A look ahead at the world economy in 2022

I'll kick off New Year with a post on arguably the most important issue facing the world economy, inflation and its consequences. The post will raise a set of questions of relevance to understanding and responding to the problem.  

Larry Summers has a brilliantly clear column making the case that inflation is not transitory. His summary of reasons,

The consumer price index’s shelter component, which represents one-third of the index, has gone up by less than 4 percent, even as private calculations without exception suggest increases of 10 to 20 percent in rent and home prices. Catch-up is likely. More fundamentally, job vacancies are at record levels and the labor market is still heating up, according to the Fed forecast. This portends acceleration rather than deceleration in labor costs — by far the largest cost for the business sector. Meanwhile, the pandemic-related bottlenecks central to the transitory argument are exaggerated. Prices for more than 80 percent of goods in the CPI have increased more than 3 percent in the past year. With the economy’s capacity growing 2 percent a year and the Fed’s own forecast calling for 4 percent growth in 2022, price pressures seem more likely to grow than to abate.

The non-transitory nature does not portend well,

There have been few, if any, instances in which inflation has been successfully stabilized without recession. Every U.S. economic expansion between the Korean War and Paul A. Volcker’s slaying of inflation after 1979 ended as the Federal Reserve tried to put the brakes on inflation and the economy skidded into recession. Since Volcker’s victory, there have been no major outbreaks of inflation until this year, and so no need for monetary policy to engineer a soft landing of the kind that the Fed hopes for over the next several years.

More worryingly, even with its recent reversal, the Fed may well be behind the curve,

We do know, however, that monetary policy is far looser today — in a high-inflation, low-unemployment economy — than it was about a year ago... The implication is that restoring monetary policy to a normal posture, let alone to applying restraint to the economy, will require far more than the three quarter-point rate increases the Fed has predicted for next year. This point takes on particular force once it is recognized that, contrary to Powell’s assertion, almost all economists believe there is a lag of about a year between the application of a rate change and its effect. Failure to restore policy neutrality next year means allowing two more years of highly inflationary monetary policy. All of this suggests that even with its actions this week, the Fed remains well behind the curve in its commitment to fighting inflation.

Or, it's possible that the Fed is playing the market in a brilliant gambit,

Perhaps the Fed’s restraint reflects less conviction about what ultimately will be necessary than a desire to avoid being itself a source of economic shocks. We should hope that what we have seen is just the first part of what will be, if necessary, a more radical policy redirection.

After having read countless pieces and papers in recent times about inflation being transitory or not, and whether Fed would be able to control it or not, and still having not been able to make up my mind, I think the clarity of the article may have slightly tipped me over into taking the side of those arguing that the current inflation is non-transitory and most likely to pull the US economy into a recession (perhaps end of the year - after all inflation is not a slow-release). 

The equity market bubble and high corporate leverage too are strong factors which may either cause or amplify the recession-risk, and could also make the downturn steeper. Worse still, the traditional instruments available to fight recessions - monetary loosening and fiscal expansion - may not be available in any meaningful manner this time around, making recovery long-drawn.

There are three things of primary interest here. Is inflation transitory? Will the Fed be able to control any outbreak? What effect will any outbreak have on the economy? They, in turn, raise a series of questions that are of critical importance to the world economy in 2022 (and immediate beyond), including for India.

Is the ongoing inflation transitory or more permanent? Can the Federal Reserve control the inflationary spiral from breaking out from its current anchors? Can it do so without triggering a recession? How would the debt markets react to the rate increases? Similarly, how would the excesses accumulated during the more than a decade long period of cheap capital availability (including the ongoing financial asset bubbles - equities, SPACs, bitcoins, NFTs, sovereign bond-spreads, junk bonds etc) unwind? How would these two likely trends (breakout of real economy inflation and unwinding of asset prices) interact with each other? How would the twin unwindings impact the economy in case of a recession? How deep and long-drawn could be the recession? How much monetary and fiscal policy firepower will be available with the US Fed and Treasury to fight for the recovery? What new monetary and fiscal policy tools are possible and likely to emerge in this fight?

The other questions of interest concerns China. How much deeper and longer will Beijing take its ongoing policy of cracking down on its technology and emerging sector companies in particular and private sector in general? What other measures are on the anvil in the Chinese experiment with rebalancing its economy and reining in perceived excesses in the economy and society? Will Beijing be able to calibrate its deflation of property market bubbles without letting off an uncontrollable spiral of corporate defaults? What would be the implications of these and other actions aimed at "common prosperity" on the Chinese economy? How much more would Beijing push on its external front, especially Taiwan, and its impact on geo-political stability? 

For the Indian economy, some questions follow. What will be the spillover effects of unwinding of monetary accommodation in the US (and attendant equity market consequences) on the Indian capital markets? How would these trends impact the ongoing flood of venture capital into the Indian startups? How much would these and their impacts constrain the RBI in its autonomy to pursue a monetary policy that balances inflation with domestic economic growth? How will a recession in the US impact the developing countries, especially India? What will be the impact of these events on commodity prices, especially oil?

As a non-trivial risk, we may well be on the last leg of a perfect storm of inflationary spiral, crashing asset prices, squeezed corporate balance sheets, stuttering and exit of the world's economic engine for nearly two decades, geo-political instability, and fiscally constrained governments. Time will tell.