If the economy is booming, why is there also fear of a recession before the 2022 election?

Raise your hand if you remember “the recession we had to have.” You are showing your age if you did.

As we approach this federal election, whoever wins had better remember those immortal words of former Prime Minister Paul Keating in November 1990, just as the economy was beginning to plunge into the abyss.

The contraction back then wasn’t nearly as severe as the COVID-inspired slump we’re coming out of now. But the after effects were much more severe and lasted much longer.

The other striking difference was that instead of an unpredictable pandemic beyond our control wreaking havoc on our lives, the last great recession was of our own making.

We didn’t have to have it at all.

And right now, the warning lights are flashing. Once again, it seems that we have forgotten the lessons of history, and it is quite possible that Western economies are about to make many of the same policy mistakes that caused the great global recession more than three decades ago.

The rainbow flag flies over the Bank of England to celebrate the launch of the new £50 note in London.
Central banks like the Bank of England triggered the recession of the 1990s with sharp increases in interest rates.(AP: Kirsty Wigglesworth)

The recession of the 1990s was engineered by central banks. After a decade of greed and excess, culminating in a financial crisis triggered by the stock market crash, central banks decided to rein in runaway inflation with the only weapon at their disposal: interest rates.

They raised them to ridiculous levels and kept them there. In the two years prior to January 1990, the Reserve Bank increased rates by 7 percentage points, reaching a maximum close to 18 percent. Mortgages and business loans were well above that.

It had the desired effect; the resulting recession certainly killed off inflation. But although the recession officially ended in mid-1991, it took a decade for employment to recover, ruining the lives of millions.

Could it happen again?

Bill Dudley certainly thinks so.

Former New York Fed President Dudley acknowledges the Fed has waited too long to take action on inflation.

According to Dudley, if the Fed wants to contain runaway prices, which at 8 percent is a 40-year high, it will have to raise interest rates to a point that triggers a stock market crash and increases unemployment.

Charging

“That means the Fed has to do more to slow the economy,” he told Bloomberg last week.

“The Fed is going to have to tighten enough to drive up the unemployment rate and when the Fed has done that in the past, it has always resulted in a recession.

“That is not their intention, they will go for a soft landing, but their chances of making it are very, very low.”

You seem to have gauged the mood correctly.

Right on cue, St. Louis Fed President James Bullard said Friday US rates could rise to 3.5 percent by the end of the year – a big yearly rise, given that they were at zero a few weeks ago. It is the equivalent of 14 rate hikes in one year.

“I would like to get there in the second half of this year,” he said. “We have to move.”

In addition to rate hikes, the US Federal Reserve is considering withdrawing about $95 billion ($128 billion) a month from the economy in a bid to reduce demand. Having pumped more than $5 trillion ($6.7 trillion) in newly minted cash into the economy during the pandemic, it is now changing course.

American actions have an immediate impact on us. If US interest rates go up, that flows out to the rest of the world. Just like it did in the early 1990s.

Why Philip Lowe is gun shy

If you can believe the money markets, we are in exactly the same boat. The RBA, by its calculations, should be planning more than a dozen rate hikes by the middle of next year, a scenario that would put many of last year’s first-time homebuyers under extreme pressure.

About half a trillion dollars is estimated to be at stake after lending was splurged last year at record levels as new entrants, lured by the prospect of years of super-cheap lending, took the plunge.

Australian Home Loan Boom Chart
Source: Australian Bureau of Statistics

Last Friday, the bank almost raised the white flag. After insisting for most of last year that rates would remain unchanged until around 2024, the latest Financial Stability Review is cause for some alarm.

For months, RBA Governor Philip Lowe has insisted that rates will not rise until wage growth kicks into gear. But it is now widely anticipated that the first rate hike is just around the corner, possibly as early as June, putting the RBA between a rock and a hard place that it had desperately hoped to avoid.

And these two subtitles clearly describe his two greatest fears.

“Rising inflation and interest rates will make it harder for some borrowers to meet debt payments.”

Then there’s this: “Large declines in property prices or financial asset prices would be detrimental to financial markets and the economy.”

Simply put, accelerated rate hikes could lead to extreme mortgage stress, possible loan defaults, a stock market crash and…a recession.

Our money mandarins have for years pointed to the large backlog of overpayments that Australians have accumulated in their mortgage clearing accounts as a comforting buffer.

As the RBA chart below shows, it looks great at a median where we have almost 18 months of bank payments. But when you drill down to those who have recently jumped on the mortgage bandwagon, many with six or more times their earnings, things look a lot tighter.

A graph shows a sharp rise in the median graph between 2019 and 2022 with a relatively stable 25th percentile.
Mortgage cushions.(Source: Reserve Bank of Australia)

The pain is likely to be concentrated among the young.

Is recession a certainty?

The only certainty right now is uncertainty. Vladimir Putin’s brutal invasion of Ukraine may have failed spectacularly, showing the incompetence of his military and the hollow structure of his regime. But it has thrown a curveball into the global economy.

Inflation was already a problem before the failed attack on its neighbor. Factory restart delays combined with low inventories and shipping restrictions squeezed global supply of a large number of traded goods just as pandemic stimulus across the developed world boosted demand.

But the exclusion of Russian raw materials and the interruption of commercial ties has sent the prices of energy, metals and grains into orbit. That is now being priced into goods and services in Europe, the US and Asia Pacific.

If the global situation weren’t complicated enough, China already appears to be in the early stages of a dramatic economic slowdown. Increasingly futile attempts to remove Omicron have resulted in widespread bans, including 26 million in Shanghai, where residents have run out of food.

Its economy was already in trouble. Attempts to slow its real estate sector have resulted in widespread defaults, including by China Evergrande, which has sent shockwaves through the economy. That came on the heels of a regulatory purge of tech giants that sent the Shanghai stock market reeling.

While Beijing is sticking to forecasts of 5.5 percent growth this year, that seems unlikely.

If there is a potential savior, deteriorating global conditions may see central bankers opt for a more cautious path in the next six months than financial markets are predicting.

But the risk of policy errors is increasing.

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