The author is a North American economist at Pimco
The question for macro forecasters has evolved from whether we will see a recession in major developed economies, to when and how deep?
Shallow recessions in developed markets remain the most likely outcome of aggressive central bank policy responses to rising inflation. However, the risk of financial market contagion triggering a deeper recession is high.
Federal Reserve, European Central Bank and Bank of England interest rates are all moving higher and are likely to stay there for longer as elevated inflation appears broad-based and entrenched in developed markets. Indeed, shallow recessions may now be required to halt this inflation – an outcome that has not been easy to construct in the past.
Between 1960 and 1991, the average real decline in gross domestic product in developed countries during a recession was 1.5 percent, while the unemployment rate rose 2 percent.
When recessions are ranked by how much core inflation rose in the two years preceding the expansion, recessions with a steeper rise in inflation were significantly worse, as were recessions after more aggressive monetary tightening.
However, higher household saving rates, an indicator of broader private sector balance sheet strength, tend to result in 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 liquidity buffer and longer-dated debt maturities that carry historically low interest rates – something that should help limit the expected downturn.
Nonetheless, aggressive rate hikes can lead to unforeseen tensions in financial markets and sudden halts in credit markets, which may increase the risk of a sharper contraction. These second-round effects of higher interest rates are difficult to predict in advance, as they only become apparent once markets are already stressed.
In the past, we have argued that policymakers’ fears of these second-round effects would ultimately limit rate hikes. However, amid elevated inflation, central banks face tough choices and so far have focused on combating inflationary pressures with the fastest rate hikes in decades.
So far, central banks have successfully tightened financing conditions without a financial market crash. Nonetheless, tightening financial conditions tend to have a delayed impact on the real economy, and events over the past few weeks are a reminder that financial weakness can materialize quickly.
In the UK, the Bank of England is now buying government bonds to “get the market working” after the government’s proposed tax cuts caused longer-dated government bond yields to rise. The jump in yields had created liquidity concerns for British pensions.
In addition, markets began to reflect increasing financial stress this month, with the price of credit event protection rising along with short-term lending rates for some European banks.
Similarly, the European Central Bank has a limited tolerance for financial market stress. Unlike the Bank of England, it did not have to announce a surprise market intervention, but preemptively created the Transmission Protection Instrument in July to ensure that spreads between Germany and other euro area countries remain tight.
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This and the European Central Bank’s decision to hike interest rates without shrinking its balance sheet may limit sovereign bond stress, although a general trend towards higher debt among euro area governments is dampening the impact of higher energy prices on households.
Where does that leave us? Shallow recessions are still the base case. But managing a mild recession becomes more difficult for central banks when they are forced to offset the inflationary effects of looser fiscal policy.
In addition, since monetary policy affects the real economy only with variable and uncertain lags, central banks must rely on historical relationships that may have developed. In the US, we expect the Fed to continue raising interest rates to ensure real interest rates are sufficiently positive to weigh on economic activity.
Given the policy error of inflation being too high or a deep recession, central bankers still appear to be solely focused on bringing inflation down – even if that increases the risk of a deeper downturn.
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