Recessionary threads begin to weave through present economic landscape

This week, Bank of England governor Andrew Bailey warned this year’s energy shock will be bigger than any seen during the 1970s.

The ripple effects on consumers from soaring energy bills has sparked a wave of economists to slash this year’s growth forecasts on concerns spending will be knocked by a steep fall in living standards primarily caused by historic high inflation.

There are parallels that can be drawn between the present situation and previous times of economic turbulence.

Consumer confidence in the UK has tumbled to minus 31, according to research firm GfK’s closely watched survey, meaning it is now hovering around levels seen during the early 1990s, 2008 and 2020, all marked by recessions.

Pessimism in the general economic situation and household finances tends to prompt consumers to either save more, delay big ticket purchases or hold off on investments, all of which weigh on spending and cool growth.

Wages not keeping pace with a 30-year high inflation rate of 6.2 per cent is driving confidence lower.

In fact, Britain’s fiscal watchdog, the Office for Budget Responsibility (OBR), reckons living standards will erode at the steepest pace since 1956 this year, caused by a combination of the cost of living averaging 7.4 per cent over the whole of 2022 and the government’s tax hikes.

Economists have downgraded projections off the back of this sharp living standards shock. The OBR now thinks output will expand 3.8 per cent this year, compared to six per cent previously.

However, a robust jobs market is likely to contain some of the drop in demand.

“The difference is that when confidence reached comparable levels in each of those four episodes [noted above], there was not a backdrop of record job growth [and] a multi-decade low in unemployment,” analysts at JPMorgan said.

“The question is how severely the drop in consumer confidence and higher energy prices feed back and interact with the resilience in the economy seen up until now,” they added.

Low levels of joblessness will partially protect cash incomes. Wealthier households can deploy pandemic-induced savings to maintain spending levels. 

Banks are keen to step up credit card lending after pulling back from riskier segments of the market during the pandemic, offering consumers alternative sources of funding to plug budget gaps, albeit this may impact their finances in the long term.

High levels of inflation are projected to ease in the second half of 2023, meaning living standards will start improving again.

The upshot is that the UK economy will contract in the short-term, with analysts at Pantheon Macroeconomics penciling in a 0.3 per cent drop in the three months to June, but still post strong growth this year.

Across the pond, a similar picture is playing out.

A robust jobs market will anchor growth this year, although real incomes may fall.

The biggest downside risk is longer and higher inflation caused by a tight labour market pushing up wages.

The world’s most influential central bank, the US Federal Reserve, has signalled its anxiety about this happening, prompting it to launch what is expected to be the fastest tightening cycle in recent history, starting this month with its first rate hike since 2018.

A key measure watched by global markets has nearly breached a threshold that has predated several US recessions over the last decade.

The 2/10 year US Treasury yield spread is nearly negative, meaning the yield curve on US government debt is close to inverting.

In each of the last six US recessions, the 2/10 spread has fallen into negative territory. 

An inverted bond curve suggests investors think short-term interest rates will be higher than long-term levels.

In times of healthy financial markets, longer-dated bonds return more than shorter-dated bonds to compensate investors for tying up their money for a greater amount of time.

Although US rates are low at 0.25-0.5 per cent, the dot plot, which measures where members of the Federal Open Market Committee think rates will land, suggests the Fed will lift rates six more times this year.

Investors have responded to this sharp policy shift from supporting the American economy to taming a 40-year high inflation rate by demanding higher yields on short-term debt. Bond holders have been forced to lower prices to attract buyers, sending yields higher.

But, returns on longer dated bonds have not jumped significantly, indicating investors think the Fed’s tightening cycle will trigger a recession, prompting the central bank to cut rates in the future to stimulate the economy. A flatter real yield curve, however, indicates a recession may be avoided.

In sum, rich economies face strong headwinds this year, the primary culprit being historically high inflation driven by a sudden energy crunch, now being stoked by the Russia-Ukraine war.

But, the cost of living jolt is unlikely to plunge them into recessions.