The U.S. economy is already deteriorating due to the humongous fiscal and monetary cliffs. These cliffs are now being compounded by the war in Eastern Europe and near record-high inflation. And, the Fed’s “PUT” is much lower and smaller in size than Wall Street believes.
The war in Ukraine will exacerbate the negative supply shocks that are already in place due to COVID-19. Worsening bottlenecks will combine with rising inflation to produce a contraction in global growth. Russia produces 12 percent of the world’s oil supply and exports 18 percent of the world’s wheat consumption. Ukraine accounts for 25 percent of global wheat production. Sanctions and war will serve to slow the economy further and send prices for these vital commodities even higher.
But the upcoming recession will be extraordinarily unique. Not only will it occur while inflation is at a multi-decade high, it will be the first U.S. economic contraction to take place while the Federal Reserve had its target interest rate at or near zero percent. For comparison, look at how much room the Fed had to reduce borrowing costs during previous economic contractions.
The following historical data indicates the level of the Fed Funds Rate just prior to the outset of all 10 U.S. recessions since WWII: 1957 3.5 percent, 1960 4.0 percent, 1969 10.5 percent, 1973 13.0 percent, 1979 16.01 percent, 1981 20.61 percent, 1989 10.71 percent, 2000 6.86 percent, 2007 5.31 percent, and 2019 2.45 percent.
In addition, the swoon in GDP will occur after the Fed has just finished printing $4.5 trillion over the past two years and with the national debt vaulting over $30 trillion due to the massive increase in government deficits in the wake of the COVID-19 pandemic. Such borrowing helped send the government’s debt to GDP ratio soaring to 125 percent. For perspective, that ratio was just 53 percent back in 1960, and only 58 percent as recently as 2000.
Inflation is destroying real wages, and rising borrowing costs are destroying consumers’ ability to consume. Consumption is 70 percent of GDP, and that means the rate of economic growth is set to plunge. This would normally spur the government into remediative action. But the fact remains that the ability of the Treasury and Federal Reserve to turn around a recession expeditiously by borrowing trillions of dollars and having that debt monetized by the Fed has become greatly fettered this time around.
Fed Chair Jerome Powell is in a conundrum that is mostly of his own making; and from which there is no innocuous outcome. If the Fed gets overly concerned about slowing GDP due to the conflict in Ukraine, it could, for the most part, shelve its plans to raise rates and the planned reduction in the size of its balance sheet. But that would risk propelling inflation even further away from Powell’s stated 2 percent target, which he has exceeded by 3.75 times. Inflation expectations could then rise intractably from there. In other words, doing nothing isn’t a viable option for Powell—not with inflation running at a 40-year high and the WTI oil price vaulting above $110 per barrel.
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