Is a recession imminent?
Yes, you read it right! Two-thirds of economists surveyed by The Wall Street Journal predict a recession will occur this year as the Federal Reserve raises interest rates to try to get inflation under control. Is it going to be as severe as the great recession of 2007-09..let us understand.
The Great recession-2008!
We are all aware about the Great Recession that happened during 2007-09. For the unversed, let us first know the reasons that led to the deepest recession since World War II:-
- In the US, loans, primarily housing loans, were given at lower interest rates till the year 2004 as a response to hampered US economy after 2001 attack. However, from 2004 through 2006, the Federal Reserve raised interest rates to control inflation. As monthly mortgage payments rose beyond borrowers’ ability to pay, many borrowers started to sell. The increase in supply burst was later widely recognized to be a housing bubble.
- Things came to a head later that year with the bankruptcy of Lehman Brothers, the country’s fourth-largest investment bank, in September 2008.
- The shadow banking system (a term used to describe bank-like activities (mainly lending) that take place outside the traditional banking sector) grew to rival the depository banking system but was not under the same scrutiny or regulation.
The contagion quickly spread to other economies around the world. As a result of the Great Recession, the United States alone lost more than 8.7 million jobs, according to the U.S. Bureau of Labor Statistics, doubling the unemployment rate.
How is the situation today similar to that in 2008?
To understand this, let us first understand that when the economy shows signs of a slowdown, the Central Banks majorly pump money into the banking system by lowering interest rates and following the process known as Quantitative Easing (QE).
What is QE?
The Central Bank buys bonds issued by the Government, the cash received from such purchase-sale then makes its way into the economy.
A similar round of interest rate cuts and QE occurred at the start of the Covid pandemic to combat the downturn caused by the covid pandemic. The banks, as expected, did extensive funding at lower interest rates, somewhat similar to what happened in 2004.
Now, when the inflation is at decades-high levels, the Central Banks have raised the interest rates and started to sell bonds. Bond prices rose as a result of the QE programmes but have fallen sharply over the past year as QE has been unwound. The aggressive action by central banks has left commercial banks to incur big and unexpected losses.
The Silicon Valley Bank (SVB) had invested heavily in long-dated US government bonds, but as rates rose sharply, the value of its bond prices fell. When customers started demanding their cash back, that forced SVB to sell bonds at a heavy loss, blowing a hole in its balance sheet.
The fall of the banking system, though in bits and pieces, is certainly not a good indicator as can be established from past trends.
Fast forward to today, why does the US Fed increasing interest rates have a domino effect worldwide?
The US Fed is increasing interest rates so as to control the soaring inflation. Inflation in general is increasing due to the following major reasons:-
1. Cost push inflation and supply shocks– Increase in the prices of food and cereals and other essential commodities, majorly due to weak production cycles, covid-19 aftermaths and the Russia Ukraine war.
2. But is inflation only due to the result of cost based factors? No, the Federal policies of the Central Banks majorly control the regulated Banking Sector. However, the shadow banks continue to fund the requirements of the economy, one of the main reasons why the effect of previous interest rate hikes has not been noteworthy.
Once the US Fed increases interest rates, Reserve Bank is nevertheless expected to do the same. The main reason being the fear of weakening Indian Rupee. If the interest rate gap between two countries increases, foreign investors will be tempted to withdraw money from Indian market which makes the rupee weaker and it prompts RBI for a rate hike in India. Although, not all US Fed rate hikes are going to impact India directly, but in the present fragile banking system it is important to keep tabs on the monetary policy changes.
Does Inflation necessarily lead to recession?
Periods of inflation don’t tend to cause recessions in and of themselves.The Central Banks thus try to control inflation in the following manner:-
- Raising interest rates makes it harder for businesses to respond to inflation by building new capacity, which would also help reduce inflation.
- Ideally, by slowing down economic activity as a whole, the government can reduce demand relative to the economy’s productive capacity. This can give prices a chance to stabilize.
Slowing down the economy is the main connection between inflation and a recession. To curb inflation, governments try to reduce economic activity until it meets the economy’s productive capacity. If they’re successful, they can slow down the cycle of spending and price increases without causing serious harm. More often, however, slowing down the economy causes businesses to start producing less and laying off workers. If that slowdown continues and magnifies, it can lead to a recession.
This isn’t inevitable, but it is common and hard to avoid.
Is a recession inevitable?
Experts worldwide are of the belief that a recession is approaching. The Central Banks today need to control inflation as well as prevent an economic downturn.
“While a recession doesn’t automatically follow a tightening; every recession is preceded by real interest rates turning positive, and looking at history, a positive real rate of over 2 percent should be high enough to cause concern.” explained Centrum, a popular Investment bank.
With regular layoffs by top companies like Google and Amazon and fall of banks in succession, things are obviously shaping towards a slowdown. Experts believe the impact of the expected recession on India would be on a small scale. If the policies of Central Banks come out successful in controlling inflation without an adverse impact on economy, we could possibly pass over an expected recession.
By CA Geetika Bhatia
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