The writer is North American economist at Pimco
The question for macro forecasters has evolved from if we’ll see a recession in large developed economies, to when and how deep?
Shallow recessions across developed markets are still the most likely outcome from the aggressive central bank policy responses to rising inflation. However, the risk of financial market contagion triggering a more severe recession looms large.
Policy rates at the Federal Reserve, European Central Bank and Bank of England are all moving higher and are expected to linger there for longer, given that elevated inflation across developed markets looks broad-based and entrenched. Indeed, shallow recessions might now be required to arrest that inflation — an outcome that has not been easy to engineer in the past.
Between 1960 and 1991, the average developed market real contraction in gross domestic product during a recession was 1.5 per cent while the unemployment rate rose 2 per cent.
When recessions are ranked by how much core inflation rose in the two years of the preceding expansion, recessions with a steeper rise in inflation were notably worse, as were recessions following more aggressive monetary policy tightening.
Higher household savings rates, a proxy for more general private sector balance sheet strength, however, tend to lead to shorter and much shallower recessions. And as a result of the unprecedented pandemic-related policy intervention, the private sector is in relatively good shape with a sizeable cash cushion and longer-dated debt maturities that carry historically low rates — something that should help limit the expected downturn.
Nevertheless, aggressive rate rises can create unforeseen stresses in financial markets, and sudden stops in credit markets that can increase the risk for a more severe contraction. These second-round effects of higher interest rates are difficult to forecast in advance as they only become obvious when markets are already under stress.
In the past, we argued that policymakers’ fear of these second-round effects would ultimately limit how high interest rates rise. However, with inflation elevated, central banks face difficult choices, and so far, they have focused on battling inflationary pressures with the fastest pace of rate rises in decades.
So far, central banks have successfully tightened financial conditions without a financial market accident. Still, tighter financial conditions tend to only impact the real economy with a lag, and events in recent weeks are a reminder that financial fragilities can emerge quickly.
In the UK, the Bank of England is now buying government bonds to restore “market functioning” after the government’s proposed tax cuts caused longer-dated government bond yields to spike. The jump in yields had created liquidity concerns for UK pensions.
Furthermore, markets this month started to reflect rising financial stress, with the price of protecting against credit events rising along with short-term borrowing rates for a few European banks.
Similarly, the European Central Bank also has limited tolerance for financial market stress. Unlike the Bank of England, it has not had to announce a surprise market intervention, but in July it pre-emptively created the Transmission Protection Instrument to ensure bond spreads between German and other euro area countries remain narrow.
This, plus the European Central Bank’s choice to raise rates without shrinking the balance sheet, may be limiting sovereign bond stress despite a broader trend of higher debt among euro area governments to dull the impact on households of higher energy prices.
Where does this leave us? Shallow recessions are still the base case. However, managing a shallow recession becomes more difficult for central banks when they are forced to offset the inflationary effects of easier fiscal policy.
Furthermore, because monetary policy only impacts the real economy with variable and uncertain lags, central banks must rely on historical relationships which may have evolved. In the US, we expect the Fed will raise its benchmark rate further to ensure real rates are sufficiently positive to weigh on economic activity.
Indeed, when faced with the policy mistake of too much inflation or severe recession, central bankers still appear solely focused on bringing down inflation — even if it increases the risk of a more severe downturn.