NEW YORK (Project Syndicate)—For the past year, I have been arguing that the increase in inflation would be persistent, that the reasons for it include not only bad policies but also negative supply shocks, and that the effort of the banks would lead a fight for it. economic hard landing.
When the recession comes, I warned, it will be severe and protracted, with widespread financial distress and debt crises. Despite their hawkish talk, central bankers, caught in a debt trap, may still give up and settle for above-target inflation. Any portfolio of riskier equities and less risky fixed income bonds will lose money on the bonds, due to higher inflation and inflation expectations.
How do these predictions stack up? First of all, it was clear that Team Transitory lost to Team Permanent in the inflation debate. In addition to overly loose monetary, fiscal and credit policies, negative supply shocks fueled price growth. COVID-19 lockdowns have led to supply bottlenecks, including labor. China’s “zero-COVID” policy has created even more problems for global supply chains. Russia’s invasion of Ukraine sent shock waves through energy and other commodity markets.
“ Central banks, regardless of their tough talk, will feel enormous pressure to reverse their tightening once the scenario of an economic hard landing and financial crash materializes. “
And the broader sanctions regime – in particular the weaponization of the BUXX dollar,
and other currencies – has further balkanized the global economy, with “buddy sharing” and trade and immigration restrictions accelerating the trend towards de-globalisation.
Everyone now recognizes that these ongoing negative supply shocks have contributed to inflation, and the European Central Bank, the Bank of England, and the Federal Reserve have begun to acknowledge that a soft landing will be extremely difficult to remove. Fed Chairman Jerome Powell now speaks of a “soft landing” with “at least some pain”. Meanwhile, a hard landing scenario is emerging as a consensus among market analysts, economists and investors.
A soft landing is much more difficult to achieve under conditions of stagflationary negative supply shocks than when the economy is overheating due to excess demand. Since World War II, there has never been a situation where the Fed has had a soft landing with inflation above 5% (it’s over 8%) and unemployment below 5% (it’s currently 3.7%).
And if the bottom line is a hard landing for the United States, it is even more likely in Europe, due to the Russian energy shock, China’s slowdown, and the ECB falling even further behind the curve relative to the Fed.
The recession will be severe and prolonged
Are we already in recession? Not yet, but the US reported negative growth in the first half of the year, and most forward-looking indicators of economic activity in advanced economies point to a sharp worsening slowdown that will worsen with a tightening of monetary policy. A hard landing by the end of the year should be considered a baseline scenario.
While many other analysts now agree, they seem to think the coming recession will be short and shallow, although I have cautioned against that relative optimism, underscoring the danger of a crisis severe and prolonged stagflationary debt. And now, the latest distress in the financial markets—including bond and credit markets—reinforces my view that efforts by central banks to bring inflation back to their intended target will only result in an economic crash and both financial.
I have also long argued that central banks, regardless of their tough talk, will be under enormous pressure to reverse their tightening once the scenario of an economic hard landing and financial crash materializes. Early signs of destruction are already visible in the United Kingdom. Faced with the market reaction to the new government’s reckless fiscal stimulus, the BOE launched an emergency quantitative easing (QE) program to buy government bonds (which have increased yields).
Monetary policy is subject to gradual fiscal capture. Recall that a similar turnaround occurred in the first quarter of 2019, when the Fed stopped its quantitative easing (QT) program and began pursuing a combination of backdoor QE and policy rate cuts – after rate hikes continuous and QT previously indicated – at the first sign of mild financial pressures and growth slowdown.
Central banks will talk tough; but there is good reason to doubt their willingness to do “whatever it takes” to return inflation to its target rate in a world of excessive debt and the risk of economic and financial collapse.
Furthermore, there are early signs that the Great Depression has given way to the Great Recession, characterized by instability and the confluence of slow-motion negative supply shocks.
In addition to the disruption mentioned above, many major economies may experience an aging society (a problem exacerbated by immigration restrictions); Sino-American decoupling; “geopolitical depression” and the breakdown of multilateralism; new variants of COVID-19 and new outbreaks, such as chicken pox; the increasingly harmful consequences of climate change; cyber warfare; and fiscal policies to increase workers’ wages and power.
Where does that leave the traditional 60/40 portfolio? I have previously argued that the negative correlation between bond and equity prices would break as inflation rises, and indeed it has. Between January and June of this year, the US (and global) equity indices SPX,
TMUBMUSD10Y long-term bond yields fell by over 20%,
it rose from 1.5% to 3.5%, resulting in huge losses on both equities and bonds (positive price correlation).
Moreover, TMUBMUSD02Y bond yields,
fell during the market rally between July and mid-August (which I correctly predicted would be a dead cat bounce), so the positive price correlation was maintained; and since mid-August, equities have continued to decline sharply and bond yields have gone much higher. As tighter monetary policy leads to higher inflation, a fair market for both equities and bonds has emerged.
But US and global equities have not yet been fully priced even in light and short hard landings. Equities will fall by about 30% during a mild recession, and 40% or more in the severe stagflationary debt crisis I predict for the global economy. Signs of pressure on debt markets are mounting: sovereign spreads and long-term bond rates are rising, with high-yield spreads widening sharply; 648/2012 Text relevant to the EEA the leveraged loan and collateralized loan obligation markets are closing; heavily indebted businesses, shadow banks, households, governments and countries are entering 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 “MegaThreats: Tendangerous Trends That Imperil Our Future, and How to Survive Them” (Little, Brown and) to come. Company, October 2022).
This commentary was published with permission from Project Syndicate — The Stagflationary Debt Crisis Is Here