The writer is an American economist from Pimco
The question for macroeconomic forecasters has evolved from whether we will see a recession in the large developed economies to when and how deep it will be.
Shallow recessions in developed markets remain the most likely result of aggressive central bank policy responses to rising inflation. However, the risk of the financial market getting infected and triggering a more severe recession is very great.
Policy rates from the Federal Reserve, the European Central Bank and the Bank of England are moving higher and are expected to stay there for longer as high inflation in developed markets appears widespread and entrenched. Indeed, shallow recessions may now be required to stop that inflation, an outcome that has not been easy to engineer in the past.
Between 1960 and 1991, the average real contraction in gross domestic product in developed markets during a recession was 1.5 percent, while the unemployment rate rose 2 percent.
When recessions are categorized by how much underlying inflation rose in the two years of the previous expansion, recessions with a steeper rise in inflation were markedly worse, as were recessions following more aggressive monetary policy tightening.
However, higher household saving rates, an indicator of the overall strength of private sector balance sheets, tend to lead to shorter and shallower recessions. And as a result of unprecedented political intervention related to the pandemic, the private sector is in relatively good shape with a sizable cash cushion and longer-dated debt maturing at historically low rates, something that should help limit the downturn. expected.
However, aggressive rate increases can create unforeseen stresses in financial markets and sudden stops in credit markets that can increase the risk of a more severe contraction. These secondary effects of higher interest rates are difficult to forecast in advance, as they only become apparent when markets are already under pressure.
In the past, we argued that politicians’ fear of these side effects would ultimately limit interest rate increases. However, with inflation elevated, central banks face difficult decisions and have so far focused on fighting inflationary pressures with the fastest pace of rate hikes in decades.
So far, central banks have successfully tightened financial conditions without a financial market crash. Still, tighter financial conditions tend to affect the real economy only with a delay, and the events of the past few weeks are a reminder that financial fragilities can emerge quickly.
In the UK, the Bank of England is now buying government bonds to restore “market functioning” after proposed government tax cuts caused longer-dated government bond yields to rise. The jump in yields had created liquidity concerns for UK pensions.
In addition, markets this month began to reflect mounting financial stress, with the price of credit event protection rising along with short-term lending rates for some European banks.
Similarly, the European Central Bank also has a limited tolerance for financial market stress. Unlike the Bank of England, it has not had to announce a surprise market intervention, but in July it preemptively created the Transmission Protection Facility to ensure that bond spreads between Germany and other euro area countries euro remain tight.
This, coupled with the European Central Bank’s choice to raise rates without reducing the balance sheet, may be limiting stress on sovereign bonds despite a broader trend of higher debt among eurozone governments to mitigate the impact. of higher energy prices in homes.
Where does this leave us? Shallow recessions remain the base case. However, managing a shallow recession becomes more difficult for central banks when they are forced to offset the inflationary effects of looser fiscal policy.
Furthermore, since monetary policy only affects the real economy with variable and uncertain lags, central banks must rely on historical relationships that may have evolved. In the US, we expect the Federal Reserve to raise its benchmark rate further to ensure real rates are positive enough to weigh on economic activity.
Indeed, when faced with the policy error of too much inflation or a severe recession, central bankers still appear to be focused solely on reducing inflation, even if the risk of a more severe recession increases.