Soft landings, hard landings

Soft landings, hard landings

Economic booms tend not to end well. Strong growth generates inflation, which in turn causes central banks to raise interest rates pushing the economy into recession. As the US economist, Rudiger Dornbusch, memorably put it, “No post-war recovery has died in bed of old age—the Federal Reserve has murdered every one of them.”

• The economies of the West have certainly boomed and, in the process, generated levels of inflation not seen since the 1980s. Central Banks have responded with sharply higher interest rates, with the US Fed funds rate going from 0.25% to 5.25% in just over a year. Yet instead of ‘murdering’ growth, as Professor Dornbusch put it, the Fed has merely dampened it. Most forecasters expect the US to avoid a recession and, indeed, keep growing.

• The outlook for Europe isn’t as rosy. But while the German economy is in recession, it is expected to be mild and both the euro area as a whole and the UK are now expected to escape recessions.

• The general thinking is that central banks will slow growth enough to cure inflation but not so much that they cause recessions. On this view we are heading for that much desired, but rare thing, a soft landing.

• Getting inflation down from a peak of over 9.0% in the US and around 11.0% in the euro area and the UK without causing recessions would be quite a feat. On current evidence the US has a better chance of pulling it off than Europe.

• The US inflation rate has halved since last October and is running at just 4.0%, well below the euro area’s 6.1% and less than half UK levels of 8.7%. The Fed is feeling more confident about inflation and last week elected to pause its campaign of rate hikes, the first meeting in ten in which the bank has not raised rates.

• The European Central Bank and the Bank of England are less relaxed. Inflation is proving stickier in Europe than the US, in part because Europe is more exposed to high gas prices than the US, where oil and cheap coal have kept energy costs lower than in Europe. The day after the Fed kept rates on hold the ECB raised euro area rates by 25bp. The Bank of England is likely to follow suit this Thursday.

• The inflation picture looks most worrying for now in the UK. UK average earnings have risen by 7.2% in the last year, the fastest rate outside the pandemic in over 20 years and well above the 3.0%–4.0% rate considered to be consistent with the Bank of England’s 2.0% inflation target. Momentum in the labour market has softened, but only modestly. Over one million jobs are unfilled and employment is growing at a rapid clip. The Bank of England governor, Andrew Bailey, last week conceded that UK inflation was taking "a lot longer than expected" to come down and the UK labour market was "very tight".

• When a mild recession was on the cards late last year, UK rates were expected to peak at 4.5%. Now, with the UK expected to avoid a recession and wages rising faster than expected, markets see rates peaking at 5.75% early next year. Good news has created bad news further out, especially for mortgage holders, raising the risk of a hard landing for the economy.

• The two- and five-year mortgages that were set around 2.0% mark in the last few years are currently resetting at closer to 5.0%, a significant income shock for the roughly 25% of UK households with such deals (the remainder of mortgages, accounting for about 5% of all households, have variable-rate mortgages).

• Monetary policy works with famously long and unpredictable lags. The precise effect of any move in rates on the economy can only be roughly estimated ex-ante. The impact of higher interest rates has been compared to pulling a brick on a rubber band. A lot of pulling does nothing until suddenly a brick is flying towards you. The growth of fixed-rate mortgages has slowed, but not stopped, the transmission of 435bp of base rate rises to households. As mortgages reset and mortgage rates rise consumer spending will come under greater pressure. The Bank of England’s task of engineering a soft landing for the economy is made harder by resilient activity and sticky inflation.

• The US is enjoying better growth and lower inflation than in the UK or the euro area. US rates look close to a peak, while rates in the UK and euro area have further to rise. US consumers have benefitted from relatively low energy prices and have proved more willing than their European counterparts to spend their savings. The US is also starting to benefit from a huge programme of public spending on renewable energy, infrastructure and home-grown industries, notably through the Inflation Reduction Act.

• Yet in the US, as in Europe, uncertainties remain. As we have often observed, risks in the financial system mount in periods of higher interest rates and sluggish growth. The US has weathered the blow up in regional US banks in March and April, but the International Monetary Fund thinks that globally financial risk is elevated. China’s bounce back from lockdowns, a significant factor in the revival of optimism about the global economy earlier this year, has been rather less robust than expected. Last week the Chinese authorities cut interest rates to try to boost activity. Moreover, the US labour market, like those in the euro area and the UK, continues to run hot. Aggressive interest rate rises have so far failed to open up much slack in the labour market – hardly a reassuring sign in inflationary times. 

