It’s hard to tell whether the world really is headed towards a recession or not. Gloomy warnings from both central banks and bond markets suggest that a recession is around the corner whereas corporate entities continue to post strong results in the US and Europe while US job growth is so strong that unemployment is down to 3.5%- lower than pre-pandemic levels. What indeed is going on?
Just last week the Bank of England announced its sixth rate-hike in a row- a respectable 50 basis points. At the same time, they forecast the likelihood of an imminent recession looming- a long recession at that. Included in the forecast was the possibility of inflation touching 13%. The likely expected peak of inflation now varies wildly between the US, UK and Europe. Whilst the Bank of England is taking a gloomy stance the belief in the US is that they are near the summit and that inflation may start to fall thanks to falling oil prices. The UK is in the middle of a very protracted extraction from the economic bond of the European Union and this is leading to inflationary pressures of its own. Plus, the UK does not have the luxury of energy independence that the US does.
Neither does the European Union whose dependence on gas and oil supplies from Russia is coming back to haunt it in spectacular fashion as Russia has drastically cut supplies to the EU ahead of winter. The Russians retaliated to sanctions by cutting supplies to prevent Europe accumulating reserves for the winter spike in usage and now has again cut supplies forcing planned electricity and heating rationing in Europe. The EU has self-imposed energy cuts of 15% in place with laws that prevent heating above certain temperatures in winter and air-conditioning below certain temperatures in summer in all public buildings. The flipside of this energy uncertainty is large spikes in energy costs.
The latest US print for inflation was at 9.1% and the Consumer Price Index print on the 10th of August is not expected to be below 8.6% despite a fall in the price of petrol at the pump thanks to international prices cooling. European inflation is hovering between 8.5 and 9.5% but the expectation of subdued demand due to the energy crisis is keeping bond yields low.
Because of these factors, the Nobel prize winning US economist JK Galbraith has put forward the argument that rate hikes are not the way to bring inflation down. He pinpoints food and energy price rises (up 10% and 40% respectively in the last year alone) as the chief culprits behind this bout of inflation- neither of which would be impacted by higher rates. He further states that there is no evidence that demand rather than cost increases have caused even the non-food/ non-energy price inflation. There is, however, evidence that corporate profits are higher than normal. In other words, the sale price minus the per unit costs are at higher-than-normal levels meaning margins (sale price minus costs) have increased. Other inflation drivers are corporate consolidation and supply blockages. This cannot be countered with rate hikes. Higher rates only benefit those who are cash-rich already- a form of transfer of wealth towards capital, and those companies that face increased rate costs simply pass them on to consumers, pushing up inflation. His solution is to address output shortages whilst monitoring profiteering. He argues that it would only be by extreme measures that the Federal Reserve would be able to get ahead of inflation. That is, interest rates of 10% or more.
If we go on the belief that higher rates will slow down demand, coupled with the beneficial- if unrelated, falls in oil prices and improved supply (for example- grain exports from Ukraine have just resumed with a shipment arriving in Turkey) then can we avert a recession? A recession happens when real GDP growth is negative for 2 or more successive quarters. By this standard the US is already in a technical recession. But, as with Europe, both show equity markets that are far from their lows and remain buoyant on strong reported earnings. With US unemployment at 3.5% it doesn’t have the feel of a recession- which usually entails job losses and high unemployment rates. Yet, the central banks are predicting one. Not just the central banks too, the US Bond market is showing a persistent negative spread in the 2-year versus 10-years of 40 basis points. This negative spread has preceded every recession in modern times in the US.
Former US Treasury Secretary Lawrence Summers has stated that the US would not get out of this excess inflation without a recession. He predicts two years of 6% unemployment would be necessary to cool inflationary pressures down- something Galbraith disagrees strongly with. Galbraith rejects the notion that pushing up unemployment to soften demand is the way forward- for reasons given earlier. He even suggests that there is an illusion of inflation due to the statistical way of reporting; to put it in his way there is a persistence of headlines longer than there is a persistence of actual inflationary pressure.
A recession of some sort then seems the most likely scenario soon. It may not be a protracted one but short-lived. In terms of inflation there are two competing schools of thought on solutions but many exogenous variables that cannot be taken for granted. The Russia-Ukraine war, Chinese supply issues due to Covid lockdowns and extreme weather events causing production damage are all unpredictable that are hampering economic activity from a smooth resumption. These affect both inflation as well as growth.
What we can read from all this is that there is little consensus on our current situation. Even the hard data is giving mixed signals. The solutions offered are also on both ends of the spectrum. Currently the Federal Reserve, Bank of England and- in fact, most central banks are fighting the demons they can see with the weapons they hold to hand. Whether this works in the short-run, the long-run or at all, is still undecided. And with all the other variables at play, it may not even be clear in hindsight what worked and what didn’t.