I’ll explain how and why the recession is coming
Inflation is proving more persistent, which implies that central banks may have to engineer recessions (and not just a period of below-trend growth) to restore price stability. The analysis by Tiffany Wilding, Managing Director and US Economist of PIMCO
In our recently published secular outlook (see Secular Outlook: Achieving Resilience) we saw a high risk of recession in the economies of industrialized countries over the next two years, due to the greater potential for geopolitical turbulence, inflation stubbornly high and the determination of central banks to focus primarily on fighting inflation, increasing the risk of financial accidents. One month after publishing these views, they are still valid. If anything, several developments suggest that the recession could come earlier, and with a more prolonged contraction, due to the initial conditions of high inflation that will limit the usual counter-cyclical political response by central banks and tax authorities (think of a form of Shallow L instead of the deep V-pandemic recession). Indeed, we expect several developed markets, including the US, to contract real GDP over multiple quarters starting this year, followed by a period of below-trend growth.
First, high-frequency economic indicators have deteriorated, both in the United States and in other countries. While we don't think developed market economies have already entered recession, real activity indicators are clearly heading in that direction. Just last week, Europe's purchasing managers' indices, which tend to lead the government's official economic indicators, fell to a level historically consistent with a contraction in real GDP growth. Even as US real GDP began to contract in the first quarter and various GDP monitoring estimates point to another contraction in the second quarter, we suspect that the National Bureau of Economic Research (NBER) will not declare a US contraction before the end of year.
Incidentally, in the United States, the NBER – the official dating arbiter of the American recession – uses a more complete definition than the 2-quarter-consecutive-quarter GDP contraction rule of thumb illustrated by many economic commentators. Specifically, the NBER looks for a "significant decline in economic activity" in various parameters, including real aggregate income and consumption, manufacturing and commercial sector sales and industrial production, as well as survey-based employment at households and industries. So far, the data are mixed. Indeed, 4 of the 6 indicators – real consumption, employment according to the Current Population Survey (CPS), real sales of the manufacturing and commercial sectors and IP – recorded small contractions on a monthly basis in May and / or June. Although wage growth reported by the labor report has been strong, suggesting that U.S. labor markets have not yet entered recession, the other key indicators of labor market conditions – jobless claims, the survey of the Conference Board on households 'perceptions of current labor market conditions (the so-called "jobs plentiful vs. jobs hard to get" indicator) and the employment indicators underlying the purchasing managers' indices – all show a future increase the unemployment rate.
Second, the inflationary supply shocks have been more acute than initially expected. The geopolitical turmoil and the war in Ukraine prompted Russia to significantly reduce oil and gas flows to the EU. Just last week the Nord Stream pipeline, which supplies Russian gas to Germany, was restarted after a maintenance period at only 40% capacity and, at the time of writing, was further reduced to 20% capacity after the reported delays in receiving a turbine due to Western sanctions. According to our analysts, the reduction in flows is expected to continue, with the likely consequence of (1) mandatory gas rationing programs in Germany and other Eastern European countries that are heavily dependent on Russian gas, and / or (2 ) a loosening of control over the prices of regulated utilities, which could bring about sufficient destruction of demand through higher prices.
As gas is used to power factories in Germany and across the EU, rising prices and rationing, especially for energy-intensive chemical companies, will further increase input costs and slow down. economic activity throughout the supply chain. According to IMF estimates, a total shutdown of Russian gas taps starting from mid-July could reduce European GDP by more than 2 percentage points, with heavier effects in countries that depend most on Russian gas. Although we expect the status quo of the current 40% of gas flows from pipelines to be maintained, Europe still appears to be heading towards an inflationary recession later in the year. Equally concerning is the fact that, due to the interconnectedness of global supply chains, the European shock will affect the United States, which supplies 30% of its exports to Europe while it depends on EU producers for 25% of its exports. imports, and the rest of the world. While some import substitution from Europe will mitigate the effects on the rest of the world (China will likely benefit), industrial sectors, including the automotive sector, which already suffered from severe capacity constraints, will almost certainly have to deal with further delays. in production factors and higher costs.
Third, more generally, inflation is proving to be more persistent, implying that central banks may need to engineer recessions (and not just a period of below-trend growth) to restore price stability. This seems particularly true in the United States, where Fed members have hinted that tight monetary policy is needed. Indeed, although headline inflation will decline in the coming months due to the recent decline in global oil and agricultural prices, wage inflation (for example, see the Atlanta Fed data) and that of the rents – two areas where price trends tend to be more persistent – have actually accelerated.
And, more worryingly, inflation has accelerated more generally in the face of slowing growth and tightening financial conditions, suggesting that tighter monetary tightening may be needed to restore price stability.
What are the broader implications? The initial conditions of high inflation mean that the contours of this recession are likely to be very different from what has been experienced in the recent past.
High inflation is likely to limit the usual counter-cyclical policy response from central banks and tax authorities (with the clarification that several European governments are looking for ways to subsidize low-income households for rising energy costs) , will help raise interest rates and, more generally, will require tighter financial conditions to restore price stability.
All of this suggests that the contraction itself may be slower, but more prolonged, and is more likely to give way to a period of slow, below-trend growth, in which real activity will remain limited and vulnerable to economic shocks as long as the inflation will not moderate. It goes without saying that this is not a favorable environment for financial assets, and, in the medium term, the high financing costs could
limit the types of investments needed to alleviate capacity constraints.
As for the short-term implications of this week's FOMC meeting, despite the high recession risks, Fed members have indicated the likelihood of another 75 basis point hike and we are not ruling out a broader adjustment. While there is a fair amount of uncertainty about the exact level of the Fed Funds rate that is consistent with a neutral policy (i.e. one that is neither restrictive nor accommodative), it is clear that the current level of 1.6% is still accommodative. and which is less and less in tune with high inflation, which requires a restrictive policy. Indeed, the more conservative policy may require a quick adjustment of financial conditions (i.e. a 100 basis point increase to bring the benchmark rate to just above 2.5%, the Fed's estimate of the long-run neutral rate). at a level that addresses the risk that even higher rates may be needed to address the current inflation problem. However, regardless of this week's final decision, we expect the Fed to revise the Fed Funds rate projections for 2022 when the new SEP is released in September, anticipating the two hikes previously predicted for 2023, thereby implementing a restrictive policy sooner and longer than previously anticipated.
This is a machine translation from Italian language of a post published on Start Magazine at the URL https://www.startmag.it/economia/recessione-inflazione/ on Mon, 01 Aug 2022 04:27:20 +0000.