In 2021, the major debate about the outlook for the global economy centered on whether rising inflation in the US and other advanced economies was transient or persistent. Major central banks and most of Wall Street researchers were on ‘Team Transitary’. He attributed the problem to base effects and temporary supply constraints, meaning higher inflation rates would rapidly drop to the central banks’ 2% target range.
Meanwhile, Harvard University’s Lawrence H. Summers, Cambridge University’s Queen’s College’s Mohamed A. The ‘Team Persist’, led by El-Arion and other economists, argued that inflation would remain high as the economy was warming from excessive totality. Demand. This demand was driven by three forces: consistently loose monetary policies, overly stimulating fiscal policies and rapid accumulation of household savings during the pandemic, which led to a pick-up in demand after economies reopened.
I was also on Team Persistent. But I argued that, in addition to excessive aggregate demand, several negative aggregate supply shocks were contributing to rising inflation—indeed, a decrease in the rate of inflation, or a decrease in growth accompanied by higher inflation. The initial response to COVID led to lockdowns, leading to major disruptions in global supply chains and reduced labor supplies (creating a very tight labor market in the US). Then came two additional supply shocks this year: Russia’s brutal invasion of Ukraine, which has driven up commodity prices (energy, industrial metals, food, fertilizers), and China’s ‘zero-Covid’ response to Omicron’s version, whose Another reason has been the period of supply-chain bottlenecks.
We now know that Team Persistent has won the inflation debate of 2021. With inflation rising near double digits, the US Federal Reserve and other central banks have acknowledged that the problem is not temporary, and must be addressed urgently by tightening monetary policy.
This has sparked another major debate: whether economic policy makers can plan a ‘soft landing’ for the global economy. The Fed and other central banks argue that they will be able to raise their policy rates enough to bring the inflation rate down to its 2% target without a recession. But I and many other economists doubt that this Goldilocks scenario—an economy that is neither too hot nor too cold—is achievable. The extent to which monetary-policy tightening is required will inevitably lead to a hard landing in the form of recession and high unemployment.
Because stagflation shocks reduce growth and increase inflation, they pose a dilemma for central banks. If their top priority is to fight inflation and prevent the dangerous de-anchoring of inflationary expectations (wage-price spirals), they will have to end their unconventional expansionary policies and raise policy rates at a pace that could potentially be a difficult one. Reason for landing. But if their top priority is to maintain growth and employment, they will need to normalize policy more slowly and risk inflation expectations, setting the stage for persistent above-targeted inflation.
So the soft-landing scenario looks like wishful thinking. So far, the rise in inflation has been so persistent that only a serious policy tightening can bring it back within the target range. Taking previous high-inflation episodes as a baseline, I put my odds of a hard landing within two years at over 60%.
But there is a third possible scenario. Monetary policy makers nowadays are talking desperately about fighting inflation so as to face the risk of it going out of control. But this does not mean that they will not eventually end and will not allow the rate of inflation to rise above the target. Since hitting the target most likely requires a hard landing, they can increase rates and then get cold feet after that scenario is more likely. In addition, because there is a lot of private and public debt in the system (348% of global GDP), a hike in interest rates could lead to a further sharp decline in the bond, stock and credit markets. This would give central banks another reason to back-pedal.
Simply put, an attempt to fight inflation can easily cause the economy, the market, or both to collapse. Already, slight tightening from central banks has shaken financial markets, with major equity indices approaching bear territory (down 20% from recent peaks), bond yields rising higher and credit spreads. Yet if central banks exit now, the result will be similar to the stalemate of the 1970s, when recessions were accompanied by high inflation and lowered inflation expectations.
Which scenario is most likely? It all depends on a combination of uncertain factors, including the persistence of the wage-price spiral, the level of policy rate increases to curb inflation (by creating sluggishness in the goods and labor markets), and the willingness of central banks to foster is included. Short-term pain to hit their inflation targets. Furthermore, it remains to be seen in which direction the war in Ukraine will go and what effect it will have on commodity prices. And the same goes for China’s zero-Covid policy, with its impact on supply chains, and the current recovery in financial markets.
Historical evidence suggests that a soft landing is highly unlikely. This leaves either a hard landing and low inflation, or a standoff scenario. Either way, a recession is likely over the next two years. ©2022/Project Syndicate
Nouriel Roubini is Professor Emeritus of Economics at New York University’s Stern School of Business, and Chief Economist on the Atlas Capital team.