Investors have become increasingly concerned that high inflation in advanced economies amid the Russia-Ukraine war-inflict supply disruptions and price shocks, coupled with the US Federal Reserve’s (Fed) aggressive hike in interest rates, could tip the US economy into a recession. The Fed and other major central banks have contended to fight inflation so as to prevent a dangerous de-anchoring of inflation expectations via two reinforcing forces of supply cum cost driven and demand-pull (wage-price spiral).
MORE and more investors are worried about a sharp slowdown in the global economy as strong stagflation risk hammering growth, compounded by higher interest rates and tighter financial conditions.
There are definitely concerns about whether a US recession could come sooner than expected, which is likely in 2023.
Investors have become increasingly concerned that high inflation in advanced economies amid the Russia-Ukraine war-inflict supply disruptions and price shocks, coupled with the US Federal Reserve’s (Fed) aggressive hike in interest rates, could tip the US economy into a recession.
The World Bank has warned that the world economy is entering a protracted period of feeble growth and elevated inflation, cutting its global growth forecasts to 2.9% for 2022 from 4.1% previously.
The pace of growth will be around 2.9% in 2023 to 2024 and many countries are likely to face recession, it added.
Stagflationary shocks, which reduce growth and increase inflation both are putting major central banks in a dilemma as it requires a delicate balancing act between sustaining economic growth and fighting inflation.
The Fed and other major central banks have contended to fight inflation so as to prevent a dangerous de-anchoring of inflation expectations via two reinforcing forces of supply cum cost driven and demand-pull (wage-price spiral).
It is not an easy task for the Fed to suppress inflation while averting a hard landing or recession.
Many past recessions were due to excessive tightening or policy missteps by the Fed. The 1981 to 1982 US recession was triggered by tight monetary policy in an effort to fight mounting inflation.
Following the Fed’s beginning of rate tightening cycle and its balance sheet purchase starting June 1, bond yields have risen higher, financial conditions have tightened, credit spreads have widened plus there is volatility in the financial and foreign exchange markets.
The familiar precursor of a recession is an inverted yield curve on March 29 – for the first time since 2019, as short-term treasury bills yield was higher than that of the longer-dated treasuries.
This is a sign that investors are losing confidence in the economy as the stubbornly high inflation continues to bite, along with rising interest rates and the shrinking of quantitative easing (QE) will hit household consumption and business spending.
Data continues to indicate a mix strength of the US economy. Rising mortgage rates have taken their toll on mortgage home applications; financial conditions have already tightened considerably.
US consumer sentiment plunged in early June to the lowest on record as soaring inflation continued to batter household finance.
The Fed’s Beige Book publication about current economic conditions across the 12 districts for the month of May, has reported continued economic growth compared with April, with a majority indicating slight or modest growth.
While most districts reported ongoing growth in manufacturing; retail noted some softening due to high prices; residential real estate observed weakness as buyers faced high prices and rising interest rates.
Eight districts reported that expectations of future growth had diminished; and an increasing number expected a recession by year-end.
As many business leaders, including the chief executive officers of the big US investment banks, believe that a recession is imminent, they will cut back on investment spending in a way that suppresses overall economic activity.
The stock market has predicted nine of the last five recessions. Asset and equity prices have been rising and were frothy, not always being justified by fundamentals.
The characteristics of a speculative bubble will likely to burst when monetary tightening continues and the QE unwinds to tame inflation from the current level of 8.6% in May.
The Fed is compelled to increase interest rates until inflation comes down to a manageable level, say to 4% or to the Fed’s 2% target even if that risks a recession or a market meltdown. The terminal interest rate is between 3% and 3.25%.
In China, multiple indicators (sales, industrial production, and fixed investments) have weakened or contracted in recent months, indicating a grim economic outlook.
China’s zero-Covid strategy and the lockdowns in some cities and provinces as well as the troubled real estate sector have not only disrupted the supply chains but also stalled economic and business activities.
While the rolling out of economic support packages (2% of gross domestic product), easing of liquidity and credit measures would help to lessen the magnitude of economic slowdown, the continued zero-Covid strategy with an unsettled global environment will pose a big hurdle to China’s economy.
The eurozone’s subdued economic growth in the first quarter of 2022 is leaning more to downside risks with a recession risk rising.
Consumers’ purchasing power are being squeezed by surging inflation, dampening their willingness to spend.
The prolonged period of supply chain disruptions and high energy prices pose a high downside risk to the industrial sector.
Against the challenging backdrop of higher and longer inflationary pressures, weaker economic growth, tighter financial conditions, weakening emerging market currencies, the central banks are confronted with a difficult task to act forcefully on inflation while not risking sapping their economies.
If the central banks hold back to hike interest rates or raise interest rate gradually and endure the supply-crunch inflation, it will result in entrenched higher inflation expectations, prompting companies and employees to push up prices and demand higher wages, respectively.
If this happens, it will be extremely costly to bring inflation down. The central banks may later be compelled to put the brakes on the economy even harder to keep inflation under control.
Lee Heng Guie is executive director of the Socio Economic Research Centre. The views expressed here are the writer’s own.
