(ORDO NEWS) — Now it has become necessary to tighten monetary policy so much that it will inevitably lead to a “hard” landing of the world economy, an authoritative American economist believes. His article in Project Syndicate suggests two scenarios. And in any there is a possibility of a recession in the next two years.
In 2021, a major debate over the outlook for the global economy has centered on whether rising inflation in the United States and other advanced economies is temporary or permanent. Key central banks and most Wall Street analysts have found themselves in the temporary inflation camp. They attributed the problem to the base effect and temporary bottlenecks on the supply side, assuming that high inflation would quickly fall back to the central bank’s target of 2%.
Meanwhile, the perpetual inflation camp, led by Harvard University’s Lawrence Summers, Cambridge University’s Mohamed El-Erian and others, argued that inflation would remain high because the economy was overheated by excess aggregate demand. Demand was pushed up by three forces: stubbornly loose monetary policy, excessive fiscal stimulus, a rapid increase in household savings during the pandemic, which triggered pent-up demand after the economy reopened.
I too was in this camp of constant inflation. But I argued that, in addition to excess aggregate demand, negative shocks to aggregate supply also contributed to inflation. Moreover, they contributed to stagflation — a slowdown in economic growth against the backdrop of rising inflation. The initial response to COVID-19 was total lockdowns, which led to severe disruption to global production chains and reduced labor supply (creating a shortage of workers in the US labor market). And this year there were two new shocks on the supply side: a brutal Russian special operation in Ukraine pushed up the prices of raw materials (energy, industrial metals, food, fertilizers), and the Chinese policy of “zero COVID”, applied in the fight against the Omicron strain.
Today we know that the camp of constant inflation won the 2021 inflation dispute. Price growth is rapidly approaching double digits, so the US Federal Reserve and other central banks have recognized that the problem is not temporary, and that they need to urgently address it by tightening monetary policy.
As a result, a new big debate has begun: whether the economic authorities will be able to provide the world economy with a “soft landing”. The Fed and other central banks are assuring that they will be able to raise interest rates just enough to bring inflation down to the target 2% without triggering a recession. But I, like many other economists, doubt that such a “Goldilocks scenario” (when the economy is neither too hot nor too cold) is feasible. The degree of monetary tightening now required is such that it will inevitably lead to a hard landing in the economy in the form of recession and rising unemployment.
Because stagflationary shocks reduce economic growth and increase inflation, they leave central banks in a dilemma. If their top priority is to fight inflation and prevent a dangerous break from the anchor of inflationary expectations (the wage-price spiral), then they need to phase out their unconventional expansionary policies and raise interest rates, at a pace that is likely to lead to a hard landing. And if their main priority is to maintain economic growth and employment, then they will have to normalize monetary policy at a slower pace, which creates the risk of breaking off inflation expectations and anchoring inflation.
That is why the soft landing scenario looks like a pipe dream. Today inflation is so stubborn so that only a serious tightening of monetary policy can bring it back to the targets. Judging by previous episodes of high inflation, I would estimate the probability of a hard landing in the economy in the next two years to be over 60%.
However, there is a third possible scenario. Today, the monetary authorities are talking tough about fighting inflation, trying to eliminate the risk that it will break out of control. But that doesn’t mean they won’t back down by allowing inflation to rise above the target in the future. Reaching this level will almost certainly require a hard landing of the economy, so they may start raising rates and then stop as soon as such a landing becomes more likely. In addition, there is so much private and public debt in the system (348% of global GDP) that rising interest rates could trigger further sharp declines in the bond, equity and credit markets, giving central banks an extra reason to pull back.
Simply put, trying to fight inflation can easily bring down the economy, the markets, or both. Already, financial markets have been wobbly due to moderate monetary tightening by central banks: key stock indices are approaching bearish territory (down 20% from their last peaks), bond yields are rising, credit spreads are widening. However, if central banks get scared now, the result will be similar to the stagflation of the 1970s, when a recession was accompanied by high inflation and inflation expectations being unanchored.
Which scenario is the most likely? Everything will depend on a combination of a number of obscure factors, including the persistence of the wage-price spiral; the level of growth in discount rates necessary to curb inflation (creating idle capacities in the commodity and labor markets); the degree to which central banks are willing to inflict short-term pain in order to reach their inflation target. In addition, it remains to be seen what turn the situation will take in Ukraine, and how this will affect commodity prices. The same goes for China‘s “COVID zero” policy (affecting production chains) and the current financial market correction.
Based on historical data, a soft landing of the economy is very unlikely. What remains is either a hard landing and a return to low inflation, or a stagflation scenario. In any case, there is a possibility of a recession in the next two years.
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