A recession is coming. And there's a danger it will be deeper and last longer than the 2008 crisis. But was this inevitable, or the making of central banks? David Blanchflower argues that a certain group-think is driving central banks to overreact to inflation pressures by sharply raising interest rates and thus inevitably triggering a recession. That recipe for dealing with inflation is based in the past, when a price-wage spiral was a big risk. But that world no longer exists. Central banks need to wake up to this new reality before they take us all down with them.
Inflation has sharply increased around the world, caused mostly by a series of supply-side shocks, including a loss of workers due to Brexit and the pandemic, bottlenecks as demand picks-up after lockdowns, the zero-Covid policy being pursued by China and the outbreak of a European war in Ukraine. In the UK the CPI has hit 9%. But the likelihood is that this rise in inflation is temporary. Even though it has taken longer to come down than I expected, just as night follows day, over the next few months inflation will drop sharply. House prices are coming down soon.
Indeed, the worry is that, as with all prior bursts of inflation, what follows is not higher inflation, as the inflationistas have predicted, but deflation. That is to say prices are about to fall as people cut their spending except on basic goods like food and energy given their limited budgets. The Bank of England produces a remarkable time series on inflation back to 1210 and it shows exactly that; periods of high inflation are followed by periods of deflation. The problem is, the panic of the US and UK central banks over inflation, and the rising of interest rates they instigated as a response, means the coming recession will be a lot worse than it otherwise would have been. The fears of a price/wage spiral of the sort we saw in the 1970s is not possible in the contemporary world. Central banks still live in the past – they need to catch up and quickly, for the good of all of us!
___
The fear central bankers have is that a period of high inflation results in a wage/price spiral as workers demand and get wage increases to fend off price rises.
___
There are already signs of slowing prices. The Personal Consumption Expenditure (PCE) measure of inflation in the US fell from 6.6% in March to 6.3% in April. Excluding food and energy the PCE fell from 5.2% to 4.9% in April with more declines coming. There is evidence that the cost of shipping containers around the world [1] as well as the price of wood, which picked up sharply in the pandemic have both fallen by more than a third recently. [2] The Baltic Dry Index, which measures the price of shipping dry goods such as grain and coal around the world – oil is wet - is down 23% since 23rd May.
The Federal Reserve in the United States and the Bank of England have both responded by raising interest rates and engaging in quantitative tightening, by selling off assets or not reinvesting money from maturing assets, along with promises that there are more rate rises to come. As a result mortgage costs are now around 5%. But two other major central banks, the European Central Bank and the Bank of Japan - also faced with inflationary pressures, have kept their powder dry, maintaining interest rates below zero with little sign they are going to raise them any time soon. They are rightly concerned about recession.
All four of these central banks have seen plummeting consumer confidence, in their economies, which are the best indicators we have of what is coming. Declines of this magnitude have always predicted recession in the past. Japan has seen declining consumer confidence for six months. Europe has seen a similar decline in consumer confidence and a rise in expectations of higher levels of unemployment and a decline in their expectations regarding consumer’s financial situation in the year ahead. UK consumer confidence reported by GFK fell to minus 40 in May, its lowest since records began in 1974. In the US both the Conference Board and the University of Michigan measures have collapsed and are at levels predictive of recession. Nothing else predicts recession as well.
___
There is no chance under God’s green earth of a wage/price spiral, believe me.
___
The fear central bankers have is that a period of high inflation results in a wage/price spiral as workers demand and get wage increases to fend off price rises. This is what happened in the 1970s, but the world is different today as workers have much less bargaining power than they did then. The Paris riots of 1968 sent shock waves around the world and union membership in the UK rose by 3 million through the end of the 1970s. I remember three-day weeks and power outages and miner’s strikes when I was a student. There were oil price hikes caused by OPEC and in 1975 wage growth in the UK reached 29.5%.[3] But union membership has been in decline for years and workers are fearful of losing their jobs and care about job security; they have little bargaining power. There is no chance under God’s green earth of a wage/price spiral, believe me. According to the Office of National Statistics regular pay growth in April was not 29.5% but 4% and slowing, down from 7.4% in May 2021.
___
Tightening monetary and fiscal policy is exactly the wrong thing to – the cure to rising inflation is worse – rising unemployment.
___
Groupthink is on full display at the Monetary Policy Comittee at the Bank of England, where are all the members live in London and who are stuck in the mindset of 1975. Their latest forecast recognizes that the recession that’s coming was worsened in part by their raising rates along with market expectations of more to come, alongside the austerity policies of the Chancellor raising taxes has ensured recession is coming. They think it will be a soft landing and the recession will be short and not too deep. Interest rate cuts are what is needed to stave off recession, but instead they are hiking them, thus making matters worse. It’s amazing to see there has been not a single voice of dissent. As a result, the independence of the Bank of England and the position of its Governor Andrew Bailey who seems entirely out of his depth, is under threat given the Bank's poor performance of late on top of the fact they missed the Great Recession. Calling for workers to take real wage cuts wasn’t helpful, not to mention morally and politically questionable. Incompetence is on full display and lessons from the recent past including the dangers of groupthink have not been learned.
The big hang-up that central bankers and economists have with inflation seems misplaced given we know that a 1 percentage point rise in unemployment, say from 4% to 5% lowers wellbeing five times more than an equivalent rise in inflation. Tightening monetary and fiscal policy is exactly the wrong thing to – the cure to rising inflation is worse – rising unemployment. The Great Recession in the UK saw output declining by about 6% across five quarters and the unemployment rate rose to 8.0%; they could go much higher this time. Jobless claims in the US are already on the up again and GDP growth was negative last month as it was in the UK. More bad news is on the way, trust me.
___
There is a danger that the recession that is coming could be deeper and longer lasting than the one that hit the global economy in 2008.
___
U-turns are inevitably coming as we saw in the UK recently with the windfall tax on energy companies and help with higher energy costs to the poorest households. In 2008, interest rates were cut from 5% to 0.5% to combat the recession, but today there is no longer that room for manoeuvre with rates being at 1%. Stock markets around the world have dropped substantially and I fully expect some very bad data to continue to come in including on retail sales as happened in the UK this week, along with output and especially from the labour market. How bad this could get remains unclear, but what we should note is that recovery in 2009 came only as the authorities threw in the kitchen sink including a global fiscal stimulus and cash for fridges and clunkers. Any such moves in this crisis, which anyway seem unlikely, would inevitably be too little and too late.
There is a danger that the recession that is coming could be deeper and longer lasting than the one that hit the global economy in 2008. Economists and central bankers missed the Great Recession but they did have an excuse that nothing like that had happened since the Great Crash of 1929. When it comes to our current post-Covid crisis, there was the precedent from the Great Influenza pandemic of 1918. The lessons weren’t learned. Look out for a rough ride ahead.
[2] https://www.nasdaq.com/market-activity/commodities/lbs
[3]https://www.ons.gov.uk/economy/grossdomesticproductgdp/timeseries/kgq2/qna
Join the conversation