That, being a persistent and generalized inflation, which the central banks must crush by an accelerated rise in interest rates, at the high risk of recession! That, explaining the foul mood on the stock market.
Posted yesterday at 9:00 a.m.
“We fought the last war. We fought as if we were waging the previous war, explains Jason Furman, professor at Harvard and ex-economic adviser to President Obama. Classic error of generals obsessed with the last conflict, in this case that of the great financial crisis of 2007-2008.
The great recession that it caused was one of the longest, because it was necessary to deleverage the private sector and recapitalize the banking system. Governments have also been blamed for the anemic stimulus, which has returned to fiscal rectitude too quickly.
So there is no question of repeating this fault, when the pandemic has closed the world economy. There were fears of deflation and another slow recovery.
The unanimous answer was not only very low rates, but also an unprecedented budgetary effort.
In the United States, the measures passed by Congress under Trump and Biden increased the general government deficit by 8.8% of GDP in 2020. In Canada, the equivalent effort was 11.4%, the largest of the G7 countries, although starting from a healthier situation.
Admittedly, government checks have helped, but the recovery in household demand has surprised by its rapidity after the deconfinement, as if the switch had been put back to “On”.
The challenge has instead come from the supply side which has not followed, disrupted by factory closures in Asia and logistical problems in supply chains. The labor supply also came up against the low unemployment rate and an aging population.
Prices therefore started to rise, but until late last fall, central banks believed that inflation would be temporary while supply adjusted.
However, the surprise invasion of Ukraine by Russia in February shattered this forecast, causing the price of oil and foodstuffs to soar.
Since then, inflation has become widespread in the world economy and has forced central banks to work twice as hard. After the Fed’s recent 75 basis points, we anticipate an increase of the same magnitude by the Bank of Canada, which would set its key rate at 2.25% on July 13.
Next year, these rates would reach 3% in Canada and 3.45% in the United States, the futures markets are currently reporting.
Review public spending
The burning problem of inflation calls for slower growth in public spending, in order to facilitate the task of central banks, which seek to calm aggregate demand.
Larry Summers, from Harvard, and Olivier Blanchard, from MIT, with yet democratic sensitivities, had criticized President Biden’s budget plan from the start, deemed inflationary because too big.
Today, Summers predicts a hard landing for the economy, as “the United States may need monetary tightening like that imposed by Paul Volcker in the late 1970s and early 1980s.” It would take 5% unemployment for five years (or its equivalent) to keep inflation down, he calculated.
Back home, Scotia economists Jean-François Perrault and René Lalonde, two former Bank of Canada veterans, recommend that governments significantly reduce the increase in their spending in order to support the central bank in its fight against inflation.
Otherwise, companies and individuals will be alone in tightening their belts, with higher interest rates than if the state does its part.
Of course, the checks and tax cuts proposed to appease voters would only add fuel to the fire by feeding an already excess demand. However, financial compensation is justified for the poorest, since inflation is regressive.
A study by Benoit P. Durocher, from Desjardins, shows that if the inflation rate is substantially the same for all incomes, the lowest do not have the leeway of the highest to deal with it.
After inflation, markets fear recession
It’s not just key interest rates that are rising, but also the yields demanded on government bonds, the value of which is eaten away by inflation.
Financiers are watching the spread between short-term and long-term rates carefully: if the former were to overtake the latter – an inversion of the yield curve – many would see this as a harbinger of recession.
We are not there yet, but the stock market is already sinking into a bear market.
The S&P 500 is down about 21% this year and the Nasdaq 30%, including Tesla 33%.
Bitcoin, correlated to tech, plunged 57%, mocking the Poilievres who see it as a hedge against inflation. The Toronto Stock Exchange, with its oil and mining companies, held up better with a decline of 10%.
It must be said that the stock market, like the real estate market for that matter, has been boosted by several years of low interest rates and the injection of liquidity by the central banks. Normal that the rise in rates has the opposite effect.
Surprisingly, the consensus of analysts who follow large American corporations still anticipates a rise in profits of more than 10% this year. Not sure, with the increase in oil and wages which will reduce margins, not to mention the decline in sales, if the recession proves. The stock market remains vulnerable.
hard choices
Central banks, on a mission to bring inflation down to 2%, remain hopeful of succeeding in the risky maneuver of a soft landing for the economy in bad weather. They would not be sorry to limit the damage to a technical recession of a few quarters and to avoid the dramatic scenario of Summers.
For the moment, they seem ready to pay the price of a sharp market discount, provided it remains orderly. Gone, perhaps, are the days of the “Greenspan put,” the option investors had to call the Fed for help when they lost their shirts.
The banking system is more solid and remains fearless in the face of the crypto rout.
Curbing the growth of public spending will be a politically delicate operation, given the fragility of the health system and the need to help companies become more productive and take the turn towards decarbonization.
The highest inflation in almost 40 years adds to a pile of problems. It wasn’t supposed to be like this.