Difficult times – invest.ch

The world economy is in a critical phase and uncertainty has increased significantly. After overcoming the recession triggered by the COVID-19 pandemic and having to contend with rising inflation, the economy is now grappling with a major negative supply and demand shock that threatens to plunge into a new recession.

Par Dr. Andrea Siviero, Investment Strategist

A rapid recovery and a short cycle with dangerous inflationary pressures

The COVID-19 pandemic ended the longest economic cycle since the end of World War II, which lasted more than ten years between June 2008 and February 2020. Thanks to unprecedented fiscal and monetary support, the recession caused by the pandemic was the shortest in U.S. history, but also marked the largest decline in gross domestic product (GDP) since the Great Depression of 1945.

Exceptional shock, exceptional political reaction. Anxious not to repeat the mistakes made during the 2008 global financial crisis, politicians reacted quickly, initiating an unprecedented fiscal and monetary stimulus that averted a depression and fostered an atypical and particularly rapid economic recovery.

With a service sector struggling to cope with restrictions related to the health crisis, demand has focused on the goods sector. As a result, inflation soared as clogged supply chains caused shortages, preventing supply from meeting the surge in demand. Oil and gas prices have reached levels not seen for several years in the face of the sharp and sudden increase in energy demand combined with the energy transition¹ that has just begun and the reduction in investments in fossil fuels. The labor market crisis that usually follows a recession has not occurred. On the contrary, the market is extremely tight and wages are soaring in some advanced economies.

We had a particularly short business cycle. The world economy quickly moved from the initial recovery phase to mid-cycle expansion with mounting inflationary pressures. Growth remains healthy, but has likely peaked across much of the global economy. Faced with longer-than-expected supply-side constraints, inflation has taken root and spread, starting to trickle into areas like wages and rents.

Hoping that inflation would subside once the supply shortage was resolved, without having to tighten policy excessively, central banks accepted the need for firm measures to contain inflation and therefore adopted a much stricter policy at the end of 2021. .

A geopolitical crisis

The tide suddenly turned at the end of February. What was considered a dangerous residual risk to the global economy a few weeks ago has suddenly become a terrible reality. The Russian invasion of Ukraine shocked the world, inflicting immense suffering on the Ukrainian people and severely hitting the global economy.

The war has only worsened the already complex scenario of persistently high inflation coupled with the abandonment of the accommodative central bank policy. Uncertainty and downside risks have increased significantly. The war and the sanctions applied by the United States and Europe have caused the price of energy and raw materials to skyrocket. Ukraine and Russia are among the main suppliers of raw materials of all kinds: oil, gas, cereals, minerals, metals, etc. A sustained rise in energy and commodity prices increases price pressure and significantly increases the risk that inflation will remain high for a long time and strengthen, prolonging second-round effects.

The specter of a new recession looms over the global economy, hit by a simultaneous supply and demand shock that will continue to disrupt global supply chains, increase inflationary pressures and slow growth by undermining confidence and hindering international trade. This type of exogenous stagflationary shock confronts political leaders with a dilemma between fighting persistently high inflation and sustaining growth as they were just beginning to downsize their ultra-expansionary policies enacted in the context of the pandemic. .

How will they react? The situation is heterogeneous and it is likely that conflict will only increase economic divergences because countries are not all equally affected by the war. Faced with this new reality, financial and monetary authorities will have to review their plans to tighten their policies. Given the growing uncertainty, the mix of macroeconomic (fiscal and monetary) policies is becoming a decisive factor in keeping inflation under control without dragging global economies into recession. Central banks will continue with their normalization projects in order to dampen inflation expectations and prevent them from strengthening. We believe fiscal policy will remain broadly accommodative to avoid a simultaneous monetary and fiscal tightening that could trigger another recession.

In a context of solid growth, full employment and strong wage pressure, the Federal Reserve (Fed) started its normalization process in March, clearly communicating its intention to fully dedicate itself to fighting inflation. The Fed also hinted that the US economy is robust and could withstand aggressive tightening with a low risk of recession. The Biden administration should work to reinvigorate its “Build Back Better” program to support households and businesses affected by rising energy and commodity prices. The European economy, which is highly dependent on Russian energy and maintains close economic relations with Russia, will be the one most affected by the consequences of the war. The ECB has announced its intention to accelerate the exit from the quantitative easing program, but will be more timid (than the Fed) in tightening its monetary policy due to economic uncertainties. With the implementation of the EU recovery plan, the revision of the Stability and Growth Pact, the introduction of any additional measures aimed at cushioning the rise in energy prices and the increase in defense spending, the policy fiscal will remain expansive. China, still reeling from the fallout from the COVID-19 pandemic, will maintain an extremely accommodative macroeconomic policy in an attempt to reach the 5.5% GDP growth target set by the Chinese National People’s Assembly for 2022.

The likelihood of a soft landing scenario remains relevant, but is increasingly decreasing. A rapid resolution of the conflict in Ukraine appears to play a decisive role in reducing the risks of stagflation. A soft landing requires the right mix of gradual normalization of monetary policy and accommodative fiscal policy so that central banks can have the leeway to reduce their support measures without triggering a recession. It is essential to avoid political missteps, but the task is all the more difficult in the current environment. Ultimately, a comprehensive solution to the health crisis remains the key to addressing supply shortages, curbing inflationary pressures and supporting global recovery. A double recession is not the baseline scenario, but a soft landing could gradually become illusory.

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