates, irrespective of where rates are relative to the neutral rate, or the level at which policy rates are neither stimulative nor restrictive. But that’s how interest rates impact the economy. As long as policy rates are below neutral, rate hikes alone will not bring about recessionary conditions on their own. The Fed announced it intends to push past neutral, which is worrying. Yet the ECB and the Bank of Japan won’t get close to neutral, and we shouldn’t forget that the fourth major global central bank, the People’s Bank of China, is actually cutting rates.
We don’t foresee global monetary conditions tightening enough to cause the recession everyone is fearing. What could cause it, however, is the relentless erosion in household purchasing power resulting from what we might as well call “The Great 2022 Inflation Surge.” The problem is, domestic demand is only partially responsible for it. In the first place, it was ignited by supply chain disruptions related to the pandemic, along with the surge in energy prices, which has been sustained by Russia’s invasion of Ukraine and the EU’s subsequent decision to stop buying Russian oil.
Economic activity was moderating everywhere before central banks started to get serious about fighting inflation, and those trends are now accelerating. Weaker demand and the unclogging of supply chains should start to moderate the pace of inflation in the coming months. Energy prices remain a wild card, however, since it’s near impossible to predict the evolution of Russia’s war against Ukraine.
The bottom line is, we still see a soft landing in most developed world economies as the most likely outcome. The central banks that are now raising rates will likely change their tune once we get to more neutral monetary policy settings and inflation rates start to moderate. At that stage of the cycle, we will also have more evidence of how quickly growth is slowing. Inflation will still be well above target, which may indeed call for moderately restrictive monetary policy. Yet it will also become obvious that a full-blown recession is too steep a price to pay to achieve a more rapid inflation correction to more historically normal levels – an outcome we expect to reach in early 2023.
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