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The Only Game in Town: A Trilogy of the Fed, Inflation, and Recession

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“Having been forced into being the only game in town, they (Federal Reserve) now find their destiny in no longer entirely or even mostly theirs to control.”Mohamed Aly El-Erian (Egyptian-American economist)

This quote from the 2016 book (The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse) befits the puzzling economic reality in the United States. Shrugging inflation as transitionary last year, the US Federal Reserve has purposefully shifted to the other side of the monetary spectrum. After not increasing the interest rates last year, the Fed has delivered a quarter-point, a half-point, and two back-to-back three-quarters of a point hikes since March. Consequently, the fears of a stark economic slowdown have compounded as critics have flagged selective metrics to convince the onlookers that the United States is already in a recession. However, while some signs allude to the possibility of an end of the business cycle, the objectivity of robust economic resilience is still hard to deny!

The Federal Reserve announced its fourth rate increase of 2022 on Wednesday in a precedented session. Citing job gains, elevated inflation, and supply chain imbalances, the Fed officially justified its second consecutive 75-basis points rate hike. And while Fed Chair Jerome Powell reiterated the notion of “not in a recession yet,” the official statement by the Federal Open Market Committee (FOMC) projected the feared forward guidance – their unanimous inclination toward slower economic growth even at the cost of substantial job losses. This rate hike is significant due to the extended period until the next meeting in September. Given the sharp disinflationary guidance manifested by the Fed throughout the first half of this year, the next meeting would be pivotal to the delicate balancing act between sustainable growth and price stability. Moreover, the latest rate increase has effectively bumped the Federal Funds Rate (the interbank overnight borrowing cost) between 2.25% and 2.5% – a range widely acknowledged as neither aggressive nor lenient. Yet with an expected target to extend the rate to about 3.4% by December this year, the next month would be crucial to watch for any cooling effects – stemming from the ripples of monetary tightening – that may legitimize smaller increments in the second half.

Many economists argue that the Fed is moving too fast – perhaps worsening the blow of a recession instead of steering toward a smooth landing. Even a few US lawmakers, including Democrat Senator Elizabeth Warren, have opposed the hawkish maneuvers of the Powell-led central bankers. Their arguments are not all unjustified. For instance, the Yield Curve – a graph charting the relationship between the annual returns of 2-year and 10-year treasury notes – has been in inversion throughout July. History shows that an inverted yield curve has always preceded an economic downturn in the United States. And presently, the bond market signals indicate that investors doubt the ability of the Federal Reserve to swerve past a recession. According to the Bureau of Economic Analysis (BEA), the US economic output, gauged by the Gross Domestic Product (GDP), contracted for a second successive quarter – signaling a sustained decline in economic activity. And even fillings for unemployment listings – a bellwether indicator of layoffs – have climbed slightly higher in recent weeks. The confluence of these factors substantiates the arguments of the Fed critics claiming a recession is already in play. However, the antipode argument is also intriguingly convincing!

According to the National Bureau of Economic Research (NBER) – the official corroborator of recessions in the US – an economy is in a recession when there is a “significant decline in economic activity that spreads across the economy, and that lasts more than a few months.” Following this definition, we should not focus on just a few sectors of the US economy to gauge the broader economic health. So to assess the first claim, let us examine the data to answer: Are we already in a recession?

Most probably not! I admit the yield curve has historically been an omen of economic collapse in the US. But a chronology of US recessions depicts that economic downturns usually start after the graph has normalized. For instance, the Great Recession officially began in December 2007 – months after the yield curve had already reverted. It is because a recession usually starts off after the Fed has completed its tightening schedule and begins to lower the rates again. Thus, a lag in policy transfer over time leads to this phenomenon.

While the GDP contracted for the first half of this year, that is also not a sure-shot indicator of an economic downturn. It is because mainstay sectors of the US economy – like the Housing and Automobile industries – could drag down the measure of economic output singlehandedly. Yet it would obviously not be considered a recessionary meltdown without a “decline in economic activity that spreads across the economy.” For example, the US economy was officially in a mild recession after the burst of the dot-com bubble, but the GDP never fell in the recession year 2001.

