[Financial Planning for the 100-Year Life] Decline in Inflation Rate Accompanied by Economic Recession

Inflation Rate Slows Due to Decreased Consumption
High Possibility of Asset Bubble Bursting
US Treasury Yield Curve Inversion Raises Recession Risk

[Asia Economy] The global economy is struggling with the so-called "three highs": high inflation, high interest rates, and a strong dollar. These three highs are likely to end with a recession in the global economy, particularly in the U.S. The core of the three highs is high inflation. Inflation rates, especially in the U.S., are expected to gradually decline, based on the following reasons.

First, demand is contracting. From the first quarter of this year, the GDP gap rate?the difference between actual Gross Domestic Product (GDP) and potential GDP?turned negative. In the first quarter, the U.S. economy shrank by -1.6%, causing the GDP gap rate to fall to -1.4%.

The U.S. economy is also estimated to have contracted in the second quarter. Analyzing statistics since 2000 shows a relatively high correlation coefficient of 0.52 between the GDP gap rate and the consumer price inflation rate.

Second, money supply is relatively decreasing compared to GDP or inflation. The appropriate money growth rate is usually expressed as the sum of the real economic growth rate and the inflation rate. Based on this, in the second quarter of 2020, the actual broad money supply (M2) growth rate was a whopping 29.2 percentage points higher than the appropriate level.

However, in the first quarter of this year, the actual M2 growth rate was 0.7 percentage points lower than the appropriate growth rate. This ratio has had a unilateral impact on the consumer price inflation rate with about a four-quarter lag.

Third, commodity prices are falling. Major commodity prices, which surged due to Russia's invasion of Ukraine, are declining, especially industrial metals like copper. West Texas Intermediate (WTI) crude oil, which exceeded $120 per barrel in early June, recently dropped below $100. Statistical analysis since 2000 shows that WTI price fluctuations lead consumer price inflation by one month, with a very high correlation coefficient of 0.78.

For these reasons, inflation rates are likely to decrease toward the latter half of the year, leading to a decline in interest rates, especially long-term rates. This would ease the degree of monetary tightening in the U.S. and cause the dollar's value to fall. This suggests that the three highs will gradually be resolved.

However, as inflation slows due to a leftward shift in the aggregate demand curve caused by reduced consumption, economic growth rates will inevitably decline. Asset price bubbles, which arose from low interest rates and abundant liquidity, have first burst in the bond market and have begun collapsing in the stock market. The housing market bubble is also likely to burst in the future.

Consumption is shrinking due to a decrease in real income caused by inflation. Additionally, interest rate hikes act as a consumption-reducing factor with a time lag. If the bubble bursts in the housing market as well, consumer sentiment will contract further.

Reflecting this, a recent inversion of the yield curve occurred, where the 10-year U.S. Treasury yield fell below the 2-year yield. Historical data shows that after such an inversion, the U.S. economy inevitably entered a recession, with only a matter of time.

Real interest rates (10-year Treasury yield minus consumer price inflation) also signal an economic downturn. In March this year, the real interest rate hit a record low of -6.4%. For real interest rates to rise, either the nominal 10-year Treasury yield must increase or inflation must decrease. The Treasury yield, which fell to 0.5% in the first half of 2020, rose to 3.5% in June this year.

In the long term, the 10-year Treasury yield has maintained a level similar to nominal GDP growth. The U.S. potential nominal GDP growth rate is estimated at about 4%. There is some room for nominal interest rates to rise slightly. However, for real interest rates to turn positive, inflation must fall below 3%. Such a scenario is expected to appear next year alongside a severe economic recession.

Kim Young-ik, Professor, Graduate School of Economics, Sogang University

This content was produced with the assistance of AI translation services.