The following is an edited transcript of an interview that UNSW did with Konark Saxena, Associate Professor in the School of Banking and Finance at UNSW Business School.
How likely is a recession in the US? Percentage chances?
A/Prof Saxena: The chance of a US recession is about 75%, by my estimates.
Why such high odds? In order to bring down inflation, the US Federal Reserve needs to increase interest rates till either inflation subsides, or economic growth starts flattening. Given the Federal Reserve’s mandate and the current momentum of inflation, I feel that economic activity will slow down before the Federal Reserve stops increasing interest rates. Technically, that means that a recession is very likely.
Having said that, I want to point out that there are various types of recessions. My expectation is that the US recession will be a mild one.
In this case, global GDP growth would slow down, but not by as much as the early 1980s, after the Federal Reserve’s Volker increased interest rates to combat inflation. And because activity wouldn’t slow down by that much, inflation wouldn’t slow down by that much either.
This mild recession scenario assumes that the FED would stop tightening before the recession became severe, even if inflation remains persistently high at that time.
What likely impact will this have on Australia, as well as the rest of the world (particularly trading partners)?
A/Prof Saxena: Let’s consider the mild recession scenario. In this case, both inflation and interest rates in the US economy are expected to remain high, while growth flattens. I don’t expect the US unemployment rate to increase dramatically, which is one of the reasons I’m calling it a mild US recession.
For the rest of the world, this has two main impacts. First, lower US growth is going to slow down the growth in the rest of the world. Especially for countries that export to the US, and those that export to other countries like China, which in turn export to the US. This typically also leads to lower commodity demand and prices.
Second, high US interest rates can create financial distress in countries that are unable to match them. High US interest rates will put pressure on countries to either increase domestic interest rates or accept a substantially devalued currency because capital chases currencies with relatively higher interest rates.
This outflow of capital from lower interest rate countries might push some highly leveraged economies into financial distress, especially those with USD denominated debt.
What factors would likely help protect Australia from a global recession?
A/Prof Saxena: The Australian economy has been resilient in a global decreasing interest rate environment. That spans the last three decades. If the US recession leads us back towards a globally low interest rate environment, then I expect Australia to continue to be resilient – even in times when global growth has slowed down.
While the current low level of wage inflation in a high consumption inflation environment is a significant issue, in the short-run, it is also a strength that will protect the Australian economy and helps keep inflation under control.
Further, this low level of wage inflation means that there is more room for fiscal policy to help wages grow to match rising interest rates. Increasing wages can help offset any required increases in interest rates, so that households with higher nominal wages will find it easier to pay off higher nominal interest rates. For example, if a household needs to pay $100 extra in interest every week, but also earns $100 more in wages, then the effect of nominal interest rate hikes is offset by nominal wage increases.
Another advantage of the current low wage inflation, and a good level of fiscal policy flexibility compared to most other advanced economies, is that it gives the RBA more flexibility to keep rates lower for longer than some international peers. This buys us time to fix some of the issues that risk household financial distress.
Where is the Australian economy more exposed?
A/Prof Saxena: In my view, the main risk to the Australian economy is financial distress. I expect the real economy to be resilient if we are able to avoid financial distress.
There are two types of financial distress risks I am concerned about: household financial distress and currency risk.
Household financial distress increases if households can’t pay their mortgages when the RBA increases interest rates too much. Currency crisis risk increases if capital leaves Australia for higher interest rate currencies when the RBA does not increase interest rates enough.
It is a delicate situation and there is a risk that eventually RBA will not have enough flexibility to manage these two conflicting forces.
As mentioned above, I feel one way to avoid these two extreme scenarios, is increasing labour productivity, wage growth, and wage inflation. If households are working and their wages are growing enough, they should be able to handle increases in interest rates thanks to their higher pay cheques. Such wage inflation can help not only working homeowners pay higher nominal interest rates, but it also benefits renters who can save more.
If we can manage an orderly reduction of (nominal) household debt without incentivising too much risk-taking, then it will give the RBA more flexibility to increase interest rates and bring them in line with US interest rates.
What would the likely impact of a recession be on the average Australian?
A/Prof Saxena: Assuming we are forced to keep interest rates low, I see the impact of the recession on Australian consumers on two main fronts – the first of which is imported US inflation.
High US inflation will also increase the price of US goods and services that we purchase from the US, and thereby increase the general price levels around the world. So, the rest of the world will import US inflation unless they can offer higher real rates and strengthen their USD exchange rates to offset US inflation.
The second front Australians may be impacted with is reduced Australian wealth in US dollars, which would lower the ability to import and consume foreign goods and services. This is likely to hurt Australian consumers as our imports from the US are an important part of our consumption basket.
While the first is largely an external factor that Australian policy cannot influence, the second is not. The reduction in (US dollar-denominated) Australian wealth, can be avoided if we are able to sustain higher interest rates without causing domestic financial distress.
Konark Saxena is an Associate Professor at the School of Banking and Finance at UNSW Business School. This article was originally published in BusinessThink, the digital platform of UNSW Business School, an alliance partner of Firstlinks.