Economic booms tend not to end well. Strong growth generates inflation, which in turn causes central banks to raise interest rates pushing the economy into recession. As the US economist, Rudiger Dornbusch, memorably put it, “No post-war recovery has died in bed of old age—the Federal Reserve has murdered every one of them.”
The economies of the West have certainly boomed and, in the process, generated levels of inflation not seen since the 1980s. Central Banks have responded with sharply higher interest rates, with the US Fed funds rate going from 0.25% to 5.25% in just over a year. Yet instead of “murdering’ growth”, as Professor Dornbusch put it, the Fed has merely dampened it. Most forecasters expect the US to avoid a recession and, indeed, keep growing.Â
The outlook for Europe isn’t as rosy. But while the German economy is in recession, it is expected to be mild and both the euro area as a whole and the UK are now expected to escape recessions.Â
The general thinking is that central banks will slow growth enough to cure inflation but not so much that they cause recessions. On this view we are heading for that much desired, but rare thing, a soft landing.
Getting inflation down from a peak of over 9.0% in the US and around 11.0% in the euro area and the UK without causing recessions would be quite a feat. On current evidence the US has a better chance of pulling it off than Europe.
The US inflation rate has halved since last October and is running at just 4.0%, well below the euro area’s 6.1% and less than half UK levels of 8.7%. The Fed is feeling more confident about inflation and last week elected to pause its campaign of rate hikes, the first meeting in ten in which the bank has not raised rates.
The European Central Bank and the Bank of England are less relaxed. Inflation is proving stickier in Europe than the US, in part because Europe is more exposed to high gas prices than the US, where oil and cheap coal have kept energy costs lower than in Europe. The day after the Fed kept rates on hold the ECB raised euro area rates by 25bp. The Bank of England is likely to follow suit this Thursday.
The inflation picture looks most worrying for now in the UK. UK average earnings have risen by 7.2% in the last year, the fastest rate outside the pandemic in over 20 years and well above the 3.0%–4.0% rate considered to be consistent with the Bank of England’s 2.0% inflation target. Momentum in the labour market has softened, but only modestly. Over one million jobs are unfilled and employment is growing at a rapid clip. The Bank of England governor, Andrew Bailey, last week conceded that UK inflation was taking “a lot longer than expected” to come down and the UK labour market was “very tight”.
When a mild recession was on the cards late last year, UK rates were expected to peak at 4.5%. Now, with the UK expected to avoid a recession and wages rising faster than expected, markets see rates peaking at 5.75% early next year. Good news has created bad news further out, especially for mortgage holders, raising the risk of a hard landing for the economy.
The two- and five-year mortgages that were set around 2.0% mark in the last few years are currently resetting at closer to 5.0%, a significant income shock for the roughly 25% of UK households with such deals (the remainder of mortgages, accounting for about 5% of all households, have variable-rate mortgages).
Monetary policy works with famously long and unpredictable lags. The precise effect of any move in rates on the economy can only be roughly estimated ex-ante. The impact of higher interest rates has been compared to pulling a brick on a rubber band. A lot of pulling does nothing until suddenly a brick is flying towards you. The growth of fixed-rate mortgages has slowed, but not stopped, the transmission of 435bp of base rate rises to households. As mortgages reset and mortgage rates rise, consumer spending will come under greater pressure. The Bank of England’s task of engineering a soft landing for the economy is made harder by resilient activity and sticky inflation.
The US is enjoying better growth and lower inflation than in the UK or the euro area. US rates look close to a peak, while rates in the UK and euro area have further to rise. US consumers have benefitted from relatively low energy prices and have proved more willing than their European counterparts to spend their savings. The US is also starting to benefit from a huge programme of public spending on renewable energy, infrastructure and home-grown industries, notably through the Inflation Reduction Act.
Yet in the US, as in Europe, uncertainties remain. As we have often observed, risks in the financial system mount in periods of higher interest rates and sluggish growth. The US has weathered the blow up in regional US banks in March and April, but the International Monetary Fund thinks that globally financial risk is elevated. China’s bounce back from lockdowns, a significant factor in the revival of optimism about the global economy earlier this year, has been rather less robust than expected. Last week the Chinese authorities cut interest rates to try to boost activity. Moreover, the US labour market, like those in the euro area and the UK, continues to run hot. Aggressive interest rate rises have so far failed to open up much slack in the labour market – hardly a reassuring sign in inflationary times.
If the authorities in the US, euro area and UK can return inflation to 2.0% and keep growth going they will have pulled off a very significant success. The US can take comfort in the fact that, despite more resilient growth than expected, inflation has fallen sharply in recent months. The story is more mixed in Europe, with growth weaker and inflation higher than in the States.Â
Inflation will decline. The only question is how quickly – and whether it takes a recession to get there.
A personal view from Ian Stewart, Deloitte’s Chief Economist in the UK. To subscribe and/or view previous editions just google ‘Deloitte Monday Briefing’.
Write to us with your comments to be considered for publication at letters@reaction.life
