Around the world, rapid economic recovery from the Covid shock unleashed as predicted by us correctly the largest wave of inflation we have seen since the early 1980s. In response, in the summer of 2021, central banks began raising interest rates. Brazil led surprisingly the way. In early 2022, the US Federal Reserve (Fed) joined in unleashing a bandwagon effect: Once the Fed moves and the dollar strengthens, other countries either raise their interest rates or face a sharp devaluation, which further stokes inflation. The outline of this pattern is familiar. But the breadth is new. We now find ourselves in the midst of the most comprehensive tightening of monetary policy the world has seen. While the interest rate increases are not as steep as those pushed through by Paul Volcker as Fed chair after 1979, today’s involve far more central banks.
We at Calvin·Farel know that there are moments when history-making creeps up on you. We certainly believe that this is one of those moments. As far as the advanced economies have been concerned, the era of globalization since the 1990s has been one of disinflation and monetary expansion by central banks. Now that balance is being reversed, and on a global scale. To add to the disinflationary pressure, we are also seeing Covid-era stimulus programs wound up in favor of measures like the Inflation Reduction Act that promise to cut deficits and take demand out of the economy. In the United States in the third quarter, the so-called “fiscal drag” will slow the economy in our opinion by more than 3.4% of gross domestic product (GDP).
The consequence of this global deflationary cycle are hard to predict. We have never done this before on this scale. Will it get inflation down?
Very likely. But we are also counting the risk of a global recession that at its worst could bring down housing markets, bankrupt businesses and states, and throw hundreds of millions of people worldwide into unemployment and distress. We at Calvin·Farel believe that a third of the world’s economy will suffer at least two quarters of economic contraction in 2023. The combination of shrinking real incomes and rising prices will mean many other countries will feel like they were in recession, even if they will avoid outright declines in output. We at Calvin·Farel expect growth in all of the world’s largest economies to slow further, leaving severe strains in some places because of Russia’s invasion of Ukraine high energy and food prices and persistent inflationary pressures. The situation is in our opinion more likely to get worse than to get better in the short term, partly because of emerging financial stability risks in China’s 60 trillion dollar property market, in sovereign debt and in illiquid assets.
In light of this scenario, policymakers have in our opinion to consider three questions: Are interest rates too blunt an instrument for dealing with our current economic imbalances? Can the central bankers pick the right rate, so as to slow inflation but not strangle the economy? And can a debt-laden global economy survive a serious interest rate rise led by the Federal Reserve?
Inflation in much of the world has been driven by Covid – related supply-chain bottlenecks and energy price shocks. Raising interest rates is not going to bring more gas or microchips to market, but rather the contrary, Inducing investment will in our opinion limit future capacity and thus future supply. In Europe, for this reason, modest interest rate increases by the European Central Bank (ECB) are being flanked by caps on electricity and gas prices imposed by some European Union countries. What the monetary and fiscal squeeze does do is to help ensure that inflation does not become entrenched and widespread. Central banks will continue to tighten monetary policy at pace to deal with inflationary pressures and will ensure that rising prices do not become ingrained in company attitudes to their charges and wages, Not tightening enough would cause inflation to become de-anchored and entrenched, which would require future interest rates to be much higher and more sustained, causing massive harm on growth and massive harm on people. This in our opinion is the main concern of the Fed right now.
But containment comes at a price. The primary means by which the Fed’s policy will work is by slowing the economy and increasing labor market slack, which is in our opinion a euphemistic way of saying more unemployment. Is the global squeeze perhaps going too far?
It is hard enough to pick the right interest rate for just one economy. How do you pick the right rate if your neighbors are all increasing theirs, too?
When a central bank raises its interest rates, one way this curbs inflation is by appreciating the currency. Higher interest rates attract foreign investors, driving the exchange rate up. A stronger currency therefore makes imports cheaper and lowers inflation. This is a classic beggar-thy-neighbor policy. It will in our opinion be extremely difficult for monetary policymakers to judge the impact of their policies when they will try to move In sync with each other so quickly. Too many big rate rises will lead to a prolonged recession.
