Inflation risk was taken lightly. Don’t treat recession the same way

The strength and sustainability of the subsequent recovery will also require that China more aggressively revamps a growth model that can no longer piggyback on greater globalisation.

The EU continues to deal with energy supply disruptions as Russia’s invasion of Ukraine persists. Strengthened inventory management and the reorientation of energy supplies are well advanced in many countries. However, they are not yet sufficient to lift the immediate constraints on growth let alone resolve longstanding structural headwinds.

Inflation is likely to remain stubborn

The US has the least problematic outlook. Its growth headwinds are due to the Federal Reserve’s scrambling to contain inflation after having grossly mischaracterised price increases as transitory following which it was initially too timid in adjusting monetary policy.

The Fed’s shift to an aggressive front-loading of interest rate increases came too late to prevent the spread of inflation into the service sector and wages. As such, inflation is likely to remain stubborn at about 4 per cent, be less sensitive to interest rate policies and expose the economy to a higher risk of accidents induced by additional policy mistakes undermining growth.

The uncertainties facing each of these three economic areas suggest that analysts should be more cautious in assuring us that recessionary pressures will just be “short and shallow”. They should keep an open mind, if only to avoid repeating the mistake of prematurely dismissing inflation as transitory.

This is particularly important as these diverse drivers of recession risk make financial fragilities more threatening and policy transitions harder, including Japan’s likely exit from its interest rate control policies. The range of potential outcomes is unusually large.

On the one hand, a better policy response, including to improve supply responsiveness and protect the most vulnerable segments of the population, can counter the global economic slowdown and, in the case of the US, avoid a recession.

On the other hand, additional policy errors and market dislocations can lead to self-reinforcing vicious cycles with high inflation and rising interest rates, weakening credit and pressured earnings, and market functioning stress.

Judging from market pricing, more bond investors are understanding this better, including by refusing to follow the Fed’s guidance on interest rates this year. Rather than a sustained path of higher rates, they believe recessionary pressures will lead to cuts later this year.

If right, government bonds would offer the returns and portfolio risk mitigation potential sorely missed last year.

Parts of the equity market, however, are still pricing in a soft landing. The reconciliation of these different scenarios is of importance to more than investors.

Without better alignment within markets and with policy signals, the favourable economic and financial outcomes we all desire will not only prove less likely but will also be challenged by the risk of more unpleasant outcomes at a time of lower economic and human resilience.

Financial Times

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