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The risks of recessions in Europe, the US and Australia

Economic Policies, News, Recent Media Interview, The Australian Economy, The Global Economy | 13th July 2022

Saul talks to Alan Kohler about the risks of recessions in Europe, the US and Australia stemming from the combination of sharply higher energy prices and higher interest rates, 13th July 2022.

And now, here’s Saul Eslake, independent economist. Well, Saul, is it even possible for Australia to have a recession with the labour market as strong as it currently is?

SE:  Well, one could start from a position where the labour market is as strong as it currently is if the economy were hit by one or more shocks that caused employment to fall significantly. While I don’t think that’s the most likely scenario for the next six to 12 months, you certainly can’t rule it out. There are at least two possible sources of such a shock. One is the significant and growing risk that Europe and the United States could fall into recessions as a result of the combination of sharply higher energy prices, particularly in Europe, and higher interest rates, particularly in the US and the UK.

And while Australia has on two occasions in the last 22 years been able to avoid a recession when the US has had one, in the aftermath of the ‘Tech-Wreck’ of 2000-2001 and during the global financial crises, an important part of our ability to see off US recessions was the very strong impetus we gained at the time from the Chinese economy, which we’re clearly not going to be getting over the next couple of years, irrespective of the state of bilateral relations between Australia and China, simply because the Chinese economy itself is in a much weaker condition than it had been on either of those two earlier occasions.

The other potential source of recession risk in Australia, is if the Reserve Bank ends up either intentionally or mistakenly raising interest rates in pursuit of its goal of bringing inflation down to a level that also results in a significant contraction in employment.

Do you think they’ll do that?

SE:  I don’t think they intend to, I think they feel that they can bring Australia’s inflation rate down from the peak they now forecast to be close to 7 per cent at the end of this year, to their 2 to 3 per cent target range by 2024. They think they can bring that off without inducing a recession and they may…

What’s their record like on that?

SE:  Well, they have done it in the past and two examples, maybe three examples, I think are relevant. The first is the quite aggressive tightening of monetary policy that Bernie Fraser instituted in 1994 when he raised the cash rate by 275 basis points in three months. That was the movement that John Howard famously described as ‘five minutes of sunshine’ in the aftermath of the recession of the early 90s, but that hike in interest rates did stop what looked like being a worrying combination of higher wage and price increases, from becoming something that would ultimately end in recession. Indeed, many would say it helped lay the foundation for the strong growth that Australia achieved over the following 25 or so years.

The second instance was when Ian Macfarlane, as governor of the Reserve Bank, began raising rates in, I think it was May 2002, whilst the Federal Reserve was still cutting US interest rates under Alan Greenspan and he raised them successively through to the end of his term and then Glenn Stevens continued it into the beginning of 2008. That was in response to Australia’s inflation rate rising above 5 per cent in 2007-2008, and as just noted, despite the fact that the US and most other advanced economies had recessions during the financial crisis, we managed to avoid it.

Then the third instance was as the mining boom resumed after the global financial crisis, Glenn Stevens raised the cash rate from the low it had reached during the financial crisis to, from memory, 4.75 per cent, and that also nipped what they feared would be an inflationary impulse from the resources boom, nipped that in the bud without causing a recession either. So, there is some historical basis for…

What about the fact that on each of those previous occasions you mentioned, the starting point was relatively high so that the increase in interest rates was no more than double? I don’t think, in fact, in any of those cases, the cash rate actually doubled. In this case, the starting point is obviously 0.1 per cent and so far, it’s increased 13.5-fold and is likely to increase 18.5-fold fairly soon. Does that make a difference, do you think?

SE:  I guess we’ll find out and that is obviously one way of thinking about the increase in interest rates, but another way is to note that although interest rates have increased by a considerable multiple, the level to which they have increased is still incredibly low by historical standards. The cash rate is now 1.35 per cent, I think it will probably get to 2.5 per cent by the end of this year, that’s an increase of, I suppose, 24 multiple from 0.1 but it is still half a percentage point below the level to which the cash rate fell during the financial crisis when it was described as an emergency low and…

But the Australian households have borrowed a whole lot of money.

SE:  Indeed, they have and that’s why I think the Reserve Bank doesn’t need to raise interest rates to the sort of levels it has done in the past in order to achieve its objective of slowing growth in demand sufficiently to make it much more difficult for firms to pass on cost increases in the form of higher prices to their consumers. They’re also of course banking on the expectation, as are other central banks around the world, that the global forces which sparked this surge in inflation over the last year will also have clearly begun to abate by next year and there’s some tentative evidence that some of those assumptions will be correct. For example, shipping costs which have risen astronomically since the onset of the pandemic, have fallen by about 30 per cent from their most recent peak over the past four or five months and there are signs that some of the gummed up supply chains that have contributed to the very large increases in the price of a range of consumer durables over the past 12 months are also starting to become unstuck.

I mean, it’s early days and the central banks, including our own, can’t assume that that will completely solve their problem because the reality is that one of the reasons why we’re seeing such high inflation almost everywhere in the world is because, with the benefit of hindsight, and it is with the benefit of hindsight, the stimulus that governments and central banks provided in response to COVID was bigger than turned out to be necessary and lasted longer than turned out to be necessary and they’re now scrambling to correct that.

But having said all of that, there obviously is some risk that central banks, including our own, will end up pushing rates to a level that may well be necessary to bring inflation down to where they want it, but also causes, to use an ugly phrase, “collateral damage” to economic activity and employment. The truth is, as central banks tacitly admit, they don’t know exactly how high they need to raise rates in order to achieve their inflation objective and they don’t know what the impact on, as you say, much more highly indebted economies will be of doing whatever they have to do to bring inflation down. That’s why the risk that they overdo it and unintentionally precipitate recession is one that cannot be dismissed at all.

And you and I don’t know either…

SE:  Indeed, we don’t and I’m not pretending to. The only thing that can perhaps be said in favour of Australia having better odds of avoiding recession than, for example, the US or Europe, is that inflation isn’t as high here as it is there. On the most recent reading, it’s 5.1, it’s expected to get to 7. Inflation in the US is already 8.5, in the UK it’s over 9 and expected to go to 11. We’re not looking at that kind of inflation here and hopefully we won’t be.

Thanks, Saul, great to talk to you.


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