The planet's largest economy, the US is facing a tangible risk of a recession. The printing press launched to handle the pandemic, the highest inflation rates in the last forty years, and Russia’s war with Ukraine have slowed down first the American, and then the global economy. Fraught with concerns over negative statistics, the stock market has shown the worst dynamics over the last half-century. Meanwhile, international institutions are lowering their growth forecasts for the world's leading economies almost monthly. Cheap oil could remedy the situation, but Russian military aggression is blocking this option.
The more money, the more problems
A sudden inflation hike and record natural gas prices
The zugzwang of the US Federal Reserve
Recession, stagnation, and co.
The grim prospects of the US economy are a hot topic for everyone, from relevant media to opinion leaders like Elon Musk and Donald Trump. The chances of a full-blown recession are estimated at 50%, with individual analysts harbingering an impending economic hurricane.
The US government has indeed found itself between a rock and a hard place: on the one hand, they have to rein in the spiraling price growth; on the other hand, they need to avoid slowing down the economy. As of May, the inflation rate beat the 1981 record, reaching 8.6%. Spiking prices have caused an equally drastic reaction on the part of the regulator, with the Federal Reserve System upping the key interest rate by a record 75 bps (unprecedented since 1994) to 1.5-1.75% a year.
However, the market doesn't seem too impressed with the financial authorities’ efforts, with indexes setting new anti-records and fueling debates on whether rock bottom has been reached yet. Two main US indexes, S&P500 and Dow Jones, have dropped by almost 20% since the New Year, with the high-tech NASDAQ plunging by an entire 30%.
The more money, the more problems
The ongoing crisis eventuated from the macroeconomic and structural imbalances that the US economy had been accumulating for years. The abscess might have taken another couple of years to burst, but black swans events such as the COVID-19 pandemic and the war in Ukraine exacerbated the festering issues.
The pandemic came to be the harshest economic shock for the entire planet since the Great Depression in the 1930s. To manage the spread of the disease, the US and many other countries were forced to take unprecedented restrictive measures, nearly freezing their economies. In Q2 2020, the US GDP shrank by a record 32.9%, to drop by 3,5% at the end of the year, which is the worst dynamic since WWII.
Overwhelming challenges required an ambitious response. Along with the central banks in many countries, the FRS chose the path of low interest rates and so-called quantitative easing (QE): increasing the money supply through the purchase of corporate and government bonds. As a result, the Federal Reserve balance has expanded by $4.7 trillion since January 1, 2020, reaching an unprecedented $8.9 trillion. In the meantime, the regulator maintained a near-zero interest rate.
The mechanism behind QE is that the increased demand for bonds results in their lower profitability. In turn, this leads to cheaper loans and boosts money lending, reinvigorating entire industries. Furthermore, massive bond purchasing encourages investors to turn to more profitable assets, such as stocks, driving enterprise capitalization and investors’ assets and stimulating economic activity.
However, the FRS wasn't the only source of “cheap money”: to combat the pandemic, American legislators adopted several stimulus packages bordering on $4 trillion. The largest one was the Response&Relief Act signed by President Trump in late 2020. The deal included lending support measures ($339 billion), stimulus payments to individuals ($166 billion), allowances for children and the unemployed ($148 billion), health care spending ($90 billion), and more.
A year later, Joe Biden picked up the torch, offering a 1.9-trillion-dollar relief package, which also included direct payments to households, health care expenditures, and assistance to struggling businesses. In all, the US has introduced fiscal stimuli to the amount of $6 trillion, which is around 30% of the GDP and four times the spending to mitigate the previous crisis.
The US spent 30% of its GDP to stimulate the economy
With the stimulus packages, the government tried to prevent a drastic decline in the economy and a protracted structural rearrangement like the one that occurred in 2008-2010. Back then, the nation lost 8.7 million jobs, and the labor market took six years to recover. However, today's almost limitless monetary emission has caused new problems.
A sudden inflation hike and record natural gas prices
The main side effect of the current US economic policy is the spiking inflation rate, the highest since the 1980s. At the end of 2021, it amounted to 7% with the target level of 2%, accelerating to 8.6% in May 2022. Economists have been ringing the alarm for two years of the pandemic. Yet, head of the FRS Jerome Powell insisted that inflation was unlikely to threaten the American economy in the foreseeable future. In unison with Secretary of the Treasury Janet Yellen, he was certain the trend was short-lived.
The two economists were guided primarily by the objective of ensuring the highest employment rate. By contrast, tightening the monetary policy posed the threat of slowing down the hiring pace and other business activity indicators. Moreover, the FRS had already had a negative experience curbing government relief in 2013, when the regulator’s short-sighted decision caused panic in the stock market.
