Most of the fiscal ammunition has been used, and public debts are becoming unsustainable. The space for fiscal expansion will also be more limited this time. The situation today is thus fundamentally different from the global financial crisis or the early months of the pandemic, when central banks could ease monetary policy aggressively in response to falling aggregate demand and deflationary pressure. When confronting stagflationary shocks, a central bank must tighten its policy stance even as the economy heads toward a recession. Today, we face supply shocks in a context of much higher debt levels, implying that we are heading for a combination of 1970s-style stagflation and 2008-style debt crises-that is, a stagflationary debt crisis. After 2008, we had a debt crisis followed by low inflation or deflation, because the credit crunch had generated a negative demand shock. In the 1970s, we had stagflation but no massive debt crises, because debt levels were low. The next crisis will not be like its predecessors. Will drive highly leveraged zombie households, companies, financial institutions, and governments into bankruptcy and default. Under these conditions, rapid normalization of monetary policy and rising interest rates As a share of global GDP, private and public debt levels are much higher today than in the past, having risen from 200% in 1999 to 350% today (with a particularly sharp increase since the start of the pandemic). There is ample reason to believe that the next recession will be marked by a severe stagflationary debt crisis. They argue that today’s financial imbalances are not as severe as those in the run-up to the 2008 global financial crisis, and that the risk of a recession with a severe debt and financial crisis is therefore low. Most of those who have come late and grudgingly to the hard-landing baseline still contend that any recession will be shallow and brief. Now that a hard landing is becoming a baseline for more analysts, a new (fifth) question is emerging: Will the coming recession be mild and short-lived, or will it be more severe and characterized by deep financial distress? I have argued that they will eventually wimp out and accept higher inflation-followed by stagflation-once a hard landing becomes imminent, because they will be worried about the damage of a recession and a debt trap, owing to an excessive buildup of private and public liabilities after years of low interest rates. Most market analysts seem to think that central banks will remain hawkish, but I am not so sure. If they stop their policy tightening once a hard landing becomes likely, we can expect a persistent rise in inflation and either economic overheating (above-target inflation and above potential growth) or stagflation (above-target inflation and a recession), depending on whether demand shocks or supply shocks are dominant. The fourth question is whether a hard landing would weaken central banks’ hawkish resolve on inflation. In both the United States and Europe, forward-looking indicators of economic activity and business and consumer confidence are heading sharply south. Several prominent Wall Street institutions have now decided that a recession is their baseline scenario (the most likely outcome if all other variables are held constant). Moreover, a model used by the Federal Reserve Bank of New York shows a high probability of a hard landing, and the Bank of England has expressed similar views. That leads directly to the third question: Will monetary-policy tighteningīy the Federal Reserve and other major central banks bring a hard or soft landing? Until recently, most central banks and most of Wall Street occupied “Team Soft Landing.” But the consensus has rapidly shifted, with even Fed Chair Jerome Powell recognizing that a recession is possible, and that a soft landing will be “ challenging.” This matters because supply-driven inflation is stagflationary and thus raises the risk of a hard landing (increased unemployment and potentially a recession) when monetary policy is tightened. While both demand and supply factors were in the mix, it is now widely recognized that supply factors have played an increasingly decisive role. The second question is whether the increase in inflation was driven more by excessive aggregate demand (loose monetary, credit, and fiscal policies) or by stagflationary negative aggregate supply shocks (including the initial COVID-19 lockdowns, supply-chain bottlenecks, a reduced labor supply, the impact of Russia’s war in Ukraine on commodity prices, and China’s “zero-COVID” policy). “ Regardless of whether the recession is mild or severe, history suggests that the equity market has much more room to fall before it bottoms out.
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