Central bank rate-hiking may bring on a recession, unemployment and debt defaults. Some say that’s just the price of suppressing inflation.
Just when the world economy seemed to be emerging from the worst of last summer’s pandemic-induced recession, signs of inflation started to appear. In February, Russian forces invaded Ukraine, wreaking havoc with markets, particularly for core necessities such as food and energy. Now, with leading central banks notching rate hike after rate hike, many economic observers say a worldwide recession is increasingly likely.
“Risks for the fall are on the downside,” says Andrea Presbitero, a senior economist in the research department of the International Monetary Fund (IMF). “Even correcting the long term for the negative shocks of the financial crisis and the Covid pandemic, the global outlook remains weak.”
In late September, the United States Federal Reserve (the Fed) announced its fifth rate hike for the year, 0.75%. The Bank of England (BoE) followed the next day with its own 0.5% rate hike, forecasting inflation to rise to 11% in October before subsiding. The UK economy is already in recession, the Bank proclaimed.
In July, the IMF cut its April global growth estimate for 2022 by almost half a point to 3.2%. The downward revision particularly affected China, down by 1.1% to 3.3%; Germany, down by 0.9% to 1.2%; and the US, down 1.4% to 2.3%. Three months later, even these estimates are starting to look optimistic.
Major macroeconomic forces at play over the coming year include lingering Covid impacts, ongoing energy-supply issues (including short-term efforts to replace Russian supplies and the longer-term push to replace fossil fuel supplies), supply sourcing, heinous debt, and political unrest due to severe inequality. Increasing debt and political unrest, in particular, relate to central bank tightening: Higher rates punish debtors, and sovereign defaults are already at record highs.
“The general picture is that the world is probably sliding into another global recession,” says Dana Peterson, chief economist at the Conference Board research group. “Is it going to be deep, like the pandemic-related recession? No. But it may be longer.”
For many, an economic downturn is simply the cost of containing inflation. “Without price stability, the economy does not work for anyone,” Fed Chairman Jerome Powell said in a late August speech. “Reducing inflation is likely to require a sustained period of below-trend growth.”
Pressed by US Senator Elizabeth Warren, Powell had earlier acknowledged that the Fed’s tightening could increase unemployment and even bring on a recession. Warren and others argue that higher interest rates will suppress growth without addressing the true causes of the current inflation. “Rate hikes won’t make [Russian President] Vladimir Putin turn his tanks around and leave Ukraine,” Warren noted during a June Senate banking committee hearing. “Rate hikes won’t break up monopolies. Rate hikes won’t straighten out the supply chain, or speed up ships, or stop a virus that is still causing lockdowns in some parts of the world.”
Too Little, Too Late
The global financial community is more inclined to chide the Fed and other advanced-economy central banks for being too slow to act. “In different degrees, the central banks were late,” says Ethan Harris, head of global economics research at Bank of America (BofA) Securities. He offers some sympathy too: “I don’t know of any forecast predicting prices to spike so dramatically. Those problems were, to a large degree, not anticipated by anyone, including forecasters like myself; so you can’t blame them for that.”
Yet some countries, perhaps more attuned to inflation’s dangers, starting increasing rates in 2021, well before the Fed (March 2022) or the European Central Bank (July 2022). Early actors included Australia, Belarus, Brazil and Iceland. Their decisions were not always popular.
“Our decision to raise rates immediately met with harsh criticism in the media,” recalls Ásgeir Jónsson, governor of the Central Bank of Iceland. “People were saying that we were paranoid, unprofessional. They kept looking at big central banks like the US Fed or the European Central Bank, saying, ‘They think inflation is transitory. You are just Icelandic hillbillies.’”
Inflation in Iceland has been falling since hitting a 13-year peak in August—it is now the lowest in Europe after Switzerland—and other central banks are following Iceland’s lead. “We were quite pleased when we started to see our approach adopted by other central banks,” Jónsson adds. “It was important for us to see the Fed embark on an aggressive hiking cycle. It is the only central bank that has the power to quell international inflation. Having been criticized for our approach, for me it was a relief.”
More Than Monetary
In a September research note titled “Is a Global Recession Imminent?” World Bank economists Justin Damien Guénette, M. Ayhan Kose and Naotaka Sugawara reviewed worldwide economic downturns from 1970 up to now. They point out that the current tightening trend is not only monetary but also fiscal: After more than a year of unprecedented government spending in the face of the pandemic, budgets are tightening too. Furthermore, this is among the most “internationally synchronous” of such policy waves in the past 50 years.
Although loathe to predict recession, the authors note two “reasons to be concerned” about near-term risk. One: The current widespread weakness makes the world economy even more susceptible to “even a moderate negative shock.” Two: In past economic upheavals, damage in one part of the world was often balanced by strength in at least one major economy. During the 1998 Asian financial crisis, for example, advanced economies held stayed strong. In 2001, the dot-com bust damaged leading Western economies, while China and India maintained growth. Currently, with expectations having sharply diminished simultaneously for the US, China and the EU, the probability of a global contraction grows. And that, the authors note, combined with a substantial increase in the cost of borrowing, “could trigger acute financial stress in [emerging and developing economies].”
To borrow a phrase: When big economies sneeze, smaller ones can catch cold. As an unwanted impact of tighter monetary policy by the Fed, the market for international bonds is drying up.
Rising yields and a strong US dollar are a dangerous mix for emerging and frontier markets that in some cases—such as African non-investment-grade countries—saw a shutdown of the eurobond market. Defaults are on the rise.