Moreover, the quarterly GDP is subject to revision as while the GDP contracted by an annual rate of 1.6%, the Gross Domestic Income (GDI) expanded by an annual rate of 1.8% in the first quarter. Such a spread between the two measures is rare, given both estimate the same metric vis-á-vis the national economic activity. Thus, it is highly likely that an upward revision in the GDP reveals that the US economy did not contract at all in the first quarter!

Lastly, while the jobless claims have increased lately, the number of unfilled job openings has consistently fallen from a record high late last year. And adding between 300,000 to 400,000 jobs a month in 2022, the unemployment rate – which typically should spike in a recessionary environment – is near a 50-year low, still declining despite inflation and consistent rate hikes. Hence, the argument for an ongoing recession is moot from an analytical perspective. But what about an imminent recession?

The answer is as complex as it is irrelevant. For the sake of argument against the anti-hawkish Fed critics, while I admit the economy is slowing down, the pace of the slowdown is not palatable. The existing home sales have notably dropped; the rent has ticked higher. The car sales are down, but the confounding shortage of microchips has skewed the indicator. How can we confidently claim that the fall in automobile sales is due to consumer restraint and not the lack of availability of cars on sale? Despite a contraction in GDP (susceptible to future revision), consumer spending grew at an annual rate of 1.8% in the first quarter. The oil prices are still looming around $100/barrel, and the US strategic crude reserves have shown a worrisome drop in the last few weeks. The war in Ukraine is still flaring the global commodity prices, and Europe is visibly suffering from a debilitating energy crisis – relying on the US-supplied LNG to survive the winter. China is dealing with an unprecedented economic crunch which could eventually lead to convoluted supply chain snarls for the US. We need to realize that the Fed policies cannot resolve these supply-side challenges of food/energy inflation. And thus, even if overdoing is a legitimate possibility that could lead to a devastating economic collapse, the Fed has no choice (or control) over its destiny but to hike interest rates in the hope of sustainable economic activity down the road.

At the expense of stating the obvious: even the most sage economists around the globe cannot definitively predict the timeline of an approaching (or ongoing) recession. But I believe the course of action by the Fed would still remain the same regardless of an acute awareness of the point of inception. We should realize that the ‘easy money’ injected during the pandemic ought to exit the system to avoid an entrenched inflationary sentiment similar to the 70s. Hiking taxes or cutting government spending cannot bring about a timely shift in the inflationary profile of any country. And the US economy cannot afford to lose any more time. Hence, even at the cost of being cast in a villainous persona, the Fed is the only game in town capable of guiding the economy out of uncertainty – though probably not unscathed.

The author is a political and economic analyst. He focuses on geopolitical policymaking and international affairs. Syed has written extensively on fintech economy, foreign policy, and economic decision making of the Indo-Pacific and Asian region.

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Economy

Baltic reality: High inflation and declining of living standards

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The Baltic States’ economy is in bad condition. The latest estimate from the EU’s statistics body shows that Eurozone inflation is continuing to soar to record highs.

The Baltic countries continue to be the hardest hit. These states in particular are experiencing the highest levels of inflation in the Eurozone. Thus, inflation in Latvia and Lithuania hit 22.4 per cent and 22.5 per cent respectively. Estonia also has seen inflation rise year on year from 6.4 per cent in September 2021 to 24.2 per cent in September 2022. The more so, the Baltic States continue to see soaring energy and food prices which lead to declining standard of living.

The Bank of Lithuania has published its latest economic forecast and revised gross domestic product (GDP) growth projections for 2023 from 3.4% to 0.9%.

Statistics Lithuania also reports that in September 2022, the consumer confidence indicator stood at minus 16 and, compared to August, decreased by 5 percentage points. The decrease in the consumer confidence indicator in September was determined by negative changes in all of its components.

According to SEB bank economist Tadas Povilauskas, the number of poor people in Lithuania will increase. Living standards will be affected by rising food and energy prices. The current price of natural gas is too high and the economy cannot “go” with it. It is evidently that energy prices shocks have far-reaching effects on Lithuanian economy and population.

