As Global Recession Looms, a Perilous Moment for Central Banks

Will there be a global recession?

The global economy is in a very difficult spot, with a real risk of recession.

A significant energy shock, particularly for importers of natural gas, has been layered onto the economic legacy of the pandemic shock. Rising inflation has forced many central banks around the world to tighten policy (i.e., raise rates), adding to headwinds from disruptions in energy markets.

Right now, all the main parts of the global economy are slowing down. China’s economy has stalled because of the combined impact of the property downturn and Beijing’s zero-COVID policy. It is effectively already in an undeclared recession, but it faces less inflationary pressure than the other large global economies. Meanwhile, Europe’s economy looks to be heading toward a recession this winter on the back of the cutoff in Russian gas supplies, and the U.S. economy has clearly downshifted over the course of this year. The dollar’s strength has complicated economic management in many emerging economies around the world, especially those that import oil, gas, or food.

As a result, a central question for 2023 will be how quickly the current global slowdown translates into less inflationary pressure in the major economies. A reduction in price pressure would result in greater scope for central banks to stop raising rates and take some of the stress off currency markets.

What is a reverse currency war? Why is it a concern?

A currency war is a vivid way to describe the policy pressure created when most governments around the world prefer to have relatively weak currencies to help boost exports and make up for demand weakness at home. Not all countries can have a weak currency at the same time, so any action by one country that pushes up another country’s currency could prompt a policy response.

For example, back when the world economy was struggling to recover from the loss of demand that followed the 2007-2009 global financial crisis, policymakers around the world generally wanted weak currencies to support their own economies. Even countries that were doing relatively well worried that U.S. monetary easing would push their currencies up. This concern prompted Brazil’s finance minister to start talk of a currency war. It also led to widespread intervention in the foreign exchange market by countries that didn’t want their currencies to get stronger while the Federal Reserve kept U.S. interest rates low.

Today, the dynamics are different. Most of the world economy is struggling with inflation, and central banks, led by the Federal Reserve, are raising rates in an effort to slow the increase in prices. Many countries are therefore facing pressure to match the Fed’s tightening policy to prevent their own currencies from weakening excessively—a reverse currency war.

The basic economics here are simple: tighter policy in the United States pulls in funds from around the world and thereby strengthens the dollar. This weakens currencies in other countries, which generally supports those countries’ exports and should thus help their economies. But a weaker currency also drives up domestic prices, particularly for traded goods. At a time of generalized inflationary pressures and relatively high global prices for imported energy and food, governments are becoming increasingly concerned about their currency’s weakness, especially against the dollar. Consequently, a number of countries now are raising interest rates in part to limit the depreciation of their currencies.

The theoretical concern in a reverse currency war is that competition between countries to avoid a depreciation could result in too much tightening of global monetary policy, and interest rates would rise by more than is needed to limit inflation. Countries looking only at their own conditions wouldn’t necessarily account for how their trading partners’ policy tightening affects their own activity, or how their own individual decisions would prompt similar measures abroad.

For now, there seems to be significant disagreement or a lack of coordination between governments on how to stamp out inflation. How hazardous is this?

Global monetary coordination is always complicated simply because the world’s leading central banks have mandates directing them to focus on domestic economic conditions. Historically, the Federal Reserve hasn’t wanted to change its monetary policy to make it easier for the Bank of Japan to hold interest rates at zero, and the Bank of Japan hasn’t wanted to raise its own interest rates to help keep the dollar stable against the yen.

In theory, floating exchange rates allow different countries to pursue different monetary policies, with the exchange rate acting as the pressure-relief valve. But that would require a willingness to accept large currency fluctuations.

There are two concerning aspects of the current global situation. One is that the gap between U.S. and Japanese policy is quite extreme, and the yen has reached an exceptionally low value. The other is that the dollar has strengthened significantly against the currencies of countries that are themselves tightening policy.  This is partly because U.S. interest rates are still higher than interest rates in, say, Europe, and partly because the United States is less exposed than most other parts of the world to the Russian natural gas shock.

Moreover, there are increasing difficulties simply coordinating national policy. This is most obvious in the United Kingdom (UK). Even with the reversal of Prime Minister Liz Truss’s proposed reduction to the tax rate for top earners, tax cuts put forward by the UK’s treasury will make it harder for the Bank of England to lower inflation. Last week’s turmoil in the market for gilts (long-term British government bonds) has had an impact on related markets around the world.

Should large economies seek more multilateral coordination on currencies, as they did in the 1985 Plaza Accord?

The dollar has now reached a level against many currencies that is undeniably a problem for much of the world. But in a sense, the underlying problem isn’t the lack of macroeconomic coordination so much as the difficulties created by a large energy price shock that came as many economies already faced underlying inflationary pressure.

Absent a willingness to coordinate monetary policy, the Group of Seven (G7) countries cannot credibly promise to keep their currencies relatively stable against each other. At least one member of the G7, Japan, remains committed to monetary easing. Britain’s recent fiscal loosening via tax cuts also works against any effort to bring stability to currency markets, given its already large external deficit. So the conditions for a collective attempt to avoid further disruptive currency moves don’t seem to be in place.

The history behind the Plaza Agreement is interesting. The Federal Reserve had actually started cutting interest rates well over a year before the agreement, and the dollar had been strong for several years before that. By 1985, the dollar’s strength had resulted in an unusually large U.S. trade deficit. There was thus an argument that the foreign exchange market hadn’t caught up with important shifts in the macroeconomic fundamentals. That isn’t the case right now.

That said, it is possible that there will come a time when the G7 countries all agree that the dollar has stayed strong for longer than the underlying fundamentals warrant. Until that happens, the discussion around a new Plaza Agreement seems premature.

What’s more likely is that individual countries will take action to support their currencies, as Japan did recently. Other Asian economies are acting similarly. Many countries around the world have resisted pressure for their currencies to appreciate and in process built up substantial war chests of foreign exchange reserves. They consequently are in a position to sell their reserves now to try to take some of the pressure off their currencies, which would make it easier to afford essential imports. There is a debate about how effective intervention in the foreign exchange market can be without changes in monetary policy, but this intervention does provide scope for countries to support their own currencies without needing to wait for global agreement. 

Would China need to participate in such an agreement?

I actually don’t think it would. In theory, China manages its currency against a basket of the world’s other major currencies, though at times it seems to primarily manage against the dollar. That means that if the G7 countries keep their currencies stable against each other, China’s currency management naturally gets easier.

But there is a much bigger question looming on the horizon, namely whether China will decide it wants a weaker currency to help boost its own troubled economy. So long as China’s economy remains in a prolonged stall, there is certainly a risk of a globally destabilizing move in the yuan against the currencies of all its trading partners, not just the dollar.

If inflation does remain elevated for a long period, how would this harm the global economy? Who is likely to suffer the most?

The distributional impact of high inflation depends a bit on the sources of the inflationary shock. Inflation driven by higher prices of heat and food hits those with low incomes particularly hard.

That said, central banks worldwide are currently committed to bringing inflation down even if that means sacrificing output. The long-term risk of entrenched inflation is thus less of an immediate concern than the risk that the measures adopted to contain it work too well, and that the current global tightening combines with China’s property slump and energy market disruptions to give rise to a strong global downturn. Financial markets are clearly nervous. Disinflation is often difficult to achieve without a recession; energy shocks are hard to manage in normal times; and China looks to have exhausted its investment-driven growth model.