There are currently four scenarios for the global economic outlook. Three of these pose potentially serious risks with far-reaching consequences for the markets.
The most positive scenario is a “soft landing”, with central banks in advanced economies managing to bring inflation back to their 2% targets without triggering a recession. There is also the option of a soft landing. Here the inflation target is achieved, but through a relatively mild (short and superficial) recession.
The third scenario is a hard landing, where a return to 2% inflation would require a protracted recession with potentially serious financial instability (such as increased turmoil among highly indebted banks and agents experiencing serious debt servicing difficulties). If efforts to contain inflation lead to severe economic and financial instability, a fourth scenario is possible: central banks go slack and decide to allow inflation above target, with the risk that inflation expectations will no longer be strengthened and that a persistent wage-price spiral develops.
Already in a technical recession
At this point, the Eurozone is already in a technical recession, with GDP falling in the fourth quarter of 2022 and the first quarter of 2023, and inflation still well above target (despite the recent decline) . The UK is not yet in recession, but growth has slowed sharply and inflation remains stubbornly high (above the OECD average). And in the United States, growth slowed sharply in the first quarter, while core inflation (excluding food and energy prices) remained high (although falling, it remains above 5%).
Meanwhile, China’s post-COVID recovery appears to have stalled, calling into question the government’s relatively modest growth target of 5% for 2023. And other emerging economies are showing relatively poor growth relative to their potential (with the exception of India), with many economies still battling very high inflation.
Difficulties in complying with price stability mandate
Which of the four scenarios is most likely? While inflation has fallen in most advanced economies, it has not been as fast as central banks had hoped, in part because tight labor markets and rapid wage increases have increased inflationary pressures in labour-intensive services sectors. In addition, the expansionary fiscal policy continues to fuel demand and contribute 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 were done with rate hikes and would even begin rate cuts 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 will have to raise rates even more before they can pause. If they do, the economic slowdown will become more persistent, increasing the risk of an economic contraction and new debt and banking tensions.
Geopolitical developments are pushing the world towards instability
At the same time, geopolitical developments – some of which come out of the blue, such as the failed march of the Wagner group on Moscow – continue to push the world towards instability, deglobalization and greater fragmentation. And as China’s recovery loses momentum, the country must pursue aggressive stimulus policies – with implications for global inflation – or risk falling sharply short of its growth target.
On the positive side, the risk of a serious credit crisis has diminished since the bank failures in March and some commodity prices have fallen (partly due to expectations of a recession), leading to a decline in commodity inflation. The risk of a hard landing (scenario three) therefore seems smaller than a few months ago. But as stubbornly high wage increases and core inflation force central banks to increase interest rates, a short and shallow recession next year (scenario two) has become much more likely.
More severe and prolonged downturn
Even worse, if a mild recession does come, it could further erode consumer and business sentiment, creating the conditions for a more severe and prolonged downturn and increasing the risk of financial and credit stress. Faced with the possibility of the second scenario evolving into the third, central banks may blink an eye and allow inflation to remain well above 2%, rather than risk unleashing a severe economic and financial crisis.
The monetary policy triptych of early 2020 therefore remains. Central banks face the extremely difficult task of simultaneously achieving price stability, growth stability (no recession) and financial stability.
The implications
What are the implications for asset prices in these scenarios? So far, US and global stocks have reversed their 2022 bear market and bond yields have fallen slightly – a pattern consistent with a soft landing for the global economy, with inflation falling towards the target rate and a growth contraction avoided. In addition, US stocks – especially tech stocks – have been buoyed by the hype around generative artificial intelligence.
But even a short and shallow recession – let alone a hard landing – would lead to significant declines in US and global stocks. And then, if central banks blinked, the resulting rise in inflation expectations would drive up long-term bond yields and ultimately hurt stock prices, because of the higher discount factor applied to dividends.
While a major hurricane for the global economy may seem less likely than it was a few months ago, there is still a good chance we will encounter a tropical storm that could cause significant economic and financial damage.
Nouriel Roubini is Professor Emeritus of Economics at New York University’s Stern School of Business, is chief economist at Atlas Capital Team, and author of Megathreats: Ten Dangerous Trends That Imperil Our Future, and How to Survive Them (Little, Brown and Company, 2022).
Copyright: Project Syndicate, 2023.
www.project-syndicate.org
2023-07-05 16:38:27
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