June 29, 2022
The global economy may be in for a bumpy ride, warns the central bank for central banks. The Bank of International Settlements (BIS) broke down the environmental variables typical of those preceding a hard landing. Most advanced economies fit this bill and are advised to start tackling inflation immediately. Those in the worst circumstances are going to find the next few years challenging.
Soft Vs. Hard Landings
Central banks like to explain monetary policy tightening as an airplane landing. At the end of the business cycle, if things go right — we get a soft landing. We barely notice the impact of the landing, with our drink in hand not a drop spilled. Oversteer or hit the tarmac too fast, and you’re in for a hard landing — it gets bumpy as heck. People survive it, sure, but no one is particularly thrilled by the event.
The definition isn’t always consistent, so let’s go over what the BIS used as the definition in this study. Tightening is a period of 3 or more consecutive quarters of interest rates rising. A recession is 2 consecutive quarters of declining real gross domestic product (GDP).
- Soft landing: No recession within the 3 years from the start of a tightening cycle.
- Hard landing: A recession within the 3 years from the start of a tightening cycle.
The organization studied 129 policy tightening cycles across 35 economies. They found some common environmental factors that may help determine the landing:
- Build up of financial vulnerability: Things like high debt loads or low liquidity are vulnerabilities. Soft landings have minimal amounts of build up typically. Hard landings tend to see build up of vulnerabilities over time. Households are less flexible in these cases, amplifying risk.
- Inflation: Lower inflation is common in soft landings, with an average rate of 2.6% in the study. Hard landings are typically preceded by high inflation, averaging about 4.1%. High inflation tends to erode consumer purchasing power, reducing consumption. Reduced consumption helps to throttle business revenues, slowly killing the economy.
- Real policy rates: These are the short-term lending rates adjusted for inflation. Higher rates tend to be seen before tightening in soft landings (averaging 1.4%). Hard landings tend to begin with lower real rates (averaging 0.4%). That makes sense, since low rates help produce higher debt loads, which is a vulnerability.
- Household credit growth: Household credit to GDP rises slower in a soft landing (+2.8 points on average). This number is much higher in a hard landing (+6.4 points). The greater the ratio, the greater debt is outpacing productivity.
Countries like Canada and the US fit the bill for a hard landing pretty well. High inflation and low real policy rates. Elevated household debt, more so in Canada than the US. Since the tightening cycle began at the end of Q1, we haven’t seen data on household credit to GDP. However, most analysts expect debt loads to climb and GDP to shrink as rates rise in the short-term.
BIS Urges Central Banks To Act “Quickly and Decisively” To Tackle Inflation
Policymakers are blaming external factors for inflation, but the BIS isn’t having it. Earlier this year, the organization attributed the global property bubble to synchronized response. That is, they blamed making the same mistake over several economies. They do acknowledge some external factors have driven prices, but it’s not the primary issue.
The BIS is taking a similar path in this report, urging central banks to tackle the inflation problem. “Central banks should act “quickly and decisively before inflation becomes entrenched,” reads the brief from the organization.
“if it does [become entrenched], the cost of bringing it back under control will be higher. The longer-term benefits of preserving stability for households and businesses outweigh any short-term costs.”
Inflation, Debt, and Real Estate Bubbles Increase Hard Landing Odds
The combination of inflation, debt, and asset bubbles, such as those seen in real estate, present a challenge. It’s already hard enough to have a soft landing with just a run-of-the-mill deterioration in spending. Now add the trifecta of danger, and it’s no wonder the BIS is expressing concerns about the global monetary system.
“Context is of the essence. For the first time in the post-World War II era, the global economy is facing the threat of higher inflation, and hence the need to keep it in check, against the backdrop of elevated financial vulnerabilities. Looming large among these are historically high debt levels, both private and public, and rich valuations, notably for residential property,” warns the BIS.
In addition, soaring food prices will add another layer of complexity. “…soaring food prices threaten to trigger major social and political unrest, especially in lower-income countries,” they warn.
Sure, things look bad, but there’s at least one bit of positive news — the worst level of stagflation is unlikely. Stagflation is a recession with high inflation levels, combining to make things worse. Employment falls, economic growth falls, but prices continue to climb higher. While they worry it’s possible, they see 1970s-style stagnation as unlikely due to more advanced monetary policy and macroprudential frameworks.
However, they warn that the high debt loads and “overvalued” assets are likely to magnify any downturn.
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