Jerome Powell and Janet Yellen
However, as early as in the summer of 2021, the FRS began aware of the need to strike a balance between the risk of overheating the economy and thwarting its recovery. It took the Fed another year to take action, raising the key interest rate by 50 bps in May and as many as 75 bps in June, which is an absolute record in the last 28 years. Apart from that, the regulator started cutting its balance on June 1, which implies selling treasury and mortgage bonds to the amount of $30 billion and $17.5 billion a month, respectively. In September, the sales volume will double.
In a nutshell, the Fed missed a good time to start tightening its monetary policy. The context matters, though: the US had been trying to boost inflation rates to stimulate the market for a long time – but to no avail. Similarly, many economists connected the inflation hikes of 2021 mostly with businesses reopening after the lockdown. There was also a period when major inflation drivers slowed down in the US without any regulatory interventions. Nevertheless, looking to curb the growth of inflation expectations, the FRS made announcements of the upcoming tightening, including plans to increase the key interest rate and cut the balance in early 2022.
The Fed missed a good time to start raising the interest rate
The economy seemed to be faring well, but the fall and winter had a few surprises in store. Firstly, the new COVID-19 strain, Omicron, turned out to be way more contagious than any of its predecessors (though its mortality rate was lower). As the IMF observed, even in the absence of lockdowns, the spread of this subvariant once again disrupted supply chains, which had only just recovered, and exacerbated the shortage of human resources. The closing down of multi-million Shanghai, an international commerce and business hub and the world’s largest container port, came as yet another shock to the global economy.
Secondly, the conflicts that sparked between Russia and the EU over natural gas drove up energy carrier prices worldwide. As early as in September, the European Parliament accused Gazprom of causing a record natural gas price growth. The EU insisted that the Russian corporation was blackmailing them with sky-high gas prices to obtain authorization for the launch of Nord Stream 2. To compare, whereas natural gas prices in late 2020 fluctuated around $200 per 1,000 cubic meters, they reached an exorbitant $2,200 in late 2021. Russia, in turn, blamed the Europeans and appealed to a multitude of factors that had precipitated the situation.
The latest black swan event has been the war in Ukraine and the unprecedented economic sanctions the international community imposed on Russia in response. The hostilities have disrupted many more supply chains and have driven up energy prices even further, with the price for 1,000 cubic meters peaking at over $3,800. Early in June, the US Secretary of the Treasury admitted that her forecasts of the inflation trajectory had been wrong. The unforeseen shocks she listed had had a detrimental impact on the American economy that she had not anticipated.
On another important note, the war has raised the specter of a food crisis and a threat of famine. The armed conflict has halted shipments from Ukrainian ports, which used to export huge quantities of vegetable oil, corn, and wheat. The global supply has sagged, driving up prices for alternatives. As the UN points out, world food prices have shown an almost 30-percent YOY growth.
The zugzwang of the US Federal Reserve
The FRS has found itself on thin ice. On the one hand, price growth must be reined in with a tighter monetary policy; on the other hand, it can't let the economy contract because this would endanger the post-pandemic progress. Despite the historically high demand for workforce in the US, the labor market has barely bounced back to its pre-lockdown normal. Meanwhile, the first signs of a recession are noticeable, following the key interest rate increase and the downsizing of the asset purchase program: thus, the Department of Commerce registered a plunge in residential construction in May.
A higher key interest rate drives the price of money: individuals and businesses become reluctant to take out loans, which lowers consumption, complicates business investment, and leads to unemployment growth. Importantly, the costs of servicing the United States’ giant national debt are also going up. Since the beginning of the pandemic, it has grown by $7 trillion, reaching an unprecedented $30.5 trillion, which is equivalent to 143.5% of the nation's GDP. Handling such an oversized debt is tricky, but President Joe Biden planned to at least reduce the budget deficit, which is usually done with borrowed money, by no less than $1.5 trillion a year.
Much depends on the Fed’s eventual choice: to battle inflation or to go for financial stability. For now, the regulator has leaned towards the latter option, despite the demonstrative decisiveness of the monetary authorities. Ethan Harris, head of global economics research at Bank of America Corp., believes that the FRS is most likely prepared for a compromise and will agree to stabilize the inflation rates at 3% or a little higher. From his perspective, such a middle ground will allow the US to avoid an economic downturn. “Recall that the great inflation fighter Paul Volcker [head of the FRS in 1979-1987] backed off with inflation down to 4%,” Harris said.
