The world was gripped in drama as a Chinese balloon loitered across US territory, eventually being shot down by a US fighter jet. President Joe Biden congratulated the successful aviators and held a fiery speech to Congress remarking that “if China threatens our sovereignty, we will act to protect our country. And we did.” China maintains that the balloon was a scientific vessel and retaliated by pulling back from a global subsea project.
The reader may be forgiven for thinking that the sequence of spiralling events and superpower bluster over a rogue balloon sounds like it originated from a B-action movie script. Or perhaps as an answer crafted by ChatGPT. Of course, the underlying tensions in superpower tensions is real and US elections are approaching, so a degree to project strong leadership is to be seized.
The Fed grapples with a hot air balloon of its own making
The rogue balloon also serves as a metaphor to thinking about the number one question posed by financial markets. Is a US recession brewing and if so, when?
The hot air balloon is an old chestnut when it comes to serving as an economic metaphor. However, the jet fighter adds a novel dimension to this old war horse of an allegory. The hot air balloon is of course the nominal economy that has drifted high into the inflationary sky on a stimulatory tail wind of epic proportions.
This balloon took off on a tail wind of unprecedented monetary and fiscal stimulus and its flight path was further convoluted by the novel complications arising from the pandemic nature of the shock. The eagerness to stimulate traces its roots to the financial crisis, when previously historical stimulus did not result in sufficient demand nor result in inflation. Hence, when corona came knocking, policy makers were determined not to fall short. The results are well known.
Jay Powell at Mach 3
Our protagonist fighter jet pilot is Fed Chair Jerome Powell. Like previous apex monetary aviators, he seeks to steer the errant economic balloon towards a soft landing. As he sets off afterburners, the word below composed of spectating strategists and economists pontificate on the likelihood of such an auspicious outcome. The crowd is near unanimously of the opinion that our protagonist is doomed to bungle the attempt and send the balloon crashing down.
Economists and strategists expect the balloon to come crashing down
And why are our spectators such as morbid crew? Surely our protagonist hailing from the Top Gun Monetary academy is properly incentivised and sufficiently resourced with an army of economists at his disposal. Nay, the negativity stems from the dismal history of federal aviators. Out of the previous twelve post-war attempts, the Fed has managed four soft landings and eight hard landings. Hence his unconditional chances are one in three.
Some politicians are so sceptical, that they believe that central banks aviation should be firmly supervised by democratically elected air traffic controllers. Such protestations are ignorant of the fact that democratically elected air traffic control has a tendency to prove lax during key moments of the electoral cycle.
Peak gloom in October
Strategists and economists hit peak gloom on October 17, 2022 when Bloomberg economics modelling gave a 100 percent chance that the US economy would be in recession in the next twelve months. To be fair there was ample ground for pessimism. Economic leading indicators were heading south, inflation was running high, rates were climbing, Europe was potentially faced with power blackouts and China was locked down by its own volition.
Unexpected resilience
The global economy has subsequently proved to be more resilient than expected. The IMF in October predicted global economic growth in 2022 of 1.9 percent. In January the Fund raised its 2022 economic growth estimate to 3.2 percent and forecasted that the global economy would turn around.
The WWF estimates that 2022 was the fifth or sixth warmest year on record, which helped reduce electricity use. The European economy avoided a recession by eking out 0.1 percent GDP growth in the fourth quarter.
A strong labour market and corona induced excess savings have both buoyed the European and the US economy. US unemployment hit its lowest rate since 1969 quieting imminent recession whispers.
The global economy may turn during 2023
This year is looking decidedly better than it did in October 2022. The IMF predicts the global economy will turn around this year. China has opened up ahead of schedule, which should support global growth albeit lend some inflationary pressure.
Economists think we have yet to see rates inflict true pain on the economy
Most economists remain decidedly more pessimistic and expect a US recession this year. Most think that the full brunt of monetary policy pain will be felt this year. Since the US economy is growing slowly it stands to reason that policy will push the economy to recession, albeit a mild one. Furthermore, the Fed has not even finished raising rates. Markets expect the Fed funds rate to peak at over five percent in the summer. It’s a strong case and is corroborated by previous historical instances.
Monetary policy lags are not long and variable
The minority view among relatively bullish economists is more nuanced. It’s always tough arguing that this time is different. Modern macroeconomic research here, here, here and here, as illustrated by for instance Goldman Sachs, and the Fed’s own models find that monetary policy affects the growth rate of the economy with a shorter lag than generally thought.
The Fed may be reluctant trust its models and seminal academic papers, as its own projections went astray with regards to inflation. Hence the Fed will err on the side of caution and lean more on data than modelling.
As to the argument that the Fed is not even finished hiking yet, one can argue that peak rates have been already hit the economy, because markets price rate hikes before they materialize. Policy effect has already been falling as measured by indices of financial conditions.
Recession has fallen, but remains elevated
Returning to protagonist chasing a rogue balloon of his own making. The economy has proved to be more robust than expected. Economists are potentially misjudging the timing of lags and peaking of monetary policy. Recession risk is still elevated, but lower than generally perceived at least in the near term. Hence the chances of Powell clinching that coveted fifth soft landing are for the Fed’s Top Gun academy are higher than the choir of gloomy spectators will have you believe.
Valtteri Ahti
