Inflation and interest rate hikes raise the question: What comes next?

Now that the economy’s strong pandemic rebound is starting to fade, there is tremendous uncertainly over what comes next.

Rampant inflation ensures the boom’s demise. But as central banks jack up interest rates to bring inflation under control, three dramatically different slowdown scenarios are realistic possibilities: “soft” landing; “hard” landing; or stagflation.

Economists continue to hold out varying degrees of hope for a “soft landing” where inflation is constrained relatively easily without too much economic pain. However, there are increasing fears of a “hard landing” where inflation is knocked down at the cost of serious recession. We could also suffer stagflation, where inflation persists alongside stagnant conditions.

Economic circumstances are highly unusual now and forecasts are never more than educated guesses, so economists disagree widely over the likelihood of each scenario.

But they are worrying far more about recession than a few months ago as central bankers struggle with soaring inflation. In Canada, the year-over-year increase in the Consumer Price Index climbed to 7.7 per cent in May, far beyond the traditional inflation target of two per cent. The U.S. CPI rose 9.1 per cent in June from a year earlier.

In response, the Bank of Canada made a dramatic hike of a full percentage point in its benchmark “overnight” interest rate last week, bringing the rate to 2.50 per cent. Other central banks are making similar large rate hikes. Further increases are expected.

Now the big questions are how high will rates go and how hard will that hit the overall economy. The impact of interest rate increases plays out over many months, so the full economic outcome should unfold gradually over the remainder of 2022 and 2023.

Soft landing

Many economists continue to hold out hopes for a soft landing, albeit one that takes an unusual form.

Two quarters of falling gross domestic product (GDP) is a common rule-of-thumb gauge for recession, although official determinations of recession look at many indicators (and are typically done long after the fact). Usually falling GDP and other key recessionary metrics like rising unemployment happen together.

But this time, some economists hope the excessive demand from the boom can be cut back without too much human cost. These economists believe that even if the economy experiences two or three quarters of modestly negative GDP, then that impact might be absorbed fairly easily as the hot economy cools down to more normal levels of unemployment and job vacancies.

So the soft landing might include some partial technical indicators of recession without the large-scale economic pain that we normally associate with it.

Something like this may be already happening in the U.S. Overall U.S. GDP fell in the first quarter 2022 and many economists believe it could fall again in the second quarter. In large part that was caused by a drawdown in inventories, which often happens in the early part of a slowdown. Meanwhile, the U.S. jobless rate has actually been falling, from 3.9 per cent in December to a lowly 3.6 per cent in June.

Canadian GDP hasn’t been quite as weak. But as the economy slows here as well, there might be room to eliminate demand excesses without too much human cost.

Many businesses have big sales backlogs to whittle down. After months of drastic employee shortages, employers will be reluctant to turn around and start laying workers off unless the slowdown gets really bad. If the cooling economy does eventually cause a moderate number of layoffs in some industries, then the economy’s starting point of exceptionally low unemployment and high unfilled vacancies should help absorb much of that impact.

According to Statistics Canada figures, the Canadian June unemployment rate was a meagre 4.9 per cent. That’s far less than the 6.5 per cent in January, but also much lower than the pre-pandemic level of 5.7 per cent in December 2019. Similarly, job vacancies hit 890,000 in first quarter 2022, massively higher than the pre-pandemic level of 509,000 in fourth quarter 2019.

Key to achieving a successful soft landing is that the slowdown must be of sufficient force to cut down inflation without hitting so hard that there are large-scale business losses and layoffs.

Hard landing

Sky-high inflation shows that economic demand is far in excess of the economy’s productive capacity. Economists who worry most about hard landing believe it will take a harsh jolt from higher interest rates to erase such a large amount of economic excess.

“The path back to two per cent (inflation) gets tougher and tougher to navigate the higher the inflation rate is,” says William Robson, chief executive officer of the C.D. Howe Institute, an economic policy think tank. “That’s a long way to go.”

These economists believe the sheer scale of required monetary tightening is bound to have a big impact including sizable layoffs. When recessions hit hard, they tend to have disproportionate impact on particular industries, such as those dependent on discretionary consumer spending like home furnishings and restaurants, points out Robson.

While starting with a backlog of job vacancies helps, workers laid off in one sector often don’t have the skills to easily fill vacancies in other sectors. So significant dislocation is likely even if there are also plenty of unfilled job vacancies and overall unemployment rates never reach sky-high levels.

On the brighter side, many economists think the hard landing might be brief. “I’m much more in the camp that says let’s get this done before the (inflationary) misery gets any worse,” says Robson. “If you’re bound to have a slump, make it shorter, sharper and then interest rates are coming down again in late 2023 or 2024.”

A survey of U.S. economists in the Wall Street Journal in late June put the average probability of U.S. recession at 44 per cent in the next 12 months. Robson is among those economists who think the likelihood of recession is even higher.

Stagflation

The third possible outcome of stagflation is the most unusual, hearkening back to the turbulent era from the late 1960s to early 1980s.

A key problem then was that central bankers showed little resolve in using monetary policy to bring inflation under control. They would start to tighten monetary policies, but then back off under political pressure when the economy deteriorated. As a result, inflation kept springing back. Finally, new leadership at the U.S. Federal Reserve under chair Paul Volcker succeeded with a more committed policy of monetary tightening in the early 1980s. Inflation was finally ratcheted down sustainably to more moderate levels, but at a harsh short-term cost of severe recession.

Recently, central bankers like current U.S. Federal Reserve chair Jay Powell have tried to demonstrate commitment to doing what it takes to bring inflation under control. But some economists doubt they will stick with it if the economy starts to deteriorate. “Jay Powell is no Paul Volcker,” wrote economic historian Niall Ferguson recently in Bloomberg.com.

However, Robson says a key difference between current conditions and the 1970s is that policymakers then were confused about the causes of inflation. Now they understand much better the central importance of monetary policies in controlling inflation.

That presumably means today’s central bankers at least know what needs to be done. Soon we’ll see to what extent they follow through.

David Aston, a freelance contributing columnist for the Star, is a personal finance and investment journalist. He has a Chartered Financial Analyst designation and is a Chartered Professional Accountant. Reach him via email: davidastonstar@gmail.com

SHARE: