Hard times
By Andrea Siviero, Investment Strategist, Ethenea
The global economy currently finds itself at a critical juncture and uncertainty has surged. While recovering from the recession brought on by the Covid-19 pandemic and grappling with rising inflation, it has been hit by a major negative supply and demand shock, which threatens to trigger a new recession.
A swift recovery and a short cycle with dangerous inflationary pressures
The Covid-19 pandemic ended the longest economic cycle of the post-war period, a cycle that lasted more than 10 years between June 2008 and February 2020. Due to unprecedented monetary and fiscal policy stimulus, the Covid-19 recession proved to be the shortest in US history, but it also resulted in the steepest gross domestic product (GDP) decline since the recession of 1945.
An exceptional shock requires an exceptional policy response. Therefore, mindful of the mistakes made during the global financial crisis (GFC) of 2008, policymakers reacted swiftly, enacting unprecedented fiscal and monetary policy stimulus measures that prevented an economic depression and produced an unusual and particularly rapid economic recovery.
With the service sector suffering from Covid-19-related restrictions, demand was concentrated in the goods sector. Here, inflation skyrocketed, as supply chains were overwhelmed and bottlenecks prevented the supply from matching a turbocharged demand. The sudden and sharp increase in demand for energy, coupled with the early phase of energy transition¹ and diminished investment in fossil fuel energy, pushed oil and gas prices to multi-year highs. The labour market slack that traditionally follows a recession failed to materialise. As a result, labour markets are extremely tight and wages are rising sharply in some advanced economies.
We have been experiencing an extremely condensed business cycle. The global economy has rapidly transitioned from the early phase of the recovery to the mid-cycle expansion with intensifying inflationary pressures. Although economic growth remains healthy, it has likely peaked in a wide section of the global economy. With supply constraints lasting longer than expected, inflation has become broader and more persistent, and it is starting to impact areas such as wages and rents.
Although central banks had hoped that when supply chain bottlenecks clear, this would dampen inflation without the need for them to excessively tighten their policies, they realised that decisive action was required to lower inflation and adopted a resolutely hawkish stance at the end of 2021.
Geopolitical crisis
At the end of February, the picture took a dramatic turn for the worse. What seemed to be merely a dangerous tail risk for the global economy just a few weeks prior, suddenly became a devastating reality. The Russian invasion of Ukraine has shocked the world, resulted in immense suffering for the Ukrainian people, and damaged the global economy.
The already complicated scenario of persistently high inflation and central banks withdrawing their accommodative policies has been exacerbated by the war. Uncertainty and downside risks have increased significantly. The war, coupled with the sanctions subsequently imposed by the US and Europe, has caused energy and commodity prices to spike dramatically. Ukraine and Russia are among the main suppliers of all types of raw materials: oil, gas, grain, minerals, metals, etc. A sustained surge in energy and commodity prices is feeding into price pressures and poses a significant risk that inflation will remain high for longer and become entrenched, triggering longer lasting second-round effects.
The global economy faces the risk of a new recession. It has been hit by a combined negative supply and demand shock that will further damage global supply chains, intensify inflationary pressures, and lead to slower growth by undermining confidence and hampering international trade. This type of external stagflationary shock is particularly challenging for policymakers, as they are faced with an increasingly difficult trade-off between curbing stubbornly high inflation and supporting growth, just as they have begun to scale back their ultra-expansionary pandemic policies.
How will policymakers react? It is a heterogenous situation and it is likely that the conflict will further exacerbate economic divergences, as countries are affected in different ways by the war. In light of this new reality, fiscal and monetary authorities will carefully reassess their plans to tighten policies. As uncertainty increases, the macroeconomic policy mix (of monetary and fiscal policies) will become a crucial factor in keeping inflation under control, without driving the global economies back into recession. Central banks will push ahead with their normalisation plans to curb inflationary expectations and prevent it from becoming entrenched. We expect fiscal policy will remain largely supportive in order to avoid a combined monetary and fiscal tightening that could trigger a new recession.
Facing solid growth, full employment, and strong wage pressures, in March, the Fed embarked on its normalisation path, sending a clear message that it is fully committed to lowering inflation. The Fed also signalled that the US economy is strong and that it can withstand aggressive tightening with little risk of a recession. The Biden administration is likely to try to revive its ‘Build Back Better’ programme to provide support to households and business hit by the increase in energy and commodity prices.
The European economy, which is heavily dependent on Russian energy and has close economic ties with Russia, will be the hardest hit by the consequences of the war. The ECB has indicated its intention to accelerate its exit from the quantitative easing programme, however, in light of the economic uncertainties, it will be more hesitant (than the Fed) to aggressively tighten its policy. With the disbursement of the EU Recovery plan, a revision of the Stability and Growth Pact, further possible measures to cushion the economy from increasing energy prices, and in order to increase defence spending, fiscal policy will remain expansionary. In China, which is still struggling with the effects of the Covid-19 pandemic, macroeconomic policy will remain strongly expansionary in order to achieve the objective of 5.5% GDP growth set by the National People’s Congress for 2022.
Although the path to a soft landing is still there, it is increasingly becoming narrower. A swift resolution of the conflict in Ukraine seems to be a crucial factor to reduce stagflationary risks. To achieve a soft landing, an appropriate economic policy mix is needed, including a gradual normalisation of monetary policy and supportive fiscal policies that provide central banks with the necessary room to scale back accommodative measures without triggering a recession. Avoiding policy missteps is crucial but this will be increasingly complicated in the current environment. Finally, a global resolution to the pandemic crisis remains key to resolving supply chains constraints, curbing inflationary pressures, and supporting the global recovery. A double dip recession is not the baseline scenario, but a soft landing might start to look like wishful thinking.
