Treasury Secretary Janet Yellen, who has spent the last year touting low unemployment and rapid growth, delivered a different message on Wednesday: New risks will test the strength of the U.S. and global economies.
Yellen said that with prices spiking around the world, especially of key commodities like oil and wheat, she's worried about the possibility of a recession in Europe, which is most vulnerable to the fallout from Russia's war on Ukraine. She also said the Federal Reserve would need a combination of "skill" and "good luck" to rein in inflation without killing a booming U.S. job market.
She's not the only policymaker who's concerned.
With the U.S. government reporting this week that inflation has hit a four-decade high and the Fed cranking up its efforts to drive down prices, President Joe Biden's economy faces a dizzying array of risks. Growth was already expected to slow this year after 2021's blistering 5.7 percent expansion, as both Congress and the central bank pull back support for the economy. But the hits keep coming — higher energy prices, a slowdown in China and the possibility of a Fed-induced recession.
Here are the big challenges ahead.
The Fed as ‘bobsled driver’
The largest threat looming over the economy is the central bank's campaign to raise interest rates, designed to reduce spending and curb inflation. But what that really means is that the Fed is going to slow growth, and that will have consequences for American workers.
The labor market has been roaring, adding an average of 600,000 jobs a month over the past six months, and as wages have risen, more people have come back into the workforce. That, coupled with the fact that there are more job openings than workers, has stoked hopes that the Fed can reduce demand for workers without leading to an increase in unemployment. But the harder the Fed slams on the brakes to halt inflation, the greater the collateral damage. And the central bank has frequently caused recessions in past inflation-fighting episodes.
“The only thing a bobsled driver can do is put a brake on,” said William Spriggs, a professor at Howard University and chief economist at the AFL-CIO. “If for whatever reason you missteer the bobsled, that’s it. You’re just stuck on the ice.”
The Fed is aiming for a so-called soft landing, meaning it would slow the economy while avoiding a recession. And economic forecasters at some of the largest global banks — Deutsche Bank, UBS and Bank of America — have said the 8.5 percent surge of inflation in March may be the worst of the price spikes, in part because the central bank will step in.
But success is far from assured. Killing inflation while preserving job growth is “not an impossible combination, but it will require skill and also good luck,” said Yellen, herself a former Fed chief, during a speech at the Atlantic Council.
Businesses have also amassed high levels of debt, and as the Fed lifts interest rates, that debt gets more expensive, which could begin to really sting for some companies. Those fears have been playing out in the stock market, where investors have been trying to assess which firms to bet on long-term.
“There’s a ton more corporate leverage now,” said Megan Greene, a senior fellow at Harvard Kennedy School and global chief economist at the Kroll Institute. “That’s fine as long as rates are low and profits are high, and to be fair, companies have built up their cash positions.”
“But if the Fed is going to hike to 3 percent by the end of the year,” as some are forecasting, “that’s going to cause some defaults, and it’s going to cause some pain in the economy,” she added.
The supply chain problems that Powell can't fix
The inflation the U.S. is experiencing, the highest since the early days of the Reagan White House, has been fed by global production and shipping delays as the pandemic shut down factories and led to a worker shortage. But it’s not clear when that will get better, which means inflation might stay stubbornly high for some time.
That, in turn, will put pressure on the Fed to do more to combat inflation, even though its tools can’t fix supply problems, only the demand side. Fed Chair Jerome Powell said in a speech last month that he was optimistic these bottlenecks would begin to ease this year, helping the central bank even out the mismatch between demand for goods and supply, but he admitted he can’t bank on that.
“It continues to seem likely that hoped-for supply-side healing will come over time as the world ultimately settles into some new normal, but the timing and scope of that relief are highly uncertain,” Powell said.
War fallout: ‘Like a big tax increase’
Energy prices rose sharply after Russia’s invasion, a phenomenon that is reverberating throughout the global economy. As oil prices rise, so do transportation costs. Higher oil and gas prices could raise the costs of energy-intensive components like steel, cement and plastics that are used across industries.
“It’s like a big tax increase,” said Joseph Gagnon, a macroeconomist at the Peterson Institute for International Economics. “People have to heat their homes, factories need energy to run. Which means you have less money to spend on non-energy things, which means it throws some people out of work.”
Gagnon said the U.S. was in a better place than Europe because it’s actually an oil exporter, which means the American economy will see some offsetting benefit to higher oil prices. But “those who are losing are going to cut back their other spending faster than those who are earning are going to spend it.”
The conflict in Ukraine is complicating supply chains, just as manufacturing has started to see some improvement on the labor side as lots of people rejoin the labor force.
Russia's invasion "is likely to be a hit to global growth, and for all those countries that already suffer from food insecurity, this is just a tremendous concern," Yellen said.
The China factor
European Central Bank President Christine Lagarde has also cautioned that the war in Ukraine poses significant perils to Europe's growth — souring sentiment and stoking inflation, which has been unusually high on the continent, too. Meanwhile, China’s economy has been slowing, a dynamic that will only intensify amid renewed lockdowns from the latest coronavirus variant.
For the U.S., that means less interest abroad in its exports. That's not likely to cause a recession on its own, but it’s one more reason why growth will slow, making the economy that much more fragile to outside blows.
“If the EU goes into recession or flatlines, that drags on demand,” Greene said. “Generally, the external demand picture for the U.S. doesn’t look great. You have to wonder what’s going to be the engine for growth.”
Lurking financial risks
Then there’s always the danger that something unexpected breaks. U.S. business debt ballooned to $18.5 trillion by the end of last year, a more than $2 trillion increase compared to the end of 2019, when corporate borrowing was already historically high, according to Fed data. As interest rates rise, that debt will become more expensive and could lead to defaults, cascading through the financial system. Meanwhile, risky investments surged during the pandemic — from cryptocurrencies to shell companies known as SPACs. If some of the bubbles pop, it could cause pain even if it doesn’t lead to an economic downturn.
JPMorgan Chase CEO Jamie Dimon on Wednesday said he’s still optimistic about the economy in the short term but warned of “significant geopolitical and economic challenges ahead.”
“I’m not predicting a recession,” Dimon, who runs the largest U.S. bank, told reporters. "But is it possible? Absolutely.”
