Clouds gather over the world economy

Troubles are coming to the world economy not as single spies but in battalions. In setting U.S. monetary policy, the Federal Reserve should take these troubles into account if it wishes to spare the U.S. economy an unnecessarily hard economic landing.

Among the more systemic of the world’s economic troubles are those emanating from China, the world’s second-largest economy and until recently the world’s primary economic growth engine. In response to Chinese President Xi Jinping’s zero-tolerance COVID-19 policy, major Chinese cities such as Shanghai and Beijing have been locked down. At times, that has involved as many as 350 million people unable to work normally.

As a result, the Chinese economy has screeched to an abrupt halt. In the year that ended in the second quarter of this year, China’s economy grew by barely 0.4 percent, which fell well short of the government’s 5.5 percent economic growth target.

Compounding China’s economic problems is the deepening crisis in its property sector. That sector accounts for almost 30 percent of the country’s economy and constitutes around 70 percent of household wealth. It is not only that after years of rapid expansion, some 30 highly leveraged Chinese property developers are now defaulting on their loan obligations. It is that house prices have now been declining for 11 consecutive months, the country has more than 65 million unoccupied housing units, and more than 1 million Chinese householders have declared a boycott on mortgage loan repayments.

Despite its deep-seated property sector problems, the Chinese government’s control over the country’s banking system makes a 2007 U.S.-style housing bust unlikely. Rather, what is more likely is that China will now experience a lost economic decade as Japan did before it. It will do so as its banking system props up its zombie property developers with large amounts of credit. That makes any early strong rebound of the Chinese economy unlikely.

Another dark cloud overhanging the world economy is Russian President Vladimir Putin’s threat to turn off Russian natural gas exports to major European countries like Germany and Italy. He would do so to pressure them to stop backing Ukraine in its war with Russia. Already Putin has cut Russian natural gas exports to 20 percent of their normal level to prevent Europe from building up inventories before the winter. This has to be of major concern considering that Russian gas imports provide almost 50 percent of Germany’s and Italy’s gas needs.

A recent International Monetary Fund (IMF) report estimated that a total Russian energy export shutdown could shave as much as 1.5 percentage points off German GDP in 2022 and 2.75 points in 2023. With the German economy already stagnating, if Putin carries through on his threat, the German economy could succumb to a deep economic recession. A German recession is the last thing Europe needs at a time when renewed Italian political instability is raising questions about Italy’s ability to service its public debt mountain.

Adding to the global economic gloom is strong capital repatriation from the emerging market economies in response to the Federal Reserve’s interest rate hikes. This is now likely to trigger a wave of debt defaults in the emerging market economies, which now carry record debt levels. Highlighting the likelihood of such a wave are the acute economic difficulties now being experienced in Argentina, Egypt, Pakistan, Russia, Sri Lanka and Ukraine.

For the United States, all of this likely means further downward inflationary pressure on the back of a strengthening dollar and a continued fall in international commodity prices. It likely also means a weakening of aggregate demand as a result of souring export markets and a reduction in risk appetite. These deflationary forces raise serious questions about whether the Federal Reserve is being overly aggressive in its quest to bring inflation under control and whether it is raising the risk of an unnecessarily hard economic landing.

Desmond Lachman is a senior fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.