Will there be a recession in the United States? What would be the Global Consequences?
Welcome to the 12th edition of Newsletter Basque Macroeconomics 5.0 published by Web 2.0: Basque Economics Worldwide Leadership
1.- Introduction
This summer, we have experienced an adverse economic-financial episode that has forced us to reevaluate the future scenario. When the “consensus” pointed to a soft landing, something that is not without great difficulty, the shadow of a recession loomed over the U.S. economy, with the collateral effects this has on other geographies. But let’s take it step by step. We will start by analyzing the facts of this episode, then proceed to study the consequences in both the U.S. and the Eurozone, and finally, the impact this may have on European companies.
2.- The Facts
- Turbulence in Japan and Its Domino Effect
After the economic bubble burst in the late 1980s, Japan has been in a state of economic stagnation characterized by low GDP growth and low inflation, from which it seemed difficult to emerge despite efforts made. The great financial crisis of 2007 presented an opportunity for Prime Minister Shinzo Abe’s government (2012-2020) to implement, in conjunction with the Central Bank, an aggressive package of fiscal, monetary, and structural reform measures. Specifically, from a monetary policy perspective, Japan has implemented, since 2013 under the leadership of Governor Haruhiko Kuroda, both conventional and unconventional monetary policy measures, such as massive asset purchases, the setting of the reference rate at negative values, and even yield curve control. Yet, all these measures seemed insufficient to lift the Japanese economy out of its long slumber.
Then came the pandemic, bringing with it the problems that the global economy has faced since 2020: significant monetary and fiscal policy measures, asynchronous pandemic effects, supply chain disruptions, limitations on service consumption with a focus on goods by consumers, a subsequent rotation toward services, geopolitical crises (wars), energy crises, and a long sequence of factors that have driven inflation globally. Obviously, starting in 2022, central banks shifted monetary policy toward a restrictive mode. However, the Bank of Japan acted with more delay. The reference rate had been set at -0.1% since January 2016, and it wasn’t until this year, first in March when it was raised to 0.1%, and later in July when it was set at 0.25%, that the first moves signaled a change in direction. Clearly, the explanation can be found in the inflation trajectory. While in the U.S. and the Eurozone, the inflation rate seems to be slowly approaching 2%, in Japan, the trend appears to be going in the opposite direction. The annual price growth rate in the second quarter was 2.6%, and expectations for the third quarter are 2.8%.
However, these somewhat special situations, with negative rates for so long and extraordinary measures, in my opinion justified, generate "other" problems. For example, the phenomenon known as "carry-trade," a practice of borrowing in a low-interest currency - the yen - to invest in assets in currencies with higher rates. Now it’s clear why Japan has been the epicenter of the recent instability in financial markets. The rate hikes and the consequent appreciation of the yen have generated significant losses for carry trade operators who bet on the continued weakness of the Japanese currency. The need to cover positions through massive yen purchases further contributed to the currency's appreciation, intensifying the problem. If we add to this the fall of the Nikkei 225 index, which plunged 12.4% in a single day and accumulated a nearly 20% drop in three days, it is easy to understand the alarm of global investors and the declines in world markets.
- Deterioration of the U.S. Labor Market
In addition to the problem described above, the U.S. labor market is also showing worrying signs of deterioration. The latest data suggest a slowdown in labor demand, with indications of an increase in layoffs. These signs are reflected in an increase in initial unemployment claims and a rise in continuing claims in June, which have reached a new high this year, possibly indicating greater difficulties for laid-off workers in finding new jobs.
Recent reports also show a decrease in the number of available vacancies and a moderation in wage growth and unit labor costs. These factors not only increase the likelihood that the United States will enter a recession by the end of the year but also challenge the Federal Reserve’s current guidance toward a gradual normalization of interest rate policy.
But perhaps the element that has had the most impact due to its simplicity is the so-called Sahm Rule, an indicator often used to predict recessions. Claudia Sahm, a former Federal Reserve economist, developed and presented the rule in 2019. The idea is very simple and could be stated as follows: “The economy enters a recession if the average unemployment rate of the last three months exceeds by 0.5 percentage points the rate of the previous year.” Of course, calling it a "rule" may create the false expectation that it is an absolute truth when in reality it is merely an empirical regularity that has served to reasonably predict recessions in the U.S. It should also be noted that the reference value, 0.5%, is also subject to debate, and the truth is that the values proposed by various specialists range from 0.3% to 0.5% in applying the rule, regardless of the monthly unemployment rate series used. Finally, Claudia Sahm and other economists have warned that the rule may overestimate the current weakness in the labor market due to distortions caused by the pandemic and other factors.
