In early 2022, the resurgence of the Omicron variant escalated pressure on an already chaotic supply chain situation and worsened production shortages. Later, the war in Ukraine increased international prices of commodities such as energy and grains. Soaring inflation forced central banks to tighten their policies. The latest Global Economic Outlook report by the World Bank not only sharply lowered its forecast for global growth this year to 2.9%, but also said that the risk of stagflation is rising, which could lead to a global economic recession.

Different countries' economic problems and inflation sources

Even though the global economy has been plagued by multiple pressures such as the pandemic, geopolitics, inflation, and supply chain disruptions, each economy still has its respective issues. As the great Russian writer Tolstoy said in the opening line of Anna Karenina, “Happy families are all alike; every unhappy family is unhappy in its own way.”

For the United States, annual growth of the consumer price index (CPI) has soared to new highs, and the inflation of the 1970s has returned. Although the Fed is no longer “behind the curve” as it was last year, and started raising interest rates to the range of 0.75-1% from early May, it has still been unable to ease the rise in inflation, and annual growth rate of the CPI in May was still 8.6%. In these circumstances, the risk that the Fed will sharpen its tightening, triggering a recession, cannot be ignored. Europe is not far behind; the war has caused an energy crisis. Inflation climbed to 8.1%, with energy up 39.2%, food up 7.5%, and cost of living soaring, prompting the European Central Bank (ECB) to plan to end quantitative easing in July and begin a course of interest rate hikes.

Because the U.S. and European central banks are turning hawkish, the market is paying attention to growth prospects. A Bank of America (BofA) survey of large fund managers showed that hawkish central banks, a global recession and inflation have become the three tail risks of top concern in May and June (at 32%, 25%, and 22% respectively).

China’s economy, meanwhile, has been hit hard due to repeated outbreaks in major cities, as well as the widespread implementation of lockdowns and control measures. Production and consumption have shrunk, and the manufacturing and non-manufacturing PMIs fell below 50, the dividing point between growth and decline, for the third consecutive month in May. This has caused the People's Bank of China to move in the opposite direction from the central banks of Europe and the US, hoping to inject liquidity into the economy through a loose policy.

The situation is even more severe for emerging markets and low-income countries. Russia and Ukraine were both major grain exporters, and the war has caused international food prices to rise. Given the monetary policy shift of major central banks, financial conditions have deteriorated in emerging markets, and the cost of food imports has increased due to currency devaluation. With food accounting for more than 25 percent of household budget expenditures in most emerging countries, these countries face food crisis risks.

Trust in the Fed has stabilized inflation expectations

Inflation in the US is more broad-based than in the euro area, where the main inflationary factor is energy prices. Furthermore, the labor market is extremely tight. Not only was the May unemployment rate, at 3.6%, significantly lower than the natural non-inflationary rate, but the sum of total employment and job vacancies still exceeded the available labor force, with a gap of 5,459,000 in April. Because of the vast chasm between supply and demand, employers must raise wages to compete for labor, and then raise product prices to ensure profits, triggering a wage-price spiral, and adding fuel to price increases.

Seeing that the rise in inflation is difficult to stop, the Federal Reserve raised interest rates by 0.75% in June, after raising rates 0.25% in March and 0.5% and in May, raising the target range of the federal funds rate to 1.50% to 1.75%. The dot plot of interest rate forecasts shows that the median target range forecast by the end of 2022 is 3.4%, suggesting that rates may be raised by 1.75% in subsequent sessions this year. At the same time, the balance sheet was also reduced in June. According to the current plan, it will be reduced by about $1.6 trillion to $7.3 trillion by the end of 2023.

One of the key reasons for the current wave of inflation in the US is that the overheated demand caused by the loose monetary environment and fiscal stimulus during the pandemic exceeded short-term supply, so tightening to increase the cost of funds and curb aggregate demand (through consumer and corporate borrowing) seems to be the right remedy. However, according to the aggregate supply and demand model, as demand decreases, equilibrium output and prices will decline (Figure 1). Therefore, although tightening measures will curb price increases, they will also lead to lower output and higher unemployment. In other words, the degree of tightening is proportional to the strength of the following recession; if the supply side experiences a shock shrinkage, a greater risk exists of stagflation.

Notes (left image): Supply-side problems have persisted since the pandemic started, thus, aggregate supply moves left (to AS₁), while due to the stimulus measures and increase in demand for pandemic-related products, aggregate demand moves left (to AD₁), causing equilibrium prices to fall (P → P₁).

Notes (right image): Higher interest rates and shrinking central bank balance sheets reduce investment and consumption demand (AD₁ shifts to AD₂). If supply remains the same, prices and output will decrease (P₁ → P₂, Y₁ → Y₂).

Source: Yuanta-Polaris Research Institute

However, after the inflation in U.S. caused a public outcry, the Fed stepped up its tightening efforts. It remains hopeful that it will achieve a “soft landing” that will combat inflation without unduly harming the recovery momentum. Judging from the recent US consumer confidence survey and stock and bond market performance, the public and investors are however not very optimistic about future economic performance. Therefore, Fed Chairman Jerome Powell once again spoke of confidence at the post-meeting press conference in June, declaring his determination to reduce inflation, and also reiterating that the current U.S. economy and overall spending are still strong enough to deal with any tightening. The goal of a soft landing is still possible, even if difficult, and monetary tightening is not expected to cause liquidity problems.

A range of outcomes

The Fed has indeed engineered successful soft landings in the past, most notably starting in 1994 when Chairman Greenspan lowered the policy rate from 3% over a period of about a year to 6%, maintaining it around 5.5% until 1998. During this period, inflation decreased moderately from 3% to about 1.5%, and the unemployment rate also decreased from 7% to about 4.5%.

