Insight - What will the US recession look like?

The Fed is walking a very fine line as it must raise interest rates fast enough to cool both cost-driven and demand-pull (wage spiral) inflation and contain inflation expectations, without causing a hard landing in the US economy. Fed policymakers have warned that the entrenched inflation poses a “significant risk” to the US economy and tighter monetary policy may be needed if prices rise more than expected.(File pic: US Fed building in Washington)

GLOBAL stagflation risk, the war in Ukraine, an almost synchronisation of interest rate hikes by major central banks, and a slowdown in China’s economic growth are among the factors that have darkened the outlook of the global economy and affecting worldwide markets.

“It’s going to be a tough 2022, but maybe even a tougher 2023,” a quote from the International Monetary Fund’s chief who does not rule out the risk of a global recession in 2023 given the elevated risks.

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Three-quarters of chief executives of Fortune 500 companies are braced for growth to go negative before the end of 2023.

The latest poll of 70% of leading academic economists conducted by the Financial Times expect the United States economy will tip into a recession next year.

While the bond yields have inverted for a short while, it flashes stress economic signs ahead.

With inflation rising above 4% and unemployment rate dipping below 4%, these two thresholds indicate that the US economy is surely overheating, this warranted prompt monetary tightening and removal of money supply growth to control inflation scare.

An overly aggressive Federal Reserve (Fed) is the biggest risk.

The Fed is walking a very fine line as it must raise interest rates fast enough to cool both cost-driven and demand-pull (wage spiral) inflation and contain inflation expectations, without causing a hard landing in the US economy.

Fed policymakers have warned that the entrenched inflation poses a “significant risk” to the US economy and tighter monetary policy may be needed if prices rise more than expected.

At this juncture, it means some mixed performance of economic numbers in response to the Fed’s tightening and extended cost pressures for consumers and businesses.

Consumer inflation accelerated to a 41-year high of 9.1% in June and inflation at the wholesale level climbed 11.3% in June.

Both the manufacturing and services activities have slowed in June; retail sales spending rose in June; personal spending slowed in June along with weak housing starts, building permits and factory production.

But, the labour market is still strong. What if there is a US recession? What will the shape look like? Will it be a long, deep or moderate and less painful when comparing to 1981 to 1982 recession, and 2008 to 2009 global financial crisis?

The depth and duration of the US recession will depend on initial economic conditions, the labour market condition and causes of the recession as well as how persistent inflation prove to be.

We have reasons to expect that the US recession should not be deep and long, probably between six and eight months but the recovery may take longer.

This is in contrast to those periods of severe economic downturns inflicted by strong interest rate hikes to control inflation during the 1970s oil shock (11 to 16 months) and in early 1980s (16 months).

The current high inflation of 9.1% in June 2022 though has been increasing since 2021 and has not fully entrenched. In 1979 to 1981, inflation had been raging for years and was deeply ingrained in expectations.

The inflation rate of 7.6% in 1978 had surged to 11.3% in 1979, and accelerated to 14.6% in March 1980, 10.3% in 1981 before coming down to 6.1% in 1982.

The record low of unemployment rate (3.6% in July 2022) since the 1950s is compared to between 6.3% and 8.5% in 1980 to1981.

The economic recession will inevitably cause a rise in unemployment rate but it should be digestible.

Private sector balance sheets are in better shape now to absorb the impact of aggressive interest rate hikes and the loss of wealth due to the assets price correction (stocks and home equity values).

Households are sitting on a huge stockpile of savings, estimated at around US$3 trillion (RM13.4 trillion) at end-2020, which they have accumulated during the pandemic.

This has boosted household debt obligations to 9.5% of disposable personal income in the first quarter of 2022 (1Q22), well below an average of 12.6% in the 2008 to 2009 global financial crisis and an average of 10.4% in 1980 to 1982.

Net private savings (household and institutions) stood at US$1 trillion (RM4.45 trillion) in 1Q22, substantially higher than US$602.6bil (RM2.7 trillion) at end-2009. Households’ net worth has increased from US$109.9 trillion (RM489.3 trillion) at 4Q19 to US$141.1 trillion (RM628.2 trillion) in 1Q22.

As at end of 4Q09, households’ net worth was US$58.5 trillion (RM260.4 trillion).

Higher interest rates (mortgage rates) have already impacted home loan applications and housing starts.

Home prices could decline at some point in time but a massive drop in home values is unlikely.

This time round it is different from the 2008 to 2009 subprime home loans crisis that was fuelled by irresponsible lending practices and loosened credit standards as well as the homeowners’ over-stretched gearing of mortgages.

If the economic condition deteriorates and results in job and income loss, the homeowners’ improved net worth and strong home equity values can help to avert a massive crash in the property sector.

While the duration of a recession may be shorter and moderate, it could end up lasting longer, depending on how persistent inflation proves to be.

The Fed may not pause its rate hike until it sees inflation has convincingly come down.

If the inflation stays elevated, the Fed may continue hiking interest rate well into economic weakness, and hence, prolonging the duration of the recession.

Lee Heng Guie is executive director of the Socio Economic Research Centre. The views expressed here are the writer’s own.