The most positive is ‘soft landing’, where central banks in advanced economies manage to bring inflation down to their 2% target without triggering a recession. There is also a possibility of ‘soft landing’. Here the inflation target has been achieved, but through a relatively mild recession.
The third scenario is a ‘hard landing’, where a return to 2% inflation would require a protracted recession with potentially severe financial instability (such as more bank crises and highly leveraged agents facing severe debt-servicing difficulties). Is. If attempts to control inflation lead to severe economic and financial instability, a fourth scenario becomes possible: central banks capitulate and allow inflation above target, leading to a weakening of inflation expectations and There is a risk of a continuing wage-value spiral.
As is the case, the eurozone is already in a technical recession, with gross domestic product (GDP) expected to fall in Q4 2022 and Q1 2023, and inflation still well above target. The UK is not yet in recession, but growth has slowed sharply and inflation remains persistently high (above the OECD average). And the US suffered a sharp recession in the first quarter, while core inflation remained high (though falling, it remains above 5%).
Meanwhile, China’s post-Covid recovery appears to have stalled, calling into question the government’s relatively modest 5% growth target for 2023. and other emerging market and marginal economies exhibiting relatively weak growth relative to their potential (except India), many of which still suffer from very high inflation.
Which of the four scenarios is most likely? Although inflation has declined in most advanced economies, it has not happened as sharply as central banks had hoped, partly because labor-market tightness and rapid wage growth have exacerbated inflationary pressures in labor-intensive service sectors. has increased. Furthermore, expansionary fiscal policies are still boosting demand and contributing to the persistence of inflation.
This has made it more difficult for central banks to fulfill their price-stability mandate. Market expectations that central banks have hiked interest rates and will start cutting rates in the second half of 2023 have been dashed. The US Federal Reserve, the European Central Bank, the Bank of England and most other major central banks would have to raise rates even further before pausing rates. As they do so, the economic downturn will become more persistent, increasing the risk of economic contraction and new debt and banking stress.
At the same time, geopolitical developments – some of which appear suddenly, such as the Wagner Group’s failed march on Moscow – continue to push the world towards instability, de-globalization and greater fragmentation. And now that China’s recovery is losing momentum, it must either adopt aggressive stimulus policies with global inflationary implications or risk substantially undermining its growth target.
On the positive side, the risk of a serious credit crunch following the banking failures in March has receded, and prices of some commodities have softened, helping to moderate commodity inflation. So the risk of a hard landing (scenario three) appears lower than it was a few months ago. But with extremely high wage growth and core inflation forcing central banks to make additional rate hikes, a smaller and shallower recession is more likely next year (scenario two).
Worse, if a mild recession occurs, it could further weaken consumer and business sentiment, setting the stage for a more severe and prolonged recession and raising the risk of financial and credit stress. Given the possibility of the second scenario developing into the third, central banks may allow inflation to remain above 2% rather than risk causing a serious economic and financial crisis in the blink of an eye.
Thus, the monetary-policy trilemma of early 2020 remains. Central banks are faced with the extremely difficult task of simultaneously achieving price stability, growth stability (no recession) and financial stability.
What would be the impact on asset prices in these scenarios? So far, US and global equities have reversed their 2022 bearish market outlook, and bond yields have eased slightly – a pattern consistent with a soft landing for the world economy, where inflation declines towards the target rate and Growth contraction is avoided. In addition, US equities – mostly technology stocks – have been boosted by the hype around generic artificial intelligence.
But even a short and shallow recession – let alone a hard landing – would lead to significant declines in US and global equities. And if central banks blink, the resulting rise in inflation expectations will push up long-term bond yields and ultimately hurt stock prices because of the higher discount factor applied to dividends.
Although the prospect of a severe storm for the global economy looks less likely than it did a few months ago, we are still likely to face a tropical storm that could cause significant economic and financial damage.
©2023/Project Syndicate