A Perfect Storm: Recession, The Fed and Scarcities
Productivity growth, assisted by technology, could make wage gains tolerable for companies and sustainable for workers.
Hurricane Ian was one of the worst national disasters in U.S. history. Estimates are still being tallied, but it idled a large portion of Florida’s trillion dollar economy and a swath of the Southeastern seaboard.
Rebuilding will be incomplete and take time to ramp up, given damages to infrastructure. Most of the boost to economic activity is expected to occur in the first half of 2023. As we saw in the wake of Hurricane Katrina, many will leave to work and live elsewhere.
Hurricanes are made up of clusters of thunderstorms that combine to become more powerful and devastating than any one storm. That is a useful metaphor for where we are. Geopolitical and economic storm clouds were gathering well before Ian came ashore.
This edition of Economic Compass takes a closer look at three key themes:
- The risk of a global recession;
- The unique role the Federal Reserve will play in determining that outlook; and
- The risk of chronic scarcities.
We are moving from a world of abundance, in which what seemed an endless supply of cheap labor and cheap goods from abroad is being supplanted by a world of scarcity. That could leave us more prone to inflation and rate hikes on the other side of the recession.
The only silver lining to those clouds is technological innovation. That could help ease the transition away from fossil fuels, secure the energy grid and enable wage gains to outpace instead of chase inflation.
An early winter
Real GDP is forecast to rise at a 2.3% pace in the third quarter, after posting two consecutive quarters of declines in the first half of the year. Consumer spending slowed to a near standstill, with a shift in spending on niceties to necessities. Home buying and building continued to contract. Home values are falling across many of what were the hottest pandemic markets.
Business investment held up better, as supply chain bottlenecks began to unwind. Imports cratered as retailers attempted to better align their inventories with consumer spending and exports picked up. The improvement in the trade deficit is the single largest contributor to growth.
Prospects for the fourth quarter are considerably worse. Real GDP is forecast to drop by 2.3% and remain in the red through the first half of 2023. That will mark the “official” start of the recession. Aggressive rate hikes, weaker growth abroad and persistent inflation will push employment down and unemployment up.
The recession is still mild but more abrupt and deeper than previously forecast. It will also end sooner than previously forecast. Unemployment, which is a lagging indicator, is expected to peak at close to 6% in 2024, when inflation finally returns to the Fed’s 2% target. The Fed will be scrambling to cut rates again before that occurs. Barring a financial crisis, rates are not expected to return to the zero bound any time soon.
Risks of a Global Recession
The energy crisis triggered by the war in Ukraine, rate hikes by central banks and lockdowns due to China’s zero COVID policy have been pushing down forecasts for global growth since the start of the year. The International Monetary Fund (IMF) will likely forecast global growth of less than 3% in 2022; that could fall further. (See Chart 1.) The data is actually worse than it appears, given the tendency by autocratic leaders to inflate their growth estimates.
Chart 1: World Outlook Downgraded
2022 World GDP Growth, Annual Percent Change
Source: International Monetary Fund (IMF) World Economic Outlook 2022
China has eased some of its strictest zero COVID policies but that is partially because recent outbreaks have been in less densely populated areas. The problem remains the overhang of debt, notably in the real estate sector. Deleveraging will be costly.
China has pivoted from lending to other developing countries for its ill-fated Belt and Road initiative to providing funds for emergency debt relief. Those loans, along with lending by the IMF, have helped to stave off defaults. That said, we are sitting on a time bomb of emerging market debt.
High debt loads prior to Russia’s invasion of Ukraine, coupled with the surge in inflation triggered by the crisis, have forced many countries to subsidize the basics of food and energy. This is at the same time that rates are rising, which is increasing the cost of that debt and exacerbating the pain across the developing world.
The phenomenon is nothing new. The Volcker rate hikes of the early 1980s triggered the Latin American debt crisis. A series of defaults set much of the region back a decade in growth.
Concerns about emerging market debt dominated debate at the 2021 Jackson Hole Symposium. Memories of the taper tantrum of 2013, which triggered a rapid rise in Treasury bond yields, quickly spread around the world. Countries whose currencies depreciated were forced to raise rates to defend their currencies and curb inflation. That prompted a sharp pullback in economic activity and compromised their ability to service the interest expense on their debts.
The impact of rapid rate hikes could be even worse today. Much of the debt issued by emerging markets is held by commercial banks in those countries. A default could trigger a “doom loop” of losses. They would lose their access to international credit markets at the same time banks are forced to mark down their bond holdings and other assets. That would force banks to increase their reserves which would severely limit their ability to lend. (Understatement.)
No one expected that to happen in a developed economy. The U.K. is an extreme. The inflation due to the pandemic is being exacerbated by the war in Ukraine and the rise in tariffs Brexit unleashed. Efforts by the new government to stimulate with record tax cuts and energy subsidies were immediately rejected by financial markets.
Sterling rapidly depreciated and triggered a jump in government bond or “gilt” yields. That triggered a Lehman-style meltdown in the country’s highly leveraged pension system. The Bank of England was forced to intervene, but pledged to do so only temporarily. The hope is that the newly formed government will scale back its reckless policies; they’ve already blinked.
The risks of recession continue to mount with OPEC+ making its largest cut to production to support energy prices since the onset of the pandemic in 2020. Vladimir Putin has upped his threat to attack NATO countries as well as Ukraine. I honestly never thought I would hear the words “tactical” and “nuclear” in the same sentence when it came to weaponry.
This is all in addition to a sooner-than-expected but still mild recession in the U.S., starting in the fourth quarter. Many forecasts are chasing rather than front-running that reality.