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A recession is coming: Will policymakers be caught flat-footed?

The economic outlook is always subject to considerable risk. But seldom before has the global economy been subject to as many major downside risks as it is today. The materialization of any of those risks could make 2022 as difficult a year for U.S. and global economic policymakers as was 2009 in the immediate wake of the Lehman Brothers bankruptcy.

With U.S. inflation now at a 31-year high and proving to be much less transitory than the Federal Reserve had hoped, one major risk to the global economic recovery is the real possibility that the Fed will soon have to slam on the monetary policy brakes to keep inflation under control.

Rising inflationary expectations are heightening this possibility, making the Fed’s policy interest rate increasingly negative in inflation-adjusted terms. This is occurring as the U.S. economy has been receiving its largest peacetime budget stimulus on record. It also hardly helps matters that wage pressures are building, housing prices are soaring, international energy and food prices are increasing and renewed episodes of the pandemic abroad are likely to prevent the early repair of disrupted global supply chains.

The danger of Fed interest hikes to the U.S. and world economic outlook is that they would likely burst the many asset and credit price bubbles around the world that have been caused by massive central bank bond-buying. This would seem to be especially the case considering that those bubbles have been premised on the assumption that today’s ultra-low interest rates would stay low forever.

The bubbles have become large and pervasive. Consider that U.S. equity valuations are now at very lofty levels experienced only once before in the last 100 years. What’s more, U.S. house prices are now increasing by 20 percent a year and, even in inflation-adjusted terms, they are now higher than they were in 2006, before the U.S. housing bubble burst.

Another major risk to the global economic outlook is the likelihood of a Japanese-style economic slowdown in China, the world’s second-largest economy. Heightening this risk is the seeming start to the bursting of the Chinese housing and credit market bubble as underlined by the acute financial difficulties of Evergrande, the massive and highly indebted Chinese property development company. The bursting of that property and credit market bubble could well usher in a lost Chinese economic decade since those bubbles are larger than those experienced in Japan during the 1980s or in the United States in the run-up to the 2008 housing and credit market bust.

While the Chinese economy does not have direct financial links to the world’s financial system, a marked slowing in Chinese economic growth would have major spillover effects to the rest of the global economy. No longer could Germany, Australia and China’s Asian economic partners count on a rapidly expanding Chinese economy for their exports. No longer too would the commodity producing countries in Latin America and Africa be able to count on buoyant international commodity markets to support their economies.

The prospect of higher U.S. interest rates and slower Chinese economic growth would be particularly problematical for the emerging market economies, especially as many of these economies have become highly indebted and have highly compromised public finances. The last thing that those economies can afford now is to have higher U.S. interest rates induce capital flow reversals or to have slower Chinese economic growth depress international commodity prices.

In 2008, U.S. and global economic policymakers were caught flatfooted by the Great Recession. The world’s economic policymakers have no excuse for being ill-prepared for another meaningful world economic recession next year, especially given all the warning signals. 

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.

Tags Business cycle Economic bubble economy evergrande Financial crises Financial economics Great Recession Great Recession Inflation Lehman Brothers Real-estate bubble United States housing bubble

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