“Over the last five years, emerging markets sold large amounts of bonds to international investors in local currency and foreign currency,” says Emre Tiftik, director of sustainability research at the Institute of International Finance (IIF), the global financial industry association. “But this year, due to rising inflation, increasing US dollar borrowing costs, and dollar strength, there are fewer new issuances in international markets. With fewer new issuances, we see a decrease in money flowing to emerging market economies.”
Most of the issuances are in local currency, he adds, “but foreign investors’ appetite for local currency bonds remains very subdued, as investors do not want to take foreign currency risk in an inflationary environment.”
If in rich countries an unwanted level of inflation seriously dampens political consent, in poorer countries it sometimes brings disorder, protests and often deaths. For example, protests over fuel and food inflation turned deadly in Peru in April and Sierra Leone in August.
Yet tightening monetary policy is likely to increase unemployment, hunger and other difficulties. “The sad truth is that there is no such thing as a slowdown without an increase in unemployment,” wrote Olivier Blanchard, former IMF chief economist, in an August comment for the Peterson Institute for International Economics. “The hope of decreasing job vacancies while leaving unemployment the same, which some officials at the Fed have suggested, is a vain hope.”
Fiscal policy should support tightening by mitigating the social damage of slow growth. Today, virtually all policymakers have less room to maneuver. In 2020, government spending worldwide increased by more than $4 trillion—to nearly 20% of global GDP. This year, the World Bank analysts warn, it will decline drastically. “Firms and consumers should be helped; but most governments, in developed and developing countries, have little room to further expand their deficit,” says the IMF’s Presbitero. “Sovereign debt is high everywhere, and there is a high risk of defaults for several countries.”
Already, sovereign defaults are well above historical norms. The 20-year average is one or two per year, according to Elena Duggar, chair of Moody’s Macroeconomic Board, and last year saw just one. Already, five countries have defaulted this year: Belarus, Mali, Russia, Sri Lanka and Ukraine—putting 2022 on par with 2020, another outlier, with six sovereign defaults: Argentina, Belize, Ecuador, Lebanon, Suriname and Zambia.
Looking ahead, says Duggar, “we are particularly concerned about several frontier markets where debt rose in the last few years and they’re going to have to refund over the next few years in a much tighter liquidity environment.” She points in particular to countries in Africa and the Caribbean that have high reliance on imports for food and energy.
Furthermore, short-term relief policies could shift resources away from more-productive long-term investment. “Amid global shocks, lower-income countries face rising political and social pressures to provide immediate support for the most vulnerable segments of the population,” says Anushka Shah, senior credit officer at Moody’s, as quoted in an August research announcement. “These measures could draw scarce resources away from their large development needs over the longer term.”
Those long-term needs include, above all, new sources of energy. Given that energy powers all economic activity, it is no surprise to find this sector played a role in past recessions. Notably, the 1973-1975 recession, induced in part by the 1973 Arab oil embargo, sparked inflation that prompted rate hikes from major central banks like the Fed. But these only brought on stagflation. The 1982 recession was driven in part by the impact on world petroleum markets of the Iranian Revolution in 1979. Those events echo in the current war in Ukraine, particularly among near neighbors.
“Over the next 12 months, Russia’s supply of gas is the main constraint for Europe,” says Rita Sánchez Soliva, an economist at Spain’s CaixaBank Research. “Weather conditions are a centerpiece: Following one of the hottest and driest summers in recent years, we will be looking with caution at the winter.” Sánchez notes that in some instances immediate needs elbow out longer-term objectives. “The war changed plans and priorities. Coal and nuclear power plants that were expected to be replaced by green energy reopened,” Sánchez adds. “In the short run, it is important to become energy independent from Russia.”
For a handful of countries, including some of the most financially stressed, the current state of energy markets is a boon. The IMF expects Saudi Arabia’s GDP to grow by 7.6% in 2022, almost entirely due to a windfall from soaring oil prices—and oil-rich Middle East neighbors are reaping similar benefits. Elsewhere, high-petroleum price beneficiaries include Russia, Venezuela,
Then there is old-school growth. Now the world’s fifth-largest economy—its highest ranking since independence—India is expected to expand notably faster than China this year, notching GDP growth of 7.4%, according to the World Bank. “India has a huge amount of young population,” says Partha Chatterjee from his home in northern Noida, a fast-expanding community just southeast of New Delhi. Chatterjee is head of the economics department at the relatively new Shiv Nadar University, founded by an Indian billionaire who made a fortune in IT with his company HCL Technologies. “The optimism about the future is all about what can be.”
But for many, the coming storm will bring destruction. Duggar says Moody’s put some former Soviet satellites that still rely heavily on remittances from Russia up for review. Elsewhere there are other pressures. “There are certain countries that have been experiencing significant pressure, especially from bond investors’ perspective: Argentina, Ghana, Pakistan, El Salvador, Ethiopia, Kenya, Egypt,” notes IIF’s Tiftik, noting rising expectations of a debt crisis in market pricing.
Duggar points out that the global corporate speculative default rate is on the way up—Moody’s projects it to be 3.8% in a year, up from 2.2%—but still below the 4.1% historical average. Still, she says, “The risks of more-severe outcomes are high.”
The deeper question is how these forces may reshape worldwide economic activity. Recent shocks, along with the increasingly clear impacts of climate change, are undermining long-held notions. “The globalization process that served the world’s economies and its people’s welfare so well in recent decades now seems to be facing significant challenges,” says Amir Yaron, governor of the Bank of Israel. “Global growth will suffer if these issues are not resolved.”