No way around another recession?

This is turning out to be a sombre week for international markets as they digest the upside August inflation surprise in the US, the prospect of a third straight 75-basis point rate hike by the Federal Reserve next week, and the painful, traumatic realisation that there might not be a way around yet another global recession.

A 10-plus-percent drop in gasoline prices was expected to finally put a lid on prices and soothe rising market anxiety since Fed Chair Jerome Powell’s hawkish demeanor at the annual Jackson Hole summit last month; where he promised to stamp out inflation by raising rates and leaving them elevated for quite a while.

Yet the Atlanta Fed’s ‘sticky’ CPI, a weighted basket of items that change price relatively slowly, recorded its biggest gain in 40 years as it rose 6.1 percent in August. The Cleveland Fed’s median CPI, which excludes categories with the largest price swings, grew 9.2 percent year-on-year, the single-highest number recorded since at least 1983. And core inflation, which excludes volatile food and energy prices categories, also beat expectations and increased 6.3 percent from a year ago.

That explains the broad-based selloff that gave equities their worst day in more than two years. The 2-year US Treasury yield, also the most sensitive to policy changes, spiked 22 basis points and settled more than 30bp above the 10-year rate; further inverting the yield curve in a textbook sign of an impending recession in the world’s largest economy. The dollar index, which tracks the greenback against six heavily traded currencies, pared the previous three days’ losses and rose almost one-and-a-half percent on Tuesday alone. According to Bloomberg, Bank of America Corp’s latest survey showed that the number of investors expecting a recession had reached the highest level since May 2020.

Surprising strength in core CPI – denting hopes that lower energy inflation would push down demand and other prices as well — is making it pretty clear to economists that “wages have now become the top driver of inflation”. That all but confirms a wage-price spiral as a tight labour market and historically low unemployment power spending in housing, food and medical care and keep the central bank on its toes. Now Chairman Powell has no choice but to put his muscle where his mouth is and engineer a Volker-like, long-term destruction of demand and sanitise the red-hot labour market.

With a 75bp rise pretty much priced in for next week, and odds of a fourth 75bp (some say even 100bp) hike in November, the next big questions will be ‘how much is going to be enough’ and for ‘how long’. There’s practically no chance of the soft landing that Powell once talked about, but since price data always comes with a lag, how is the Fed going to time its squeeze to make sure it doesn’t push down too hard on the brakes?

Such questions will do the rounds in emerging and frontier markets a lot sooner than in the developed world because the Fed’s tightening will also give yet more strength to the dollar — already at a multi-decade high – encourage more hot money carry trade into the greenback and also hurt their currencies when they are already very weak. They will also worry that if, rather when, another recession comes out of the US, it will be a long one even if it is relatively mild. Because most of them have been struggling with deficits and devaluations ever since the first Covid lockdowns and another exogenous hit to aggregate demand, just when they desperately need to grow out of their troubles, could prove to be one blow too many at a very inopportune time.

Such things ought to raise very loud alarm bells in Islamabad because Pakistan is right at the front of the line of countries most vulnerable to such global flows. Just like we suffer the most from climate change even though we make practically zero contribution to it, we must now brace for very strong economic/financial headwinds even though we have nothing to do with the slowdown in the US economy or the stubborn strength of the world’s reserve currency.

Copyright Business Recorder, 2022