Inflation is upon us, and it won’t be going away very soon, echoes the sentiment in Washington D.C. as the Federal Reserve sets out to combat it. Whenever inflation passes above 4% and unemployment falls below 4%, the U.S. economy has gone through a recession, as per Lawrence Summers, Harvard professor and former Treasury Secretary. A recession is the medicine that’s necessary for an inflation plagued economy to put itself back on track. As of this writing, inflation is running about 8.2% in the U.S. economy, and unemployment is about 3.6%. It has required much scrutiny by the Federal Reserve and the U.S. Treasury, but the status quo on this inflation is that it won’t be “transitory” and it will not go away by itself. The preferred result of monetary policy would be a “soft landing” whereby the raising of interest rates to cool the economy down would not stymy economic growth to the extent that the economy would suffer a recession as determined by two consecutive quarters of negative growth. However, with the tardy start the Fed has taken with monetary tightening, the prospect of a soft landing is quite remote. Considering the financial system, the real economy, and the Fed all working together on the same page, the economy might find its way to an equilibrium via a mild recession that doesn’t last very long. Both households and businesses have relatively strong financial positions going in, and the overall risks in the financial system do not appear to be unmanageable.
Impact of Household Debt: On the plus side is household debt that’s about 25% lower across the board than in 2007/8 during the financial crisis. Further, many households have extra cash left over from the fiscal stimulus package passed down during Covid, when expensive vacations or buying a new car was either not available, or not possible owing to Covid restrictions. As the restrictions end, the consumer is in a good position to provide much demand across a number of sectors of the economy. Since a recession is all but certain and a mild recession becomes more likely, the fly in the ointment could be that the recovery itself would be slow moving. The consumer’s cash buffers have a tendency to disappear and low debt balances have a tendency to climb during a recession, particularly as unemployment begins to creep back up. A few of the more recent recessions in the U.S. have been earmarked by a jobless recovery.
Impact of Business Debt: However, in the business sector the aggregate debt has not declined significantly as companies have taken advantage of low rates in recent times to refinance some of their debt and take on new debt. Companies with riskier credit worthiness also loaded up on inexpensive debt, sending BBB rated corporate bonds to record levels. A recession could drive some of these bonds to fall below investment grade into junk, causing a number of losses to take place as investors want out. The overall number of defaults could also climb. Standard and Poor’s, a credit rating service, reckons that about 6% of speculative grade (junk) bonds could go into default during the next year. This would be much higher than today (1.5%), but much lower than the tail end of the 2007/8 financial crisis when it was 12%.
Banking’s Position: Compared to the financial crisis of 2007/8, banks today are much better positioned for failed loans, as capital requirements for banks have been raised from about 8% up to about 13%. One problem with this statistic is the amount of debt management, particularly mortgages that is handled by non-bank financial institutions. These shadow banks relieve regular banks from some of the mortgage burden, but in turn the regular banks have increased the amount of lending to the shadow banks thereby still shouldering some of the risk. The collateralized loan obligation (CLO) market has changed since the blazing days of the financial crisis when mortgages of all stripes and credit worthiness were bundled into a securitized package known at the time as a collateralized debt obligation or CDO. The concept of securitizing individual loans is not entirely bad, but the management of them during and before the financial crisis was loosely regulated and contributed significantly to the seriousness of that recession. The biggest difference between the CLO’s and the CDO’s is that the former includes other types of lending besides strictly real estate as in the case of the CDO’s.
Conclusions: A lot rests with the Fed’s ability to manage monetary policy. While it’s not a perfect science, it nonetheless worked well for the U.S. economy to keep the collar on inflation for over the past forty years. The goal of a soft landing might be unreachable, but wise management can shorten the recession and speed up the recovery.
Sources: The Economist, The Shape of Things to Come, June 4th, 2022.