However, the key difference between Volcker’s times and now is the planet-wide nature of the record-breaking inflation. The global economy is coming apart at the seams due to domestic and geopolitical tensions. As experts from the Bank of International Settlements (BIS) warn, we may be facing the risk of rapid, uncontrollable price growth becoming the new normal.
Rapid, uncontrollable price growth may become the new normal for the entire world
For instance, the EU's situation is even worse than in the US due to its dependency on Russian energy carriers. Thus, the European inflation rates reached a historic high in June, plateauing at 8.6%. Fuel prices have soared by almost 42% year over year, and the sky is the limit, considering the prospects of a European embargo on Russian oil supplies. The World Bank and the International Monetary Fund (IMF) have toned down their GDP forecasts for the eurozone in the current year, predicting growth of 2.5% and 2.8%, respectively, as compared to earlier forecasts of 4.2% and 3.9%.
The blood-curdling figures are pushing the European Central Bank (ECB) to hike rates, following in the Fed's steps. However, the risks are high, as this measure will deliver a blow to the budgets of already problematic and debt-ridden eurozone members: Greece, Italy, Spain, and Portugal. If the interest rate stays the same, more issues will emerge, as disadvantaged population groups will grow poorer and require government support, which will mean printing more money. In turn, further money issuance in the current conditions will accelerate inflation with a risk of hyperinflation and the collapse of the monetary system. As it appears, in contrast to Europe, the US still has some room for maneuver.
In contrast to Europe, the US still has some room for maneuver
Recession, stagnation, and co.
And yet, the talk about the US economy sliding swiftly towards a recession is becoming louder by the day. As Goldman Sachs analysts have recently reminded, the majority (around 80%) of monetary policy tightening cycles since the Second World War were followed by two years of recession with today's growth pace. Overall, American economists are unanimous that the nation has a 44% chance of facing a recession in the next 12 months. To compare, economists put the probability of recession at 38% in December 2007 and at 26% in February 2020.
Chair of the IMF Kristalina Georgieva has also hinted at the likelihood of a recession: “We expect the U.S. economy will slow in 2022-23 but narrowly avoid a recession. ... There are, nonetheless, material risks that the current headwinds prove more persistent than expected.” There is, however, a more radical perspective that the US is not risking a recession but is already in one. For one, this opinion has been voiced by former president Donald Trump. “This is not something that's going to happen in two years...We're in a recession,” he asserted, expressing the sentiment shared by most Americans. Judging by the IBD/TIPP Economic Optimism Index, 53% of Americans believe their economy has gone into a recession; 25%of respondents hesitated, and only 20% believed that there was no recession in progress.
For want of data, there is no saying for certain if the US economy has entered the recession cycle yet. A recession is a fact when the country's GDP has been decreasing for two quarters running. In Q1 2022, the American GDP indeed shrank by 1.4% against all forecasts. However, there is no data for the second quarter yet. If the concerns voiced by analysts and citizens come true, the US economy faces a tangible risk of playing out the worst-case scenario: stagflation, when key macroeconomic indicators decrease against the backdrop of rapidly growing prices.
If the recession does begin, its ramifications won’t be limited to the US. Its shock waves will engulf the entire world. Turbulence in the planet's largest economy will undoubtedly result in similar events across developing and mature markets alike, especially considering that many economies have been worn out by the pandemic and geopolitical challenges. Thus, the prospects of China's economic growth have been hampered by the rigid restrictions designed to combat the spread of Omicron; European households are amidst a living costs crisis, and poorer, developing countries could be looking at a food crisis.
The implications of the American recession for Russia are less likely to be as dramatic – but only because the Russian economy is already struggling with an unprecedented number of shocks and severe isolation. For Russia, a future recession is a given. The World Bank expects Russia’s GDP to contract by 8.9% in 2022. The Russian government is also bracing itself for the devastating consequences. According to the official forecast by the Ministry of Economic Development, the GDP will have shrunk by 7.8% at the end of the year. In June, the Bank of Russia issued a somewhat more optimistic forecast, predicting a decrease of 7.5%. These figures invite parallels with 2009, when Russia’s GDP plunged by 7.9%.
However, Oleg Vyugin, the chairman of the Moscow Stock Exchange Supervisory Council, believes that comparing the current situation to past crises is hardly appropriate. “It's a new type of crisis. We can't compare it to either 2008 or 2014 because both earlier crises could be mitigated through market mechanisms. What is happening now goes beyond the market. This crisis has eventuated from a mass exodus of investors and companies, so the blow will be heavier,” the expert remarked. Head of the Accounts Chamber Alexei Kudrin is also convinced that the current crisis will be much harder to overcome than the one in 2009.