Inflation and Financial Dominance

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Today we published our latest Cyclical Outlook, "Prevailing Under Pressure," where we discuss our expectations for large developed market economies to realize (1) stubbornly elevated inflation, (2) central banks that remain focused on driving real rates above their neutral levels and (3) shallow but more prolonged recessions. In the U.S., we think the Federal Reserve will lift the federal funds rate to 4.5%-5% and sustain that level there for some time, while the Bank of England is expected to move overnight rates above 5% and the European central bank above 2% in light of estimates of a very low r* in Europe. In other words, elevated inflation across developed markets now looks sufficiently broad-based and sticky that shallow recessions are likely exactly what is needed to arrest accelerating inflation.

But is shallow recession possible? History isn't kind. The average recession in a developed market (DM) economy between 1960 and 1991 was characterized by a 1.5% contraction in real GDP and 2% rise in the respective country's unemployment rate. However, when we ranked recessions by how much core inflation rose in the last two years of the preceding expansion, recessions with a steeper rise in inflation in the two years prior were notably worse, as were recessions proceeded by more aggressive monetary policy tightening.

The one caveat is that higher household savings rates, a proxy for more general private sector balance sheet strength, tend to lead to shorter and much shallower recessions. And as a result of the pandemic-related unprecedented policy intervention, the private sector was able to amass cash and push out debt maturities at historically low rates. Indeed, average household savings rates since the pandemic have been well above their pre-pandemic levels. Even in the U.S., where the household savings rate has fallen below pre-pandemic levels, overall debt to GDP ratios for the household and non-financial corporate sectors are low.

Still, looking at the average balance sheet health of households or corporations is only so useful. To predict financial market stress that leads to contagion, debt market sudden stops and more severe recession, what matters are the corporates or households with the weakest balance sheet and how systemically important they are when financing conditions tighten. Needless to say these second-round effects are difficult to forecast ex ante, as systematic financial market linkages only become obvious with a lag when markets are already under stress.

In our secular outlook, we argued that policymakers' fear of these second-round effects (i.e., financial market dominance) would ultimately limit how high interest rates rise (see Reaching for Resilience). However, with inflation elevated, central banks face difficult choices, and so far they have managed to engineer the fastest pace of tightening in financial conditions since the 2008 Lehman Bankruptcy and great financial crisis, with few signs of any financial market accidents.

However, tighter financial conditions tend to only impact real economic variables with a lag, and financial market fragilities have already started to emerge from the policy induced elevated market volatility.

Last week, the Bank of England was forced into announcing that it would buy long-dated government bonds at a rate of up to 5 billion pounds per day to restore "market functioning" after liquidity concerns for the UK pensions spiked as a result of the 100-basis-point rise in longer-dated government bond yields (for more see "UK Market: Growth, But at What Price?"). The bond market was reacting to the government's budget announcement, which surprised markets with broad tax cuts in addition to providing more details on how the government planned to cap household energy bills.

While the swift BoE actions managed to pressure gilt yields lower, it's unclear how the market will behave once the BoE's latest buying program ends (currently scheduled for October 14) and the bank must raise its policy rate by 100 basis points or more to offset the additional inflationary pressures caused by the government's tax and spending actions.

Furthermore, at that time of this writing, markets were also starting to reflect some rising financial stress, with the price of protecting against credit events rising along with short-term borrow rates for a few European Banks. To be sure, banks on average are more capitalized and holder greater amounts of liquidity now compared to 2008. However, as with the broader corporate and household sector, it's the outlier that matters.

Similarly the European Central Bank (ECB) has also revealed its limited tolerance for financial market stress. Unlike the BoE, it hasn't had to announce a surprise market intervention, but it previously preemptively installed a mechanism – the Transmission Protection Instrument (TPI) – to ensure bond spreads between German and other euro area counties remain narrow. This plus the ECB's choice to raise rates without shrinking the balance sheet may be limiting sovereign bond stress despite broader trends by euro area governments to limit the blow to households of higher energy prices.

Where does this leave us? While shallow recessions across developed markets are still the base case, the risk of financial market contagion triggering a more severe recession is sizable. So far central banks have successfully engineered tighter financial conditions without a financial market accident. However, managing a shallow recession becomes more difficult when they are forced to offset the inflationary effects of easier fiscal policy. Furthermore, because monetary policy only impacts the real economy with variable and uncertain lags, central banks must rely on historical relationships which have evolved. Nevertheless, when faced with the policy mistake of too much inflation or severe recession, they still appear solely focused on bringing down inflation, at the risk of more severe recession.

This report, like future reports, summarizes the vast array of data analysis that we do at PIMCO. Please don't hesitate to ask us about the underlying data and analysis. If you would like to reach out to us, please e-mail me at [email protected].

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Please note that this communication contains the opinions of the manager as of the date sent and may not have been updated to reflect real time market developments.

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