Fragilities can persist for long periods, hidden from view, without the system breaking. Regime change is, as history shows, a process not an event. It needs a trigger but also internal system dynamics that reinforce, rather than negate, any emergent shift towards volatility and disorder.
The most plausible trigger is a realisation by market participants that the FOMC is not prepared to bail out investors by pivoting towards looser policy aggressively in the coming recession – at least not initially. The transition from “sufficiently restrictive for some time” to interest rate cuts won’t happen immediately.
An immaculate disinflation is for the birds. In this cycle, the Fed is hitting the brake late and hard. Whenever this has happened historically, the US economy has gone into recession.
But, if the recession turns out to be short and shallow, shouldn’t a cyclical bear market be the base case?
REVERSE CAUSATION
No. The logic is backwards. A cyclical bear market cannot follow from a short and shallow recession. In that scenario, the inflation genie escapes, something central bankers are not currently prepared to countenance.
A short and shallow recession is the probable outcome for the real economy but only because a much nastier drawdown looms for risk assets, a drawdown that ensures the monetary cavalry arrives. Only then will central bankers have the political tailwinds necessary to loosen policy despite still-elevated inflation. Too late for markets; in the nick of time for the real economy.
Both the FOMC and investors believe the coming recession will be short and shallow. For this reason, policy will need to ensure a more dramatic and sustained tightening of financial conditions. In Fed speak, Powell will want to err on the side of tightening too much.
That could well be when markets least expect it, just as a recession is beginning, when anticipation is mounting that the cavalry will arrive in the form of an early and aggressive Fed pivot.
It is the emergence of disorderly market conditions in the face of a recession that will bring the Fed put into play. A subsequent easing cycle should ultimately ensure a short and shallow recession, but the damage to asset prices will already have been done.
THE GENIE HAS ESCAPED
The drawdown in equity and credit markets has further to run. The central conceit in markets today (shared by the Fed) is that, absent high inflation, there are no economic or financial imbalances that will deepen any recession. But to think high inflation will remedy itself, as the pandemic disappears into the rear-view mirror, is a fallacy.
First, this view downplays how far demand-led overheating, induced by the largest stimulus programme in peacetime history, has driven the inflationary surge.8 Too much money chasing too few goods.
Second, it assumes the dramatic changes in where people choose to live, how they choose to work and on what they choose to spend will reverse quickly post pandemic. The opposite is true. These shifts, and the disruptive impact on economies’ productive capacity, seem likely to persist, many indefinitely (Figure 2).
Source: ISM 8 Eickmeier & Hofmann (2022), What drives inflation? Disentangling demand and supply factors