NEW YORK (Project Syndicate)—For a year now I have argued that rising inflation would be persistent, that its causes include not only bad policies but also negative supply shocks, and that the banks’ attempt power plants to fight it would result in an economic hard landing.
When the recession does come, I warned, it will be severe and prolonged, with widespread financial difficulties and debt crises. Despite their hawkish rhetoric, debt-trapped central bankers can still run out of steam and settle for above-target inflation. Any portfolio of risky stocks and less risky fixed income bonds will lose money on bonds, due to rising inflation and inflation expectations.
How do these predictions stack up? First, Team Transitory clearly lost to Team Persistent in the inflation debate. In addition to excessively loose monetary, fiscal and credit policies, negative supply shocks have boosted price growth. COVID-19 related lockdowns have resulted in supply bottlenecks, including for labor. China’s “zero COVID” policy has created even more problems for global supply chains. Russia’s invasion of Ukraine has sent shock waves through energy and other commodity markets.
“ Central banks, regardless of their harsh rhetoric, will feel immense pressure to reverse their tightening once the scenario of an economic hard landing and financial crash materializes. ”
And the broader sanctions regime, including the weaponization of the BUXX dollar,
and other currencies – has further balkanized the global economy, with “friends shoring” and trade and immigration restrictions accelerating the trend of de-globalization.
Everyone now recognizes that these persistent negative supply shocks have contributed to inflation, and the European Central Bank, Bank of England and Federal Reserve have begun to recognize that a soft landing will be extremely difficult to achieve. . Fed Chairman Jerome Powell is now talking about a “soft landing” with at least “a little pain.” Meanwhile, a hard landing scenario is becoming the consensus among market analysts, economists and investors.
It is much more difficult to achieve a soft landing under conditions of stagflationary negative supply shocks than when the economy is overheated due to excess demand. Since World War II, there has never been a case where the Fed has managed a soft landing with inflation above 5% (it is currently above 8%) and unemployment below 5% (it is currently 3.7%).
And if a hard landing is the baseline for the US, it’s even more likely in Europe, due to the Russian energy shock, China’s slowdown and the ECB’s even bigger pullback from the Fed. .
The recession will be severe and prolonged
Are we already in a recession? Not yet, but the United States recorded negative growth in the first half of the year, and most forward-looking indicators of economic activity in advanced economies point to a marked slowdown that will worsen further as the Monetary Policy. A hard landing by the end of the year should be considered the baseline scenario.
While many other analysts now agree, they seem to think the coming recession will be short and shallow, as I cautioned against such relative optimism, pointing to the risk of a severe and protracted crisis. stagflationary debt. And now, the latest distress in financial markets – including bond and credit markets – has reinforced my view that efforts by central banks to bring inflation back to target will cause both an economic and financial crash. .
I have also long argued that central banks, regardless of their harsh rhetoric, will feel immense pressure to reverse their tightening once the scenario of an economic hard landing and financial crash materializes. The first signs of wimping out are already visible in the UK. Faced with the market’s reaction to the new government’s reckless fiscal stimulus, the BOE launched an emergency quantitative easing (QE) program to buy government bonds (whose yields soared).
Monetary policy is increasingly subject to budgetary capture. Recall that a similar reversal occurred in the first quarter of 2019, when the Fed halted its quantitative tightening (QT) program and began to pursue a combination of disguised QE and policy rate cuts – after previously signaling continued rate hikes and QT – at the first sign of mild financial pressures and slowing growth.
The Great Stagflation
Central banks will talk tough; but there are good reasons to doubt their will to do “whatever it takes” to bring inflation back to its target rate in a world of over-indebtedness with risks of an economic and financial crash.
Additionally, there are early signs that the Great Moderation has given way to the Great Stagflation, which will be characterized by instability and a confluence of negative supply shocks in slow motion.
In addition to the disruptions mentioned above, these shocks could include the aging of society in many key economies (a problem compounded by immigration restrictions); Sino-American decoupling; a “geopolitical depression” and a collapse of multilateralism; new variants of COVID-19 and new epidemics, such as monkeypox; the increasingly damaging consequences of climate change; cyber war; and tax policies to increase wages and worker power.
Where does that leave the traditional 60/40 portfolio? I have previously argued that the negative correlation between bond and stock prices will break down as inflation rises, and indeed it does. Between January and June of this year, the US (and global) SPX stock indices,
fell more than 20% while long-term bond yields TMUBMUSD10Y,
rose from 1.5% to 3.5%, resulting in massive losses on both stocks and bonds (positive price correlation).
Additionally, bond yields TMUBMUSD02Y,
fell during the market rally between July and mid-August (which I correctly predicted would be a dead cat bounce), thus maintaining the positive price correlation; and since mid-August, equities have continued their steep decline while bond yields have gone much higher. As rising inflation led to a tightening of monetary policy, a balanced bear market for stocks and bonds emerged.
But US and global equities have yet to fully price in even a light and short hard landing. Stocks will fall about 30% in a mild recession and 40% or more in the severe stagflationary debt crisis I predicted for the global economy. Signs of stress in debt markets are growing: sovereign spreads and long-term bond rates are rising, and high-yield bond spreads are rising sharply; markets for leveraged loans and secured loan bonds are closing; highly indebted companies, shadow banks, households, governments and countries enter into debt distress.
The crisis is here.
Nouriel Roubini, professor emeritus of economics at New York University’s Stern School of Business, is chief economist at Atlas Capital Team and author of the forthcoming book “MegaThreats: Ten Dangerous Trends That Imperil Our Future, and How to Survive Them” (Little, Brown and Society, October 2022).
This commentary is courtesy of Project Syndicate — The Stagflationary Debt Crisis Is Here