Recession could be ‘pretty brutal’ if Fed goes too far, professor says

Ken Rogoff, Harvard University professor of economics joins Yahoo Finance Live to discuss recession potential amid rising interest rates and China’s real estate market impact on its economy.

Video Transcript

- All right, let's talk about the implications of all of this and the implications of higher rates on the economy overall. For that, we bring in Ken Rogoff. He is Professor of Economics at Harvard University. He's joining us now. Ken, thank you so much for being here, first of all.

KEN ROGOFF: Thank you.

- Here is sort of a very visible, real-world impact of Fed policy, right? The rate increase that we have seen in mortgages specifically, and the effect that-- the knock-on effect that has on the housing market. What do you think overall about the effectiveness of Fed policy with fighting this current bout of inflation?

KEN ROGOFF: Well, we haven't had them fight about inflation in a very long time. So whatever models we had, you know, we have to dust off and see. I think we know that their long-lagged effects hits the markets very quickly. It hits equity markets more slowly, housing markets.

But things like employment, the peak effects can be a year off. So it's a very hard-- you know, it's one of the things that makes it so hard for the Fed to get to a soft or soft-ish landing, which I'm pretty skeptical about.

- OK, and so with your skepticism about getting to a soft-ish landing, what would the reality of the economic detriment incurred be if we were to see what many economists are calling for, a recession in mid 2023?

KEN ROGOFF: Well, I mean, I think it could be pretty brutal if the Fed really is hell bent on having inflation come down as quickly as possible to 2% or 2.5%. We have Europe very likely going to recession, China, in at least a growth recession by all measures for them, a recession. That's a lot of pressures on us.

The dollar is very strong and interest rates are rising very fast. So I think the idea that it's going to be a really mild recession if that would be lucky. I'd say it's going to be a tough trade-off for the Fed once the numbers start setting in.

I'm a little worried that having, you know, gone the wrong way in one direction with the change in their framework and not looking at the unemployment and what that was saying about inflation, they're now going in the other direction. And possibly, moving too fast given the long legs.

- Professor, if the economic-- if the economy does get brutal, like you just suggested, do you think this is a Federal Reserve at some point next year that is back to unwinding these aggressive rate hikes they've been taking recently?

KEN ROGOFF: So here's the thing. Yes, but I think where we're going to land at the end of this-- and now I'm looking maybe two years ahead-- is at a level of interest rates higher than we're used to, even after inflation comes down. The real interest rate, the premium of the interest rate over the inflation rate has been extraordinarily low since the financial crisis.

Some people say it's secular stagnation, demographics, low productivity, inequality, what have you. I think if you look at a long horizon, in fact, it was abnormally low in that period. And we're going to get some movement back to mean, meaning that interest rates, even when they start coming down, may not come down all that much.

- So how do we then determine what the sort of natural or stable rate should be, right? Is there any way of sort of gaming that out what that could look like?

KEN ROGOFF: Very tough. My own research sort of speaks to the 10-year rate, which I think will end up at a higher place than we've been used to before the pandemic. But what's going on with the Fed funds rate, with all the regulation and the financial repression, is a little hard to say. So they really have no idea. That's one of the things making it difficult. But if you're asking. I think it will be higher than we're used to.

- For consumers right now what should they be navigating? How can they best navigate, perhaps, even leading into the scenario that you've described?

KEN ROGOFF: Well, I mean, it's a tough picture. We're probably headed towards a, you know, difficult situation coming out of a difficult situation. Certainly, I think employment is the key.

Everybody's been-- particularly, young people have been moving jobs, you know, every six months or a year. They better think twice about that in this period when it might not be so easy to land on another job.

- Ken, I want to switch gears a little bit, because you focus not just on the US, but on the globe as well. And you and some others are just out with some really interesting research on the real estate market in China. Now, so much-- there's been so much attention on the sort of zero-COVID policy and the negative effect that's having on China.

But there's some underlying risk here that you illustrate in this research. We're looking now-- you look at so-called Tier 3 Chinese cities-- some of the smaller cities, although still pretty large-- and that there is this excess of housing stock and that there's been really a sharp slowdown in prices, in housing prices in those areas. What kind of risk is this presenting for the Chinese economy?

KEN ROGOFF: Well, I think it's a huge long-term problem with or without the zero-COVID policy. Housing, real estate, more generally, commercial real estate infrastructure has been the go-to policy for China. I did some research a couple of years ago, peak China housing, showing all the factors that suggested we really have come to an end of it.

And more recently, my co-author and I have shown that a lot of that is concentrated in the more hidden Tier 3 cities-- you know, the Cincinnatis of China, so to speak. But they add up-- like to say, that Cincinnatis of China could be 5 and 10 million people, and, like, maybe Cincinnati is a few hundred thousand. And on top of that, there are a lot of them. They account for 60% of GDP.

You don't see it. People travel to the big cities, they're less visible. But they really have a problem where they've been building like crazy and are sort of getting to the end of the line of that development strategy. And it's not that easy for them to pivot.

- And so what then happens? When we do see China coming out of zero-COVID, at the same time that the rest of the globe is slowing down or even entering recession? I mean, do we see sort of a circular effect here where China's troubles maybe exacerbate the troubles of the rest of the globe?

KEN ROGOFF: Oh, China has been enormously important for the rest of the globe. It counted for, I don't know, like, a quarter of all global growth over the decade before the pandemic, maybe going into the first year, at least according to the IMF. And those days are over.

I think we're looking at much slower growth in China. Who knows what the real numbers are, but much slower growth in China for years to come. And of course, it matters. I mean, it hits commodity exporters the hardest that they have a voracious appetite for commodities.

But European luxury car makers et cetera-- I think it's going to have a very big effect. And that's even without the Ukraine war and whatever happens there and which side China ends up on.

- Ken Rogoff, Professor of Economics at Harvard University. Thanks so much for the insights and the--

KEN ROGOFF: Thank you.

- --forecasts and calculations. All of it. Great conversation.