The main cause of such state of affairs is deteriorated relations with Russia. Russia has lately been the EU’s top supplier of oil, natural gas, and coal, accounting for around a quarter of its energy.

The conflict in Ukraine and political confrontation between Russia and the West has exacerbated the energy crisis by fuelling global worries it may lead to an interruption of oil or natural gas supplies from Russia. Moscow said in September it would not fully resume its gas supplies to Europe until the West lifts its sanctions.

It is obviously that the conflict in Ukraine dramatically worsened the situation on the markets, as Russia and Ukraine account for nearly a third of global wheat and barley, and two-thirds of the world’s exports of sunflower oil used for cooking. Ukraine is also the world’s fourth-biggest exporter of corn.

According to Euronews, the prices of many commodities – crucially including food – strained global supply chains, leaving crops to rot, caused panic in many European countries, including the Baltic States.

High inflation has become the direct consequence of sanctions imposed on Russia. As for the Baltic States, the lack of wisdom to find compromises and blindly following the European Union’s decisions have lead to declining standards of living. The desire to punish such huge state as Russia played a cruel joke on the Baltic States. It will be difficult to explain the population why they should turn down the heating in homes, schools and hospitals over the winter.

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Policy mistakes could trigger worse recession than 2007 crisis

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The world is headed towards a global recession and prolonged stagnation unless fiscal and monetary policies holding sway in some advanced economies are quickly changed, according to a new report released on Monday by the UN Conference on Trade and Development (UNCTAD).“There is still time to step back from the edge of recession,” said UNCTAD chief Rebeca Grynspan.

‘Political will’

“This is a matter of policy choices and political will,” she added, noting that the current course of action is hurting the most vulnerable.

UNCTAD is warning that the policy-induced global recession could be worse than the global financial crisis of 2007 to 2009.

Excessive monetary tightening and inadequate financial support could expose developing world economies further to cascading crises, the agency said.

The Development prospects in a fractured world report points out that supply-side shocks, waning consumer and investor confidence, and the war in Ukraine have provoked a global slowdown and triggered inflationary pressures.

And while all regions will be affected, alarm bells are ringing most for developing countries, many of which are edging closer to debt default.

As climate stress intensifies, so do losses and damage inside vulnerable economies that lack the fiscal space to deal with disasters.

Grim outlook

The report projects that world economic growth will slow to 2.5 per cent in 2022 and drop to 2.2 per cent in 2023 – a global slowdown that would leave GDP below its pre-COVID pandemic trend and cost the world more than $17 trillion in lost productivity.

Despite this, leading central banks are sharply raising interest rates, threatening to cut off growth and making life much harder for the heavily indebted.

The global slowdown will further expose developing countries to a cascade of debt, health, and climate crises.

Middle-income countries in Latin America and low-income countries in Africa could suffer some of the sharpest slowdowns this year, according to the report.

Debt crisis

With 60 per cent of low-income countries and 30 per cent of emerging market economies in or near debt distress, UNCTAD warns of a possible global debt crisis.

Countries that were showing signs of debt distress before the pandemic are being hit especially hard by the global slowdown.

And climate shocks are heightening the risk of economic instability in indebted developing countries, seemingly under-appreciated by the G20 major economies and other international financial bodies.

“Developing countries have already spent an estimated $379 billion of reserves to defend their currencies this year,” almost double the amount of the International Monetary Fund’s (IMF) recently allocated Special Drawing Rights to supplement their official reserves. 

The UN body is requesting that international financial institutions urgently provide increased liquidity and extend debt relief for developing countries. It’s calling on the IMF to allow fairer use of Special Drawing Rights; and for countries to prioritize a multilateral legal framework on debt restructuring.

Hiking interest rates

Meanwhile, interest rate hikes in advanced economies are hitting the most vulnerable hardest

Some 90 developing countries have seen their currencies weaken against the dollar this year – over a third of them by more than 10 per cent.

And as the prices of necessities like food and energy have soared in the wake of the Ukraine war, a stronger dollar worsens the situation by raising import prices in developing countries.

Moving forward, UNCTAD is calling for advanced economies to avoid austerity measures and international organizations to reform the multilateral architecture to give developing countries a fairer say.

