Why the world is waiting for a sharp slowdown in the US economy

The Fed’s abrupt shift in policy has wreaked havoc on markets the world over, pummelling currencies, bonds and commodity prices
The US central bank’s fight against inflation is likely to inflict more pain on other countries, unless the American economy slows enough to force an end to the tightening campaign

Nicholas Spiro

Published: 1:30am, 30 Sep 2022

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As the global economy and markets come under severe strain, policymakers in developed and developing countries look upon the United States with a mixture of envy and indignation.

The US continues to benefit from its “exorbitant privilege”, a phrase coined by former French president Valéry Giscard d’Estaing when referring to the US dollar’s role as the world’s primary reserve currency. One of the most important advantages is the “safe haven” status of US assets, which provide a refuge for investors in times of uncertainty, even when the source of the uncertainty is the US itself.

What is more, the US economy is performing relatively well at a time when other leading economies are slowing rapidly or have slipped into recession. The US added a further 315,000 jobs last month, causing total employment to surpass its level before the eruption of the Covid-19 pandemic.

On Tuesday, reports showed US consumer confidence rose for a second straight month in September to its highest level since April, buoyed by the sharp fall in petrol prices. More surprisingly, new home sales surged 29 per cent year on year in August despite the steep rise in mortgage rates.

All this breeds envy in other countries, yet US monetary policy is stoking indignation. Having underestimated the strength and persistence of inflation, the US Federal Reserve has been forced to embark on an aggressive tightening campaign. Earlier this month, it delivered its third consecutive increase of 75 basis points to interest rates and expects to increase borrowing costs further in the coming months.

The Fed’s abrupt shift in policy has wreaked havoc on markets the world over. The dramatic rally in the US dollar – which is underpinned by higher bond yields and a resolutely hawkish central bank determined to restore its inflation-fighting credibility – has pummelled currencies in advanced economies and emerging markets alike.

The turmoil, particularly in the last month, is akin to the sell-offs witnessed during major financial crises. Last week, Japan’s government was forced to intervene for the first time since 1998 to shore up the yen after it tumbled to a 24-year low versus the US dollar.

On Wednesday, China’s onshore yuan fell to its weakest level against the US dollar since the 2008 financial crash. The most disorderly moves, however, have been in Britain. The British pound is down a staggering 21 per cent against the US dollar this year.

The fallout from the Fed’s tightening campaign extends far beyond currencies. Global bonds have entered their first bear market since 1990, according to Bloomberg data. Commodity prices have fallen sharply since June. Most worryingly, surveys reveal that global manufacturing output last month contracted for the first time since June 2020 because of softening demand, fanning fears about a worldwide recession.

To be sure, country-specific factors are at work. In China, the double whammy of the disruption caused by the “dynamic zero-Covid” policy and the crisis of confidence in the property market is weighing heavily on sentiment. In Japan, the persistence of negative rates is exacerbating the fall in the yen.

Meanwhile, in the UK, the government is slashing taxes when inflation is soaring and there are fears over a balance of payments crisis. Reckless policymaking is inviting comparisons with meltdowns in risky emerging markets.

Yet, the underlying cause of the acute stresses in the global economy and markets is the Fed’s new-found resolve to crush inflation, which is fuelling concerns about monetary overkill. The grim reality is that the world is desperately waiting for a sharp enough slowdown in the US to put a stop to the Fed’s rate-raising campaign.

Even the US central bank itself is now signalling that a recession may be a necessary trade-off for regaining control of inflation. In a report published on Wednesday, JPMorgan said there was a “rising risk that the Fed engineers a recession”.

A pedestrian carries shopping bags in Detroit, Michigan, on September 14. US retail sales unexpectedly rose in August. Photo: Bloomberg

Yet, this is easier said than done. Until recently, the Fed was clinging to the hope it could pull off a “soft landing” for the economy. It is still reluctant to even use the word “recession”. A recession could be disastrous for US President Joe Biden whose approval ratings have already suffered amid high inflation.

Furthermore, it could take a long time for inflation to fall, partly because monetary policy operates with a lag. That the Fed allowed inflation to exceed 8 per cent year on year makes its job harder. Research from Bank of America shows that when inflation in advanced economies rose above 5 per cent, it took years to bring it back down to 2 per cent.

While there are increasing signs the US economy is slowing – the labour market is not as resilient as the headline figures suggest while the rental housing market appears to be softening – the Fed’s fight against inflation is likely to inflict more pain on other countries before the tightening campaign comes to an end.

A US recession is a bleak prospect. Yet, it is a testament to the severity of the damage wrought by the dramatic rise in US rates that the world is waiting for the US economy to tank.

Nicholas Spiro is a partner at Lauressa Advisory