Written By William Meng
Aggressive monetary tightening in an overly indebted economy has pushed us to the brink of recession. However, what should be discussed is what happens next. In the face of impossible fiscal situations and potential debt crises, central banks will be forced to give in on inflation fighting. Simultaneously, the world faces several challenges that will reduce productivity and supply, resulting in higher inflation over the long run.
A few months ago, I wrote an op-ed on the economy and argued that various economic indicators were signaling that a recession in the US was likely around the corner. Since then, there have been additional signs of a weakening economy, and a second quarter GDP print of negative 0.6%. Following the contraction in the first quarter, this makes for a second consecutive quarter of declining GDP - often the traditional definition of a recession. While there is anything but a consensus on whether the economy is currently in recession, there is no arguing that the economy has seen a slowdown.
The indicators discussed in the last article included the inverted yield curve, persistent inflation that has weighed on consumers, and the Federal Reserve’s tightening campaign that has led to deep selloffs in the market and corrections in the housing market - eventually sparking a reverse-wealth effect. Since then, the yield curve has only inverted more, with Treasuries inverting all the way from 6-months to the 10-year. Inflation has remained high with August CPI rising to 8.3% year-over-year, and the Fed has tightened interest rates to over 3%, signaling more rate hikes to come [1].
Expect a Hard Landing
If the Fed continues with their tightening campaign, expect virtually everything - from stocks, bonds, real estate, and commodities - to fall. The markets and the Fed are certainly projecting further tightening to come - with the Fed’s latest dot plot projecting the Fed funds rate going above 4.5% next year. This, alongside the Fed’s Quantitative Tightening program, will result in a significant decline in liquidity and credit in the economy and a likely hard landing. However, what must also be considered is the enormous levels of debt in virtually all sectors of the economy. Debt burdens around the globe make further monetary tightening increasingly difficult and raises the risk of the Fed breaking something as it does so - potentially triggering economic crises around the world.
Sovereign Debt Levels Will Force Central Banks to Pivot
According to research done by Carmen Reinhart, the current Chief Economist at the World Bank and Keith Rogoff, former Chief Economist for the IMF, 98% of countries who saw sovereign debt-to-GDP levels of over 130% ended up defaulting on their debt. Having exceeded this threshold back in 2020, and with debts currently at 121% of nominal GDP, the Fed’s rate hikes are pushing the US into dangerous territory. Additionally, with federal budget deficits being approximately 4-5% of GDP [2], it seems rather unlikely that the Fed can continue aggressively tightening for much longer. Many other countries, such as Italy and Greece, are in even worse fiscal positions, and Canada, the UK, and others are not far behind. And as history shows us, governments almost never allow themselves to default nominally, opting to inflate away debts instead.
Federal Debt-to-GDP is currently at 121% | Source: Federal Bank of St. Louis
Federal Debt-to-GDP is currently at 121% | Source: Federal Bank of St. Louis
This places the Fed between a rock and a hard place. Tighten too much and cripple the economy or tighten inadequately and risk inflation spiraling out of control. Regardless, it seems unlikely that the Fed and other central banks around the world can successfully bring inflation back to target. In addition to the previously discussed high debt burdens around the world, it appears as if the past few decades of disinflation and stable growth - a period in which former Fed Chair Ben Bernanke famously described as “The Great Moderation” - is over. This is because factors that led to it, such as globalization and relative world peace, have seemingly begun to reverse.
Geopolitical Tensions and De-globalization will be Inflationary
Tensions between the US and China have led to trade tariffs and restrictions, as well as the re-shoring of supply chains. Trump’s trade tariffs and Biden’s plan to re-shore critical industries, such as through the CHIPS act, appears to be only the beginning. While such measures may be important, they lead to decreased trade, higher government deficits, and increased inflationary pressures in the short run. With the cold war between the US and China getting colder, particularly following House Speaker Pelosi’s visit to Taiwan, we should expect this trend to only continue.
And of course there is Putin’s war with Ukraine, which has led to sanctions, soaring energy costs, and food shortages around the globe. The war has certainly contributed to higher inflation. However, something that receives less attention is the energy situation in Europe, with the potential for a full-blown crisis - particularly if Russia ends the flow of natural gas. The EU is heavily reliant on Russian energy and receives 40% of its natural gas from Russia. With multiple European nations already passing significant energy-saving measures, many are preparing for a worst-case energy crisis this winter. For example, Germany has limited heating of public buildings to 19 degrees and stopped the heating of public swimming pools and showers. Similarly in Spain, buildings can only be heated up to 19C, and air conditioning is limited to a minimum of 27C [3]. Such dramatic measures may only be the beginning, with many fearing a shutdown of industries and manufacturing as energy input costs continue to soar. In fact,
Europe has already seen a loss of 30% in its aluminum production capacity, and 70% of the region's fertilizer production has either been halted or shut down [4].
Energy Crises in Europe May Lead to Another Leg Higher in the CPI
What ought to be mentioned is the impact that an energy crisis in Europe will have on inflation. In the same way that the coronavirus pandemic and related lockdowns have led to supply chain bottlenecks and an elevated CPI, energy-induced shutdowns in Europe will also be inflationary. European supply chains and in particular, German industry, play a key role in the global supply chain and a shutdown will have a calamitous impact on the global economy.
Stagflation - The Likely Scenario
Furthermore, there are other factors in the economy that will curb productivity and make it very unlikely that central banks reach their inflation targets. The largest wealth inequality in decades has led to social and political instability around the world. In the US, political polarization has led to gridlock, ineffective leadership, and in some cases, social unrest. The instability reduces productivity and makes it more difficult to effectively respond to challenges. Many other nations face similar issues. Next, climate change will also be inflationary, with natural disasters and extreme weather events accelerating over the past few decades. All of which will lead to damaged infrastructure, diverted resources, and supply chain issues - resulting in a reduction of output and higher prices.
Despite the most aggressive tightening campaign by central banks since the stagflationary 1970s, it seems rather unlikely that inflation will come back to target. While central banks can slow demand, factors such as de-globalization, energy shortages in Europe and elsewhere, social instability, and climate change will make it impossible for supply to catch up. Enormous debt virtually everywhere - on the household, corporate, and sovereign level - means that prolonged tightening risks mass defaults and a depressionary collapse, like the Great Financial Crisis. And just like in 2008, as well as past historical examples, it is more likely that governments will intervene with bailouts and monetary easing to stop the pain. All in all, current debt levels ensure that the rate of interest that is high enough to contain inflation is too high to prevent a recession.