Looking at history, however, besides soft landings, the U.S. has also experienced other combinations of inflation, unemployment and growth. The pain spectrum, classified from light to heavy by the success of price stabilization and impact on the real economy, includes soft landings, bumpy landings, hard landings, and aborted landings (Figure 2).

Source: Bloomberg

After World War II (1946-1947), supply had not yet recovered, and rapidly increasing demand caused prices to rise rapidly. The Fed adopted tightening policies such as relaxed rate controls and higher reserve ratios. Inflation declined from double digits all the way into deflation. After prices rebounded in 1950, the Fed intervened again, and inflation fell again, resulting in a second recession from 1948-1954. The unemployment rate continued to decline, and prices rose and fell repeatedly, demonstrating a bumpy landing.

The 1980s represented the classic hard landing. In order to curb high, multi-year inflation, after Paul Volcker took office as Chairman of the Fed in August 1979, he pushed up the policy rate by nearly 1,000 basis points, which affected a real economy that was also suffering from the second oil crisis. Inflation was not quelled before ushering in a recession, forcing the Fed to cut rates again. After growth picked up again, tightening restarted, increasing rates to close to 20% within a year. Inflation fell below 2% in 1986, but not before the economy fell into a deep recession. At one point, the unemployment rate exceeded 10%.

The most painful among the four types of landings was the failed landing of the 1970s. At that time, due to the major supply-side shock of the first oil crisis, inflation soared rapidly. For the first time, the government faced the problem of rising prices and unemployment at the same time, leading to fiscal and monetary policy mistakes – for example, after the end of the price control implemented by the Nixon government, which led to a resurgence in inflation, the Fed hesitated to tighten. The sharp hikes from 1973 to 1974 caused inflation to drop temporarily, but led to a recession and rising unemployment. Inflation continued to rise to double digits due to soaring oil prices, resulting in stagflation. This is also the most worrying situation in the current market.

Risk of hard landing remains high

Looking at the previous landing scenarios, some are still optimistic about the prospects of a soft landing. First, in contrast to the long-term high inflation in the 1970s and 1980s, prices have remained stable over the past 30 years, and this bout of inflation has only lasted for a year. It is not easy for consumers’ long-term inflation expectations to become un-anchored. According to a survey by the University of Michigan in May, the median consumer inflation expectation over the next five years is 3.3%, and the five-year inflation expectation in five years (5y5y) does not exceed 3%. Interest rates have turned from negative to positive since May, suggesting that the market still has confidence that the Fed will control inflation.

Second, the economy is still in good shape. The May ISM manufacturing and non-manufacturing indices were 56.1 and 55.9, respectively, remaining above the 50 threshold, and the unemployment rate was close to a historical low. By raising interest rates and shrinking the balance sheet to cool demand, the Fed indeed has a chance to ease the labor market without substantially increasing the unemployment rate. American household savings have increased significantly over the past two years of the pandemic, and the overall household financial situation in 2022 will be even better than in 2019, mitigating the impact of any downturn.

Nonetheless, the risk of a failed soft landing is still high. The rate hike in 1994 was an active preventive measure before inflation worsened, so it could stabilize prices in time and avoid hurting the economy. Not only is inflation worse now, but the timing is also significantly behind. Moreover, the current price rise shows that the moderate rate hike strategy the Fed adopted in the first half of the year was ineffective, forcing it to hike again in June. In this way, not only will the impact on fundamentals expand, but confidence in financial market stability will be affected, which could trigger a chain reaction and plunge the economy into a recession.

At the same time, the labor market seems to be extremely hot. However, the Beveridge Curve over the past few months, showing the relationship between the unemployment rate and job vacancy rate, shows that under the same unemployment rate, the job vacancy rate is much higher compared with that before the pandemic (Figure 3). This statistic implies that the current labor market may have efficiency problems, and it has been difficult to match job seekers with openings. Therefore, the Fed’s attempt to reduce excessive labor demand through monetary policy and ease prices without raising the unemployment rate may fail. Several looming uncontrollable supply-side risks, such as a failure to eradicate the pandemic, China's strict lockdown measures, supply chain shortages, the ongoing war, and energy prices, all hinder the effectiveness of monetary policy against inflation and increase the possibility of recession.

Source: Bloomberg

Developing countries with excessive foreign debt will experience new crises

Considering the current conditions facing the U.S. economy, a soft landing is almost an impossible task, and given that the Fed has given priority to price stability, a failed landing scenario (that is, letting inflation run out of control, resulting in stagflation) is unlikely, so a bumpy landing and a hard landing are more likely outcomes. Because the Fed's policy is lagging behind, the interest rate required for tightening to be effective has become higher, and there is a delay in policy transmission of several months through the supply and demand market mechanisms, increasing the chances of a hard landing. 

If inflation does not cool, the Fed will continue to raise rates, and the impact of demand contraction will continue to ferment. Although the current labor market, production and consumption are still good, and the unemployment rate will not increase significantly in 2022, it is expected to increase significantly by 2023. Even if the unemployment rate only rises by 2-3% during this period, it means that about 3-5 million people will be unemployed, impacting consumer and household income, and causing the US to face a predicament of low growth. Shrinking demand and a recession in the US will impact the global economy. In addition to affecting imports and exports of countries with close trade relations such as Asia and Europe, rising rates in the US will lead some countries to raise their rates accordingly to prevent capital flight and stabilize exchange rates, exacerbating debt problems and financial conditions (such as exchange rates) in emerging market and low-income countries with large external debt burdens (especially those denominated in US dollars). It may also trigger debt crises in developing countries, as seen in the 1980s.

The author of this article is Professor Emeritus at the College of Technology Management, National Tsing Hua University.