• If the authorities in the US, euro area and UK can return inflation to 2.0% and keep growth going they will have pulled off a very significant success. The US can take comfort in the fact that despite more resilient growth than expected inflation has fallen sharply in recent months. The story is more mixed in Europe, with growth weaker and inflation higher than in the States.

• Inflation will decline. The only question is how quickly – and whether it takes a recession to get there.

For the latest charts and data on health and economics, visit our Economics Monitor:
https://www2.deloitte.com/uk/en/pages/finance/articles/covid-19-economics-monitor.html

OUR REVIEW OF LAST WEEK’S NEWS
The UK FTSE 100 equity index ended the week up 1.1% at 7,643. Markets around the world rose after the Fed kept interest rates on hold.

Economics

• US inflation fell to 4.0% in the year to May, down from 4.9% the previous month
• US core inflation saw a more modest decline from 5.5% to 5.3% over the same period. A rise in house prices is responsible for much of the stickiness of US core inflation but given that US house prices have stabilised, core inflation is expected to fall sharply in coming months
• The Fed kept its interest rate target on hold at 5%–5.25%. Markets around the world reacted positively to the news
• The default rate on lending to US companies with a poor credit rating has sharply increased this year as borrowers face higher interest rates 
• The ECB raised its main interest rate from 3.25% to 3.5% and indicated it was likely to raise rates again in July. It cautioned that inflation is set “to remain too high for too long”
• The UK economy grew by 0.2% from March to April following a fall of 0.3% the previous month
• Company insolvencies in England and Wales in May were 40% higher than in the same month last year and approximately double pre-pandemic levels
• UK labour market data came in stronger than expected in the three months to April. Unemployment unexpectedly fell, average earnings growth rose to 6.5% and the UK economy added 250,000 jobs
• UK bond yields rose on the news as investors judged the data suggestive of rising inflationary pressures, strengthening the case for further rate rises by the Bank of England
• A number of major mortgage lenders in the UK raised their rates more than once as markets moved over the week
• The FT reported that UK chancellor, Jeremy Hunt, has ruled out the provision of direct support to households dealing with rising mortgage rates 
• UK public satisfaction with the Bank of England’s handling of inflation hit a record low. A majority of the public do not think that inflation will be close to the 2% target in two to three years’ time
• The Bank of Japan kept interest rates on hold at -0.1%. The central bank is unusual in advanced economies in not having raised rates since 2007
• Chinese retail sales, industrial production and fixed asset investment in May came in below expectations. This, together with a fall in housing construction and exports and a rise in youth unemployment, suggest a weakening in the Chinese economy
• China’s central bank cut two of its key interest rates in response to recent data

 Business

• US chipmaker Micron announced a $600m investment in its facility in Xi’an, China, despite Beijing recently banning the use of Micron chips in key Chinese infrastructure citing security risks
• Intel announced a new $4.6bn semiconductor plant in Poland, a sign of the industry diversifying its supply chain away from Asia
• Job cuts at large US banks are on course to exceed 11,000 this year as higher interest rates have slowed M&A activity, the FT reports
• EU lawmakers passed legislation to regulate AI use in applications such as facial recognition, social scoring, hiring and predictive policing
• Vodafone and CK Hutchinson, which runs the Three UK mobile network, agreed a £15bn merger which is expected to be examined by competition regulators
• WE Soda cancelled its planned listing on the London Stock Exchange. The listing would have been the largest of the year
• Junior doctors in the UK staged a 72-hour walkout over pay, rejecting the government’s 5% offer

Global and political developments

• Russian president Vladimir Putin is planning legislation to allow the Russian state to appropriate Western assets at significant discounts, the FT reports
• A report by the Committee of Privileges of the UK House of Commons found that former prime minister Boris Johnson had deliberately misled both Parliament and the Committee
• The EU signed a trade deal with Kenya, its first with an African country since 2016
• Former US president Donald Trump pleaded not guilty to 37 charges related to his possession of classified documents
• The UK’s COVID inquiry held its first public hearing
• At least 78 people died after a boat carrying migrants sunk off the Greek coast. Greek officials denied reports that the boat had sunk after a Greek coastguard vessel attached a rope to the crowded boat

And finally… economists blamed a higher than expected rise in inflation in Sweden in May on Beyoncé’s decision to start her world tour there. Demand for accommodation spiked as fans travelled to Stockholm from around the world, driving the cost of hotel rooms to unusual levels – if I were a boy-ant inflation reading