Why a soft landing for the global economy looks unlikely
- The global economy is in a race against time. Core inflation needs to drop sharply and quickly enough for central banks to call time on their tightening campaigns
- Unfortunately, the damage may already be done, with inflation expectations becoming entrenched
Since the end of last year, disagreements among investors and analysts have shifted from whether central banks must do more to curb inflationary pressures to how severe the effects of aggressive monetary tightening will be.
Optimists anticipate a “soft landing”. This occurs when interest rates rise sharply enough to bring down inflation without causing a full-blown recession. Worryingly, many of those who believe in a soft landing wrongly predicted that the surge in inflation would be temporary.
Pessimists expect a “hard landing”, whereby inflation remains stubbornly high for a significant period, necessitating a contraction in output to bring prices down to an acceptable level. Having fallen behind the curve, most central banks have been forced to slam on the brakes, making a recession more likely.
Britain’s central bank deserves credit for its candour and directness, particularly at such an uncertain and confusing time for the global economy. Yet, its apocalyptic outlook is dangerous and lacks credibility.
Such doom-mongering risks exacerbating the deterioration in household and business confidence. Moreover, by scrapping its forward guidance – the BOE’s decisions will now be made meeting to meeting, as will the Fed’s and the ECB’s – Britain’s central bank is tacitly admitting that its forecasts are highly uncertain and prone to substantial revision.
It is difficult to envisage inflation remaining in double digits while the UK suffers a severe recession. Unacceptably high inflation for a long period is plausible, so is a steep downturn given the scale of monetary tightening. Yet, to suggest that Britain will experience both outcomes simultaneously for several quarters strains credulity.
Still, the BOE’s extreme pessimism shines a spotlight on how much growth needs to be sacrificed to bring inflation back into normal bounds. Much depends on the speed at which prices start to fall in the coming months, and whether the decline shows up in the closely watched “core” inflation rate, which strips out volatile food and energy prices.
The publication of data on Wednesday revealing that headline inflation in the US last month declined to 8.5 per cent year on year, down from 9.1 per cent in June, attests to the impact of the recent plunge in energy prices.
However, for the Fed to take its foot off the monetary brakes, there needs to be a meaningful and sustained drop in core inflation. In the United States, this measure remains stuck at nearly 6 per cent year on year due to persistent increases in a range of components of the price index, in particular housing rents.
The global economy is in a race against time. Core inflation needs to drop sharply and quickly enough for central banks to call time on their tightening campaigns. The faster it falls, the bigger the scope for a soft, or at least a softer, landing.
Unfortunately, the damage may already be done. Inflation expectations are becoming entrenched. In the US, wage growth has surged as firms are forced to pay up to secure the best workers, fuelling price gains. One of the biggest debates on Wall Street right now is whether higher rates can cool the country’s tight labour market without causing mass lay-offs.
The dilemma facing the ECB is even more acute. Previous attempts at raising rates, in 2008 and 2011, backfired as financial crises forced policymakers to reverse course. This time, inflation is much higher and the integrity of the euro zone remains a concern.
For developing economies, even for those that have tightened policy aggressively over the past year, the landing has already been a bumpy one. Emerging market bond and equity funds are suffering their longest period of outflows of foreign capital since records began, data from the Institute of International Finance shows.
A soft landing was a more realistic scenario before central banks allowed inflation to get out of hand. Now, policymakers can only hope that the landing will not be as hard as the BOE’s grim forecasts suggest. Over the next several months, all eyes will be on core inflation.
Nicholas Spiro is a partner at Lauressa Advisory