Recession is unlikely to be as harmless as some analysts believe

Inflation was the dominant economic and financial issue for most countries around the world in 2022, especially for those advanced economies that have a consequential impact on the global economy and markets.

The effects were felt in the deterioration of living standards, increased borrowing costs, losses in the stock and bond markets, and occasional financial mishaps. In this new year, recession has joined inflation as a driver of the global economy and is likely to eventually play that role without it.

Mohamed El-Erian, president of Queen’s College at Cambridge, explained to the FT that this is a kind of evolution that makes the global economy and investment portfolios susceptible to a broader range of potential outcomes, something that an increasing number of bond investors understand more than many equity partners.

The International Monetary Fund (IMF) is likely to soon revise down its economic growth projections, as it expects that ‘recession will hit a third of the world this year.’ What is particularly important in this increasingly bleak global outlook is not only that the three main global economic areas (China, EU, and the US) are slowing together, but also that this is happening for different reasons.

In China, a rather clumsy exit from the misguided zero-Covid-19 policy undermines demand and causes increasing supply disruptions. Such management will continue to undermine domestic and global economic well-being until China succeeds in improving the efficiency and spread of vaccination in the country, El-Erian believes. Additionally, China will need to rethink its growth model that can no longer rely on greater globalization.

The situation in the US is the best

The European Union still has to deal with energy supply disruptions as the Russian invasion of Ukraine continues. Some countries have learned to manage supplies very well and have managed to redirect supply, but this is still not enough to remove immediate growth constraints, let alone address long-standing structural issues.

As things currently stand, the situation in the US is the best in the long term. The state has been buoyed by the efforts of the Federal Reserve to rein in inflation after characterizing price increases as transitory, and then being too timid in the early stages of adjusting monetary policy.

The Fed’s shift to aggressively raising interest rates, however, came too late to prevent the spread of inflation to the service sector and wages. Inflation will, according to numerous analysts, remain around four percent and be less sensitive to interest rate policies, exposing the economy there to additional risks from political missteps that sabotage economic growth.

The uncertainties facing each of these three economies we have listed suggest that some analysts should be more cautious in assuring that recessionary pressures will be short-lived and weak. They should remain open-minded, at least to avoid repeating the mistake of prematurely ‘stamping’ inflation as transitory and untroubling.

This is particularly important given that different drivers of recession risk make financial instability an even greater threat, and political transitions even more difficult, including the likely exit of Japan from its interest rate control policy. The range of possible outcomes is unusually large, El-Erian believes.