Recessions have different causes. The more recent recessions were mainly caused by the financial system. As a result, the main fear was deflation. Such fear combined with a large amount of debt is lethal. If there is deflation, the cash flows to pay off the debts shrink and the contraction keeps deflation going. Such a debt-deflation spiral must be avoided at all costs. Japan's two forgotten decades are often taken as an example of such a development. In such a recession, it is not about interest rates, let alone deflation. It is about stabilising the economy and for that, central banks have to go deep. Governments took massive debt from the private sector and a lot of unconventional monetary policy was required this time, even beyond the edge where there is monetary financing. Central bankers were no longer paid to monitor purchasing power. The job description was turned 180 degrees. Inflation was not to go down, but up, and to the point where deflation could never happen again. Well, it succeeded. Whereas after the Great Financial Crisis, liquidity injections remained stuck in the financial system (in fact, there had already been inflation in the form of sharply rising house prices), during the corona pandemic, a lot of liquidity went directly to citizens. This created more inflation partly due to the restrictive measures resulting from Corona. There was more demand thanks to liquidity, especially for goods, but those very goods were harder to transport and produce due to corona.
Recession-Indicator NY Federal Reserve
The impact of corona caused central bankers to assume for a long time that inflation was a temporary phenomenon, something that would be transitory (transient). Mind you, these are still the same central bankers with a job description that they had to fight deflation at all costs, and they were also bankers who realised that a debt problem can be solved with reflationary policies (financial repression). A little more inflation was not a bad thing at all. Until the moment they had a thought about a quote by Karl Otto Pohl of the Buba. Who compared inflation to toothpaste? Once out of the tube, it goes back in so awkwardly. That comparison was mainly about the phenomenon that a higher inflation level at some point gets into the heads of market participants and is therefore difficult to fight. The question is whether it was already there. What was the case was that when prices rose 10 per cent everywhere, hardly anyone could keep up. Suddenly, thanks to Corona and Ukraine, every company seemed to have pricing power. Central bankers then turned like a leaf on a tree. The path of transitory inflation was abandoned and inflation had to be fought tooth and nail à la Volcker. Now, central bankers too are human beings and even donkeys don't stumble twice on the same stone. The accusation they received is that they were all wrong with transitory inflation (although in hindsight it was actually not that bad) and therefore they do not want to make another mistake with the current policy. The only mistake they can make is that they did not fight inflation sufficiently. In that context, a recession with millions of unemployed is part of fighting that inflation. I am still not convinced whether the current generation of central bankers (which in many respects are politicians or at least thanks to social media are much more of an extension of politics) ultimately prefer to choose the safe path without a recession after all, but unfortunately, the facts increasingly contradict this.
The market has been convinced for much longer that central bankers have gone too far. This is evidenced by the inverse yield curve, a curve that has not been so inverse for a long time. Now, the long side of the curve is also depressed by the biggest buyer in the government bond market (central bankers themselves) and by institutional investors' ALM policies. Still, there are more signs that a recession is approaching. With increasing disinflation, there is also less pricing power for companies. With a lag, the burden on those companies is now also starting to rise (wages, rents, interest etc), while the post-corona consumer has now caught up with what needed to be caught up with. Shrinking profit margins are a reason to start laying people off. Besides, a holiday with such heat waves is no fun either. That automatically curbs the appetite for buying. Furthermore, the money supply is also shrinking and monetarists believe that inflation is always and everywhere a monetary phenomenon (a matter of money) and that means that a shrinking money supply has far-reaching consequences. Finally, the big difference was that a recession was virtually impossible early this year due to the strong momentum of the economy (in addition to consumers, investment and exports), but weakness in China, higher interest rates now affecting consumer spending and possible financing problems for large investments (partly due to high-interest rates) have made the economy more sensitive to any shock that a real recession (in which the economy falls off a cliff, as it were) might cause. Recessions are also caused with some regularity by central bankers continuing to tighten for too long. That likelihood has clearly increased in the past month.
Despite this, equities continue to rise even in recent weeks. This quarter, earnings are expected to contract by 7 per cent, while the US economy grew 7 per cent in nominal terms in the second quarter. Still, rising stock prices this year are not supported by rising profits. That means share price gains are the result of P/E expansion. Now, while that fits the Uber-Goldilocks scenario in which the all-powerful central bank brings inflation under control with a simple move, it is difficult to navigate to the soft landing scenario. That soft landing now gets competition from the scenario where central banks have gone too far. There are two years in recent history where there was also a tightening Fed combined with k/w expansion and they are 1998 and 2019. In both years, the Fed cut interest rates several times in the second half of the year, but they were also years where the August/September period showed a solid correction and something like that is necessary for the central bank to pivot. August and September are statistically not the best stock market months anyway. Combined with a euphoric mood, this is not reassuring. At the same time, investors who entered in 1998 or 2019 are standing on hefty gains. After all, the mirror image of every crisis is an opportunity.
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