Global Economic Growth: Inflation or Double Dip Recession?

Inflation has captured the world’s attention. Around the world, businesses and consumers are grappling with across-the-board hikes in the prices of everything from food and gas, to electronic goods and automobiles. In the U.S., the inflation rate rose to a staggering 6.8 percent in November 2021 from a year ago, well above the 2 percent rate that the country’s central bank, the Federal Reserve, typically considers as its “sweet spot” level and a sign of a healthy and growing economy.

This rise in inflation has been mirrored in many of the largest economies in the world, fueled by stimulus and pandemic disruptions, although it has generally remained low in Asia.
Is inflation here to stay or is it transitory? And how can economies around the world fight it without risking a double-dip recession? To make sense of these questions requires an understanding of the structural changes that have taken place since COVID-19 first reared its head in the beginning of 2020, says Paul Kitney, Professor of Practice in Finance and Economics at The Chinese University of Hong Kong’s (CUHK) Department of Decision Sciences and Managerial Economics.

“Inflation is expected to remain a force to be reckoned with in the immediate future.”

Prof. Paul Kitney

“What we are seeing now is a new round of supply chain disruptions that are very different from the shocks we experienced when COVID-19 first hit,” says Prof. Kitney, speaking at a recently-held EMBA Forum. He noted that the lockdowns in early-2020, which stopped travel and shutdown businesses, were deliberate and designed to prevent the transmission of the disease.

Fast forward to the present, and consumer spending habits have drastically changed because of the pandemic. With many countries around the world have yet to reopen their borders to tourism, people are diverting their spending on services (such as purchasing airline tickets to go somewhere or booking a hotel room at their destination) to buying physical goods that require a long and complex supply and logistics chain for its manufacture and transport.

“For every $3 spent, if $2 was previously on services that did not require a physical delivery of something by a truck, ship, or airplane, it now is. The logistical setup and infrastructure is just not geared for this, and it’s not something that changes overnight,” he says, adding that this is happening as governments around the world are seeking to sustain the recovery, mostly through massive fiscal stimulus that boosts spending.

Demand for energy, a crucial component of consumer price indices, is also being buoyed by the economic recovery, leading to higher prices. At the same time, the production of energy (whether from oil, gas or coal) is also suffering the same disruption that is plaguing a myriad of goods. These factors all contribute to inflationary pressures, he says, noting that companies are seeing price inflation in the intermediate goods that contribute to the production of final products.

The Role of the U.S. Federal Reserve

On to the main topic, Prof. Kitney says whether the global economy continues with its inflationary path or makes the second part of a double dip from this point forward depends on a number of factors.

Most importantly, it will depend on how the U.S. Federal Reserve, whose monetary policies are carefully watched by other central banks around the world, reacts. “Until recently, the Fed has said that the inflation that we’ve experienced is transitionary. Recent guidance from the Fed indicates that not only are they beginning to question this conclusion, but they are becoming increasingly mindful of the risk that high inflation will be prolonged. A more permanent inflationary path will mean they will raise interest rates, and they’ll raise them sharply,” he says, referring to recent comments by Federal Reserve chair Jerome Powell that all-but-confirmed that the central bank will raise interest rates for the first time in three years by as early as March.

Mr. Powell also said the Fed will be “nimble and humble” in raising rates, which the market has interpreted as a sign that it would be more aggressive in tightening monetary policy than previously thought. Indeed, market-based estimates including the Federal Funds Futures markets are indicating at least 3 hikes in 2022 of 25 basis points. Yet, will this be enough to stem inflation? Thinking beyond this, what if the Fed overdoes it and raises rates too much?

Prof. Kitney says an overaggressive string of rate rises would reduce aggregate demand and lower prices. If the Fed does indeed tighten monetary policy too quickly, it may expose vulnerabilities in credit markets around the world, including in China (where around 80 percent of its foreign debt is dollar-denominated), causing price levels to fall back to where they were in March 2020. “That’s your risk of a double dip recession,” Prof. Kitney says.

The other scenario is that the Fed raises interest rates too moderately, and the spread of COVID-19 continues to prevent people from resuming their previous consumption pattern of spending more on services.

“It’s going to take decades to build the logistical infrastructure to be able to cope with that and no one wants to invest in it now because no one knows if it’s really permanent or not,” he says. In that case, supply disruptions will continue and prices will continue to rise.

On the other side of supply and demand, if other governments around the world continue their asset purchase programmes (the U.S. has confirmed it will end its asset purchase programme in early March and start to shrink its bond holdings) and nominal interest rates remain low, then real interest rates would fall. This stimulates investment and helps to further drive a rise in aggregate demand. “So you’ll just end up with higher and high prices and that’s how you end up with this inflation spike.”

How Will the Fed React?

To make sense of how the Fed will act going forward, Prof. Kitney notes that the U.S. central bank typically considers two factors in its policy reaction, namely the output gap of the economy (a measure of the difference between its actual and potential outputs) as well as inflationary expectations.

On one hand, with COVID-19 and its variant strains continuing to spread, consumers are unlikely to return to spending more on services too quickly. Energy prices are also rising, which means higher inflation expectations.

For the jobs sector, the U.S. unemployment rate is falling rapidly and is nearing the theoretical level below which inflation is expected to rise. All these factors are driving inflationary pressures, which the Fed will heed, he says.

In financial markets, bond yields are currently being buoyed by inflation expectations, driving bond prices down and bond yields up. This will drive continued losses in bond portfolios. Equities, which are currently on the pricey side relative to bonds, are generally at risk in either scenario. A rise in inflation will increase a firm’s cost of capital, while a slowdown in the economy will hurt earnings. Both these scenarios are likely to lead to a contraction in price-to-earnings multiples for equities, and a general correction in equity markets, perhaps more.

Inflation Here to Stay

To conclude, Prof. Kitney says that the global economic recovery from COVID-19 continues, led by a coordinated effort on monetary and fiscal policy. Aggregate demand is expected to continue to see upward pressure, driven by U.S. fiscal spending as well as supply agreements between oil-producing OPEC countries and Russia that are driving energy prices. This recovery has been demand-driven through aggressive policy stimulus, but production capacity expansion remains subdued in many industries and in some cases are adding to the inflationary pressures.

“Inflation is expected to remain a force to be reckoned with in the immediate future,” he says, adding that in which case the Fed may raise rates and taper policy more aggressively than previously thought. This could spell trouble for the recovery either by reducing demand directly or people’s likelihood to spend because of their lower level of wealth. “Policy makers will need to carefully manage credit risks and avoid financial contagion, which can have negative real economy outcomes,” he adds.