Insight – Economic warfare pushes business cycle to tipping point


The longer the war lasts, the greater the risk of an economic downturn, according to the chief executive of commodities trader Vitol at a recent CEO conference hosted by the Financial Times.

Recession risks were already high prior to Russia’s invasion of Ukraine and the ensuing spike in commodity prices and disruption of supply chains have compounded adverse economic trends.

Recessions have proven notoriously difficult to predict or identify when they start, even for the most erudite researchers of the business cycle.

For the most part, recessions are caused by a complex interaction of output, employment, prices, costs, productivity, interest rates and credit, among other variables, rather than a single shock. external factors such as a spike in oil prices.

But a sudden rise in the price of oil, or some other shock, can serve as a tipping point if the business cycle has already become susceptible to a pullback, as it likely did in early 2022.

Cost of living crisis

Prior to the Russian invasion, leading economic and financial indicators painted a mixed picture of the state of the US business cycle.

Output and employment indicators were strong, suggesting a recession was unlikely for at least six to 12 months, but price and income indicators were more pessimistic.

US manufacturing output rose nearly 1.2% in the three months from November to February, according to the Federal Reserve, implying that the economy had strong positive momentum.

Manufacturers reported a general improvement in economic conditions, with the Institute for Supply Management (ISM) composite indicator standing at 58.6 in February.

The ISM index was well above the 50-point threshold, signaling an expansion rather than a contraction, although it has already started to pull back from a peak in the summer of 2021.

The number of non-farm payrolls rose by more than 1.7 million between November and February as businesses reopened and rehired after the coronavirus recession and shutdowns.

But core consumer prices for items other than food and energy have risen at an annual rate of more than 6%, consistent with the onset of a recession in previous business cycles.

The Treasury yield curve had flattened considerably and the spread between two-year and 10-year bonds had narrowed to levels consistent in the past with the onset of a recession or at least a mid-cycle slowdown.

Real personal income less transfers (LTIP) fell 0.3% between October and January, according to data from the US Bureau of Economic Analysis, as wages failed to keep up with rising prices.

The LTIP is one of a series of indicators that the National Bureau of Economic Research’s Business Cycle Dating Committee uses to identify peaks and troughs in the business cycle.

The LTIP’s three-month decline put the indicator in the 14th percentile only for every month since 1990, which helps explain why consumer sentiment has fallen even as job growth has continued.

LTCP growth fell to rates that heralded the onset of recessions in 1990, 2001, 2007 and 2020 and mid-cycle downturns in 1995, 2005, 2012 and 2015.

The contrast between the strength of manufacturing output and business surveys on the one hand and the weakness revealed by the LTIP on the other confirms that the main problem in the economy is the crisis in the cost of living.

Russia’s invasion and the sanctions imposed in response have intensified this problem by driving up oil and gas prices and disrupting other manufacturing and food supply chains.

turning problem

Recessions are difficult to predict in real time because, by definition, the onset of a recession is also the peak of the previous expansion.

Business cycle downturns always begin when economic and employment conditions have been relatively good until recently.

The recent momentum encourages forecasters to be overly optimistic about the persistence of positive conditions and they underestimate the likelihood that the economy is at a turning point.

“The biggest errors in forecasting (…) are made near turning points in the business cycle and the growth cycle, especially the peaks,” wrote economist Victor Zarnowitz in his landmark study of business cycles. .

“Many forecasts are overly influenced by the most recent events or developments; they rely on the persistence of local trends and are insufficiently cyclical,” he said. (Business Cycles: Theory, History, Indicators and Forecasts, 1992).

Forecasters also have professional reputational reasons for maintaining an optimistic outlook and predicting a soft landing for the economy.

“A forecaster is naturally concerned with avoiding erroneously or prematurely predicting a downturn ahead of others, which is why some indicator warnings are overlooked,” Zarnowitz wrote.

As a result, professional forecasters generally fail to identify turning points before they have happened, even when the data starts to turn unfavorable.

shock the system

The crucial question is whether the invasion and sanctions will worsen adverse trends in the economy enough to push it into a significant downturn or even a full-blown recession.

The economic shock caused by the Russian invasion is much less than that created by the spread of the coronavirus epidemic around the world in the first quarter of 2020.

But it is at least as important as the shocks caused by Iraq’s invasion of Kuwait in 1990, the Iranian revolution in 1979 and the Arab oil embargo in 1973, all of which were followed by recessions.

The current shock is also spreading through multiple channels simultaneously, including the energy system, the food system, manufacturing supply chains, the international freight network, and the global payment system.

To complicate the picture, the US Federal Reserve and other major central banks are trying to reduce inflation, limiting their leeway to cut interest rates or ease credit conditions to offset any negative impact on activity. companies.

Recessions usually occur when, as today, there is a contradiction between political objectives, forcing central banks and governments to make an uncomfortable choice, prioritizing other objectives at the expense of a temporary slowdown in the growth of production and employment.

The scale and complexity of the current shock make the impact on the business cycle particularly difficult to predict, but in the context of an already serious inflation problem, it is likely to be significant and negative.

Even if the United States manages to avoid a recession, Europe is much more integrated into the Russian economy, and the probability of a recession is therefore much higher.

The more the conflict and sanctions escalate and the longer they persist, the greater the disruption to the economy and the greater the likelihood of an ensuing recession. —Reuters

John Kemp is a market analyst at Reuters. The opinions expressed here are those of the author.


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