But be that as it may, the fact is that the rule has raised the possibility that the U.S. economy has entered a recession.
3.- Consequences on the U.S. Interest Rate Path
Before the events described in the previous sections, expectations about the interest rate path in the U.S. were that the Federal Reserve would adopt a more gradual interest rate path, focusing on a slow reduction. However, after the latest labor data and the aforementioned turbulence, which point to increased downside risks for both employment and inflation, the forecast has changed substantially.
Specifically, the Fed is expected to cut interest rates by at least 100 basis points by the end of the year. It is likely that there will be a 50 basis point cut at the September meeting, depending on economic developments and financial market behavior until then, with an additional two 25 basis point cuts before the end of the year. These moves aim to return policy to a neutral level more quickly. In the medium term, the federal funds futures market anticipates a rate of 3% for December 2025, indicating a normalization of policy toward this level, with further cuts possible if the economy deteriorates further.
But while there is certainly a risk that the market has anticipated these cuts too much, which could complicate the Fed's efforts to avoid a recession without reigniting inflation, the combination of a slowdown in wage inflation and productivity gains has realigned unit labor costs to a level consistent with the Fed's 2% inflation target. This justifies a more aggressive easing policy by the Fed, considering that inflationary risks are more balanced.
4.- Impact on the Eurozone and the ECB
The change in the Fed's monetary policy will have significant implications for the Eurozone and the European Central Bank (ECB), forcing it to engage in a complex balancing act.
On the one hand, the ECB may be pressured to adjust its monetary policy in response to the Fed's easing. On the other hand, it is expected to maintain a gradualist approach due to concerns about inflation and economic uncertainty. In this regard, central banks in developed economies, excluding Japan, have shown caution despite the decline in core inflation, reflecting the need to carefully manage risks.
The reduction in U.S. interest rates could lead to an appreciation of the euro against the dollar, negatively affecting European exports and, consequently, economic growth. A stronger euro would make European products more expensive in the international market, reducing the competitiveness of exports and possibly negatively impacting GDP growth in the Eurozone.
The ECB will need to balance the need to support economic growth without triggering a rise in inflation. This could mean keeping interest rates low for longer and continuing with selective stimulus measures. Although inflation has decreased, there are still fears of sustained inflation in service prices due to tight labor markets and high wage inflation, complicating the ECB's strategy.
5.- Impact on European Companies
European companies will face several challenges and opportunities in this new economic environment:
- Financial Risk Management:
Companies should strengthen their risk management strategies, including hedging against exchange rate volatility and diversifying their sources of financing. Volatility in currency markets can significantly impact the margins of exporting companies, making the implementation of effective hedging strategies crucial.
- Market Diversification:
Given the possible appreciation of the euro, companies should seek to diversify their export markets beyond the United States and China, focusing on regions with robust economic growth such as Southeast Asia and Latin America. Geographic diversification can help mitigate the risks associated with dependence on specific markets and offer new growth opportunities.
- Innovation and Competitiveness:
Investing in research and development to innovate and improve the competitiveness of products and services will be key. The adoption of new technologies to improve operational efficiency and reduce costs will also be crucial. Companies that can enhance their efficiency and offer innovative products will be better positioned to compete in the global market.
- Pricing and Cost Strategies:
Companies must reevaluate their pricing strategies to remain competitive in international markets and seek operational efficiencies to maintain margins in a volatile exchange rate environment. The ability to effectively adjust prices and find ways to reduce operating costs will help companies remain profitable.
6.- Conclusion
The possible recession in the United States and the consequent change in the Fed's monetary policy, along with the financial turbulence originating in Japan, have profound and multifaceted implications for the global economy, ECB policy, and European companies. The ability to adapt quickly to these changes and effectively manage risks will be crucial in navigating this challenging economic
Consultant & Speaker, Lean Quality Systems, Design Control, Process Validation, and Lean Manufacturing at Atzari
7moMonetary policy is still central banking no matter which levers it uses. What it is not and never will be is free market capitalism. Imagine only having one wrench and pretending to fix an engine with only that one wrench. Government’s other actions with respect to immigration, price controls, tariffs, taxation, subsidies, and criminalization of behavior cannot be overlooked.