In Fathom’s Global Outlook, Autumn 2022 the single most likely scenario sees all major global hubs enter recession. The UK and euro area are already there, as the cost-of-living crisis bites. The US is not there yet but is expected to join Europe before the year is out.. Policymakers and commentators failed to anticipate this swift return to recession — so how did we get here?
In the wake of the pandemic, the recovery in aggregate demand has outpaced the recovery in aggregate supply by a substantial margin in both the US and UK. It is likely that policies adopted through the pandemic played a big part (i.e., financial support led to excess savings and, in turn, to the so-called ‘big quit’). But, not only has demand outstripped supply — the composition of demand has changed too, with consumers pivoting away from spending on services and towards spending on goods. This led to a surge in shipping costs as supply chains were squeezed. However, the peak impact of this shock on inflation has now passed.
A similar thing can also be said of the inflationary impacts of higher commodity prices. Russia’s invasion of Ukraine briefly pushed oil prices higher, and propelled European gas prices much higher for a sustained period. The fragmented, regionalised nature of gas markets has meant that that particular shock was always more limited to European economies (US gas prices have remained relatively stable in comparison). However, gas prices are now on the decline.
Therefore, in the absence of another energy price shock, the main upside risk to inflation is that it becomes self-sustaining through second-round effects.
One thing that could provoke these second-round effects is tightness in the labour market. This risk appears especially pronounced in the US, where unemployment has fallen dramatically from its peak in 2020. Cyclical tightness in the labour market can amplify existing inflationary pressures, as it gives workers increased bargaining power in wage negotiations (leading to a so-called ‘wage-price spiral’). The ratio of job vacancies to unemployed workers is one metric through which labour market tightness can be judged. In the US, this ratio is at historic highs (there are roughly two vacancies for every unemployed person).
The scatter chart below plots how wage and consumer price inflation have evolved over time. As can be seen, there is very little evidence of a relationship between these two concepts when consumer price inflation is low. However, when it rises substantially above target, we start to see evidence of wages rising in response. The orange dot plots the latest data point. As can be seen, the US appears to be in the early stages of a wage-price spiral. Wages have responded to higher inflation. However, they have done so by less than they might.
Wage-price spirals are an example of a ‘second-round effect’ that could keep inflation higher for longer. Dependent on the extent of the second-round effects, a more significant tightening of monetary policy may be required to bring inflation back under control. Indeed, the last time US inflation was this high and the US economy managed to avoid recession was in the 1950s. This simple observation suggests that there is a high likelihood that all the major advanced economies will experience a recession soon. Whether this time could be different is one of the key questions covered in Fathom’s Global Outlook, Autumn 2022. 
 Charts from Fathom’s Global Outlook, Autumn 2022 are available now for all Refinitiv users via Chartbook’s Global Overview folder.
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