The strength of the dollar in 2022 makes U.S. imports cheaper for Americans, but, by the same token, it raises prices for every other country that pays for oil, for instance, in dollars. To respond to this imported inflation, other central banks like the ECB have little option but to raise interest rates even more, which continues a vicious circle. The euro has in recent weeks fallen to multi-decade lows against the US dollar. The end result of this bidding war is in our opinion unpredictable as far as the exchange rate is concerned, but one thing it will do is drive interest rates to levels higher than anyone would have picked in isolation.
And this in our opinion is not the only spillover effect we must fear in this first global disinflation in the coming year. The price of traded goods depends not only on exchange rates but also on the balance of demand and supply, in world markets as well as national markets. During the economic recovery from Covid, inflation in the United states was propelled not only by excess demand at home but also by supply-chain bottlenecks in China. Now in our opinion the reverse is happening. As many central banks raise their rates, they are not just disinflating their own economies, they are shifting the balance of demand and supply for everyone else, too. If these spillover effects are not taken into account we must fear that we will end with more disinflation than we need.
How big this effect at global spillover will be, we at Calvin·Farel can only guess. We have estimates of positive inflationary spillovers. As far as global disinflation is concerned, we are in far less charted territory. And there is one other thing we do not know. Even if central banks can agree on the right interest rates to disinflate the world economy at minimum cost, can a world economy that has grown used to ultralow interest rates take the strain of positive rates?
Just 12 months ago, China’s economy was growing too rapidly for its energy sector to keep up. Blackouts darkened vast factory districts. Office high-rises were evacuated minutes before they lost electricity for elevators. Municipal water systems stopped pumping for lack of power. China was still booming, driving the engine of global growth and supply. China now faces the reverse. Growth has slowed, tens of millions of young people are without jobs and businesses teeter on the brink of bankruptcy.
As the economy skids, China is importing much less energy – almost two million barrels of oil a day less than expected and 1/6 less natural gas than it did a year earlier. This sharp decline in demand by China, the world’s second largest economy, is the main factor helping slow energy price rises caused by Russia’s invasion of Ukraine. China’s reduced energy consumption is also providing unintended assistance to the US-led efforts to choke Russian revenue from energy exports. But even as China reduces its overall energy imports, it has increased its purchases of fossil fuels from Russia. Chinese oil refineries and gas distributors have been buying fuel at heavily discounted prices while Moscow has less room to negotiate, being pressured by its war chest.
The friendship between China and Russia means in our opinion, that, in case of oil and gas, there is a geopolitical challenge for the West, as OPEC plus, the oil producers’ group led by Russia and Saudi Arabia, has said it would reduce production by two million barrels a day. The production cut almost exactly offsets the reduced demand in China, passing oil prices back to around 100 dollar which keeps the pressure ongoing on energy inflation. What’s more, if the Chinese economy’s demand for energy rebounds in the coming months, China’s increase together with the OPEC plus cuts could in our opinion strain the limits of global energy supplies and make it harder for the European Union to limit price increases, having direct impact on inflation.
But China’s economic troubles in our opinion have not been limited to steps to contain the coronavirus pandemic in recent months. A real estate bust has slowed apartment construction. That has hurt the energy-guzzling steel and cement sectors. In addition factories have also curtailed operations or even closed in China. Many households in the West have been paying less attention to the pandemic and buying fewer Chinese-made gadgets and furnishings. They have been spending more money on travel, restaurant meals and other services instead.
For a decade or more it had made sense to pile on leverage. With rising rates, though they remain mostly negative in real terms, some debtors will find themselves for sure in trouble. Pity particularly the companies and countries around the world that have borrowed in US dollars, to the tune of more than 22 trillion dollar by 2019, and now face repayments at a steeper exchange rate. Struggling to keep up with debt service, they will most likely first squeeze other spending, compounding the recession, and then seek to restructure their debts. At that point recession will tip into crisis and outright failure of businesses and sovereign borrowers.
