tThe global financial and economic outlook for the year ahead has deteriorated rapidly in recent months, with policymakers, investors and households now wondering how much and for how long to revise their expectations. That depends on the answers to six questions.
First, will the rise in inflation in most advanced economies be temporary or more persistent? This debate has been raging for the past year, but now it’s largely resolved: “Team Persistent” won, and “Team Transitory” — which previously involved most central banks and fiscal authorities — admits they were mistaken.
The second question is whether the rise in inflation was driven more by excessive aggregate demand (easy monetary, credit and fiscal policies) or by stagflation negative aggregate supply shocks (including the initial Covid-19 lockdowns, supply chain bottlenecks, a reduced US labor supply, the impact of the Russian war in Ukraine on commodity prices and China’s “zero-covid” policy). While supply and demand factors have been a mixture, it is now generally recognized that supply factors have played an increasingly decisive role. This matters because supply-driven inflation is stagnant and so increases the risk of a hard landing (increased unemployment and possibly a recession) if monetary policy is tightened.
That leads directly to the third question: will monetary policy tightening by the US Federal Reserve and other major central banks lead to a hard or soft landing? Until recently, most central banks and most of Wall Street occupied “Team Soft Landing”. But the consensus has quickly shifted, with even Fed Chair Jerome Powell acknowledging that a recession is possible and that a soft landing will be “very challenging”.
In addition, a model from the Federal Reserve Bank of New York shows a high probability of a hard landing, and the Bank of England has expressed similar views. Several prominent Wall Street institutions have now decided that a recession is their base case (the most likely outcome if all other variables are held constant). In the US and Europe, forward-looking indicators of economic activity and business and consumer confidence are moving sharply south.
The fourth question is whether a hard landing would weaken the central banks’ aggressive decision on inflation. If they stop their policy tightening as soon as a hard landing becomes likely, we can expect a continued rise in inflation and either economic overheating (above target inflation and above potential growth) or stagflation (above target inflation and a recession), depending on whether demand shocks whether supply shocks are dominant.
Most market analysts seem to think that central banks will continue to be aggressive, but I’m not so sure. I have argued that they will eventually pass out and accept higher inflation – followed by stagflation – once a hard landing is imminent, because they will worry about the damage of a recession and a debt trap from an excessive build-up of private and public liabilities after years of low interest rates.
As a hard landing becomes the basis for more analysts, a new (fifth) question arises: will the coming recession be mild and short-lived, or will it be more severe and marked by deep financial problems? Most of those who have been late and reluctantly reached the baseline of a hard landing still argue that a recession will be shallow and short. They argue that today’s financial imbalances are not as severe as those leading up to the 2008 global financial crisis and that the risk of a recession with a severe debt and financial crisis is therefore low. But this view is dangerously naive.
There is ample reason to believe that the next recession will be marked by a severe stagflationary debt crisis. As a share of global GDP, private and public debt is much higher today than in the past, from 200% in 1999 to 350% today (with a particularly strong increase since the start of the pandemic). Under these circumstances, the rapid normalization of monetary policy and rising interest rates will cause zombie households, corporations, financial institutions and governments to go bankrupt and default.
The next crisis will not be like its predecessors. In the 1970s we had stagflation, but no massive debt crises because debt was low. After 2008 we had a debt crisis followed by low inflation or deflation because the credit crisis had caused a negative demand shock. Today, we are facing supply shocks in a context of much higher debt, implying that we are heading for a combination of 1970s-style stagflation and 2008 debt crises – that is, a stagflationary debt crisis.
When faced with stagflationary shocks, a central bank must tighten its policy stance, even as the economy heads for recession. So the current situation is fundamentally different from the global financial crisis or the early months of the pandemic, when central banks were able to loosen monetary policy aggressively in response to falling aggregate demand and deflationary pressures. The scope for fiscal expansion will also be more limited this time around. Most of the fiscal ammunition has been used up and government debt is becoming unsustainable.
Because today’s higher inflation is a global phenomenon, most central banks are tightening at the same time, increasing the likelihood of a synchronized global recession. This tightening is already taking effect: bubbles are deflating everywhere – including in public and private equity, real estate, housing, meme stocks, crypto, Spacs (special acquisition companies), bonds and credit instruments. Real and financial wealth decreases and debt and debt repayment ratios increase.
Which brings us to the final question: will stock markets recover from the current bear market (down at least 20% from the last peak), or will they plunge even lower? Most likely they will dive lower. After all, in typical regular recessions, US and global stocks fall by about 35%. But because the next recession will be stagnant and accompanied by a financial crisis, the stock market crash could be closer to 50%.
Regardless of whether the recession is mild or severe, history suggests that the stock market has a lot more room to fall before bottoming out. In the current context, any rebound — such as those of the past two weeks — should be considered a dead-cat bounce, rather than the usual buy-the-dip opportunity. While the current global situation presents us with many questions, there is no real riddle to solve. Things will get much worse before they get better.
Nouriel Roubini, professor emeritus of economics at New York University’s Stern School of Business, has worked for the IMF, the US Federal Reserve and the World Bank
© Project Syndicate