Calm markets, dampen speculation

For much of the last two years, rising commodity prices – particularly food and energy – have posed significant challenges for households everywhere.

And while upward pressure on fertilizer prices threatens lasting damage to many small farmers around the world, commodity markets have been in a turbulent state for a decade.

Although the UN-brokered Black Sea Grain Initiative has significantly helped to lower global food prices, insufficient attention has been paid to the role of speculators and betting frenzies in futures contracts, commodity swaps and exchange traded funds (ETFs) the report said.

Also, large multinational corporations with considerable market power appear to have taken undue advantage of the current context to boost profits on the backs of some of the world’s poorest.

UNCTAD has asked governments to increase public spending and use price controls on energy, food and other vital areas; investors to channel more money into renewables; and called on the international community to extend more support to the UN-brokered Grain Initiative.

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Economy

‘Sanctions Storm’: Recovery After the Disaster

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After the start of the special operation in Ukraine, a “sanctions storm” hit Russia; more sanctions were imposed against Russia in a few months than against Iran in decades. But a catastrophe did not take place, and the stage of stabilization came.

Indeed, almost all the weapons in the sanctions arsenal were used one after another: commodities exchange was suspended in some sectors, export and import controls were put in place, restrictions on air and sea transportation were introduced. The sanctions have spread to the investment and financial sectors, paralyzing many transactions with the West and complicating them with the East. An image impact came from the mass withdrawal of foreign business from the Russian market—not directly caused by the sanctions, but demonstrating “over-compliance,” excessive submission to them.

In the public mind, the destabilizing wave created the impression of the end of the story of the market economy in Russia, an impending catastrophe. But the catastrophe did not happen. The stage of stabilization has come, and it is important to use it correctly.

What to do?

In the near future, the Russian authorities and business will have to solve three groups of interrelated tasks. First, they must provide the domestic market with necessary goods, and restore value chains by the use of alternative partners. Second, they need to establish reliable financial mechanisms for working with these partners. Third, it is necessary to look for new growth points for the future, industries in which dependence on the West was critical. It is important to work out the possibilities: for new partners entering the markets and for attracting investors from friendly countries, as well as trying to integrate into new value chains.

Partners, first of all, include China and India. The southern direction is also not unpromising—to begin with, this includes Iran and Turkey, as well as a search for investors in the Arab world and the development of logistics routes through the Middle East. Nevertheless, in all areas, the key obstacle is the threat of secondary sanctions by the United States and the EU—which means that the second task becomes the main one: building a safe infrastructure for financial cooperation.

China remains Russia’s first trading partner—but despite the strategic partnership on the political level, large Chinese companies and banks that are active in the international market are suspending cooperation with Russia, fearing secondary US sanctions. In these conditions, it is important to work on explaining the nuances of the sanctions policy for Chinese business, creating secure payment channels that do not depend on foreign banks or on the dollar and the euro, and developing profitable package offers. Beijing seeks to use the opportunities opening up in the Russian market to occupy the vacant niches and strengthen the yuan in international payments, which means that its interest in finding a common solution is high.

A similar situation is developing in the Indian market, with the difference that Indian business is more connected than Chinese business with America, and its awareness of doing business in Russia is lower. As a consequence, Indian companies and banks integrated into the global economy will comply even more closely with sanctions restrictions, despite their interest in developing ties with Russia. Accordingly, even more active informational work is needed to establish Russian-Indian business ties, as well as the creation of a secure settlement mechanism. India already has similar experience, from doing business with Iran. In particular, UCOBank was formed to trade with it in rupees. Similar structures can be created in the Russian direction.

If the necessary channels are laid, both China and India can not only replace some Western goods in Russian markets, and ensure purchases from the Russian energy, agricultural, and military-industrial sectors—preserving their prospects for business—but also become zones of qualitative economic growth. Chinese partners can become a support in the development of bilateral cooperation in the fields of electronics and digital technologies (including 5G), and Indian, in pharmacology and high-tech agriculture. It also makes sense for business to look at these countries from the point of view of the development of green technologies in energy and agriculture, and the introduction of ESG practices, since these countries are also interested in this.

From our partner RIAC

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