Just a year ago, the world's economists were celebrating a rapid recovery from recession. They are now worried that another recession is imminent. In the United States, the Federal Reserve is preparing to fight high inflation by sharply raising interest rates and shrinking its balance sheet. In Europe, expensive energy takes away purchasing power from consumers and increases the cost of operating factories. And in China, the outbreak of the Omicron variant of the coronavirus has led authorities to impose the strictest lockdown since the pandemic began.
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This is a bleak combination for global growth, and the outlook is bleak. Some economies may even experience recession, at different times depending on the obstacles they face.
The US economy is overheating. The annual consumer price inflation rate is 7.9%, and hourly wages are up 5.6% compared to a year ago. America has nearly twice as many jobs as unemployed people, the highest rate in 70 years. For much of 2021, central bank officials had hoped that Americans who left the workforce after the pandemic would return, leading to a cooling of the labor market. Over the past six months, their prayers have been answered and more than half of the missing prime-age workers have returned. Yet wage growth is rising anyway, perhaps because workers are bargaining harder as rising prices undermine living standards.
For the Fed to reach its 2% inflation target, it will need to keep both wage and price growth in check. The short-term interest rate was raised from less than 0.25% at the beginning of this year to more than 2.5% by December, and is expected to continue to rise to more than 3% in 2023. This week, the central bank followed suit with its plan to cut interest rates by $8.5. Since May, trillion bond holdings have increased at a much faster pace than during the previous “quantitative tightening” period.
Hitting the financial brakes, while necessary, puts growth at risk. As history has shown, the Fed finds it difficult to cool the job market without ultimately pushing the economy into recession. Since 1945, China has only successfully made a “soft landing” three times. And we've never done it while battling high inflation. Bond investors expect the Fed will have to cut rates again within two years as the economy slows. Given track record, it seems likely that we will be in recession for the next two years.
Europe also has an inflation problem, but so far it has been caused more by expensive imported energy and food than by overheating. Russia's invasion of Ukraine and Western sanctions threaten the continent's energy supplies. Gasoline prices next winter will be five times higher than in the US, and household energy spending is almost twice as much as a share of GDP (partly because Europe is poorer). Consumer confidence is stagnant as energy prices soar. Businesses are also struggling, with French industrial production falling in February.
The euro area economy will likely continue to grow overall in 2022. But it looks like it's about to break. If Europe were to stop importing Russian gas, whether by choice of European governments or the Kremlin's decision to cut off supplies, the risk of economic recession would increase.
The threat to global growth posed by the spread of Omicron infections in China is the most serious and immediate. China reported more than 20,000 new virus cases on April 6th. Shanghai's 26 million residents and those in other large cities where infections are spreading are under lockdown as the government ramps up its efforts to stamp out the coronavirus. According to Goldman Sachs, if the historical relationship between lockdowns and GDP holds, China's real-time output will be 7.1% lower than in the unrestricted world. Lockdowns will also disrupt global trade, which is still suffering from a hangover from the early days of the pandemic. Shanghai is the newest global port, with hundreds of ships waiting to return offshore and unload their cargo.
Chinese President Xi Jinping has called on authorities to reduce regulatory costs. But opening up too soon could lead to a wave of infections and deaths in mainland China like the one that recently plagued Hong Kong. That would frighten consumers and cause economic turmoil in its own right. Until China has vaccinated enough elderly people with the most effective drugs, lockdowns will remain a permanent feature of China's economy and a source of global volatility.
The blame for many of the world's economic problems lies squarely with policymakers. The Fed's job should be to pick up the punch bowl the moment the party starts. Rather, it caused an explosion. European governments have allowed the continent to become dependent on Russian natural gas. And it was predictable and widely predicted that China would have difficulty reining in Omicron. Economic problems often come like a bolt out of the blue. Today's recession fears were avoidable. â–
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