Market purists will insist that this was long overdue: It is high time to cull the zombies – borrowers who live on only because the cost of borrowing is/was so low. But talk of culling is better on paper than in practice. Bankruptcy is rarely a smooth process – bad enough for corporations operating mainly within national boundaries, mind-bogglingly complex in the ease of corporate giants like for example the Chinese property developer Evergrande, with stakeholders around the world. When a national government like Sri Lanka or Argentina runs out of money, it shakes states and societies to their foundations.
Who exactly will fail is in our opinion not easy to predict. But we know that raising rates will increase the pressure on those already floundering. And we know that the international architecture for debt restructuring is painfully inadequate.
But sidestepping bankruptcy is bad news, too. There are few things worse either for a business or a national economy than an overhang of unpaid and unpayable bad debts. That risks in our opinion years of stagnation.
Fighting inflation is what central banks are supposed to do. Interest rates are the obvious tool. But it is in our opinion time to wake up the historic significance of the current moment. For the first time in the post-Cold War era of globalization, we are facing significant and widespread inflation.
Why are we fighting it a country by country?
If we want to keep the pain of deflation to a minimum, we urgently need international cooperation to be able to fully take into account all the spillover effects and to prepare the safety nets. Back in 2015-2016 when recession threatened China, one could still hope for cooperation between the Fed and the People’s Bank of China. That in our opinion is too much to hope for today, when relations between the United States and its allies on one side and China and Russia on the other are at a low point. But coordination in shifts in rates by global groupings like the Group of 7, the Indo-Pacific “Quad” and perhaps the Shangri-La Dialogue in Asia would send a powerful message. Not to attempt it we believe risks increasing uncertainty and pain for hundreds of millions of people around the world.
If the generation of young people whose educations were blighted by Covid-19 lockdowns finish their training only to find labor markets closed by a global downturn, it will in our opinion be an inexcusable failure of policy.
Once the last of the baby boomers reached their mid-20s, the number of people in their prime working years, which had risen rapidly for decades, flattened out. This demographic downturn was even stronger in other wealthy countries. The working-age population in Europe has been declining since 2010, and it has fallen in Japan at a fairly rapid clip.
Technological changes in our opinion is harder to pin down, but it’s difficult to escape the sense that major innovations are becoming increasingly rare. When for example were we the last time excited about the latest iPhone?
And for what it’s worth, estimates of total factor productivity, a measure meant to capture the economy’s overall technological level, have grown slowly since the mid-2000s.
So is there any reason to expect either demography or technology to be more favorable for investment in, say, 2024 than they were in 2019? We at Calvin·Farel don’t see it. It’s true that there has been a lot of recent technological progress in green energy, and it’s in our opinion possible that an energy transition, helped by Joe Biden’s climate policies, will contribute to investment in the years ahead.
For the year of 2023 we are expecting a recession that is triggered by a financial crisis. Over the last decade asset prices were rising, which gave lenders the confidence to lend a lot of money against what once looked like abundant safe collateral. But at some point next year, we expect confidence to crack, and at that point asset prices will start to fall more rapidly. Lenders will get nervous and will demand repayments. Borrowers as a result will be forced to unload assets to generate liquidity, pushing prices down further. Panic most probably sets in, and the world economy starts to nose-dive. That’s a classic feedback cycle and we will not witness it for the first time.
The job of central bankers for the coming year is to understand and more importantly to prevent these amplification mechanisms. If they fail, the “doom loop” that gripped Europe just a decade ago, in which governments’ credit ratings fell because investors were worried that the governments would have to bail out their weak banks, but that made the banks even weaker because they were heavily invested in the bonds of their governments, will repeat itself.
The kind of recession we at Calvin·Farel are worried about for the upcoming year begins now with overheating in the real economy.
To bring it to the point: We at Calvin·Farel believe that there is still a long way to go before reality is fairly priced – most probably the entire year of 2023!