Nouriel Roubini details prediction for Fed hard landing: 'More distress, more recession'

NYU Professor Nouriel Roubini joins Yahoo Finance Live anchors Julie Hyman and Brian Sozzi from the 2023 World Economic Forum in Davos, Switzerland, to discuss the state of the labor market, a recession, Fed policy decisions, and the outlook for the economy.

Video Transcript

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JULIE HYMAN: Dr. Doom is how he's known, although at our All Market Summit last fall, he told us he prefers Dr. Realist. I'm talking, of course, of NYU professor and economist Nouriel Roubini. We talked to him today about some of the themes being discussed here at Davos, what has been dubbed the poly-crisis going on right now, all of the things in the world going wrong, climate crisis, the Russian invasion of Ukraine, et cetera.

His book is called "Megathreats," which is basically a different word for the same thing. Listen now to our conversation with Nouriel Roubini.

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NOURIEL ROUBINI: I've been speaking about megathreats, not just economic, monetary, financial, but also political, geopolitical, environmental, health, technological, de-globalization. And now this buzzword of polycrisis, the same idea as megathreat is one that everybody is using. I was on the stage with the head of the IMF last month in Washington. And she spoke about that confluence of calamities, saying that the world economy has never faced so much threat since World War II.

Larry Summers made the same kind of arguments. And the WEF just published their World Global Crisis Report which again is talking about severe threats and about polycrisis. And there are all these interconnected threats that are both on the economic side, political, geopolitical, social, environmental, health, technological, and so on.

So I think is becoming something of a common wisdom. And the topic of the WEF this year is cooperation in a fragmented world, the emphasis is on the fragmented because there is not much cooperation in a world in which there are geopolitical depression and great powers are rivaled with each other on most things.

So it's a world of megathreats or polycrisis. It doesn't matter how you call it.

BRIAN SOZZI: It's all disturbing.

NOURIEL ROUBINI: It's just the same idea.

BRIAN SOZZI: In large part because that fragmentation, Nouriel, there's a lot of CEOs here predicting a mild recession. Do you think they will be surprised by the severity of any recession we do get, if we do get one?

NOURIEL ROUBINI: Yes, the consensus about the short and shallow recession, a couple of quarters of negative growth, and then you have a collapse of price and wage inflation. The Fed, ECB, and others stop hiking by midyear. Then they cut rates by the second half. And then markets and economy grow again.

I'm skeptical for many reasons. Reason number one is that there will be a spike in commodity prices this year, not just energy but also all across the board, other ones. Goldman Sachs actually predicts a 42% increase in commodity prices this year.

And the reason is there has been a massive underinvestment in new capacity, not only in oil and natural gas but across the board. Demand is growing gradually, with China coming back to growth. There'll be more demand-supply constraints. They will have a spike.

Second reason is that labor markets all over in advanced economies are very tight. Unemployment rate is very low. Labor force participation rate has fallen. Aging of populations, restriction to migrations, the Great Resignation, labor strife, fiscal policy are pro-labor. So you don't need more than 5%, 6% wage growth like in the US with productivity of 1% to have unit labor costs going up 5%, and therefore inflation getting stuck around five. It's easy to go from 10% to 5%. It's much harder to go from 5% to 2%.

And in the service sector is dominant in the economy, it's mostly labor costs rather than raw material and so on. So my view, markets and Fed, ECB will be surprised on the upside on how much. While inflation has fallen now, it's going to remain sticky around 5%-6%. And then they'll have a very tough dilemma.

Either they raise rates more, say, towards 6% for the Fed, above 4% for the ECB, and they cause a real hard landing. And at the top of the heartland there is also a financial crash, stock market, credit spreads, bond yields, and so on. So you have economic, financial crash, so a real hard landing.

They feed on each other. As you have more distress, you'll have more of a recession. And more recession means more distress on the debt side. Or as I believe, they're going to wimp out, they're going to blink. They're not going to raise enough. But then you have a de-anchoring of inflation expectations. You get the wage-price spiral. And then you end up, again, with stagflation. And you postpone that crisis by a couple of years.

So damned if you're doing them, damned if you don't. I think the optimism is really misplaced.

BRIAN SOZZI: Well, do you think the Fed would be to blame here? They're unwinding this massive liquidity here, raising rates. They have raised rates aggressively. The US housing market is slowing down. Aren't they the ones to blame for a potential massive recession in the US?

NOURIEL ROUBINI: Well, inflation got out of control in part because there was a loose monetary credit, fiscal policy. So the Fed has to be blamed, like other central banks, for not seeing the rise of inflation.

Secondly, there were also negative supply shocks that reduced growth and increased inflation, like the impact of COVID on production, on global supply chains, on labor supply, the impact of Russia-Ukraine on global commodity prices, and of course until recently, the zero COVID policy of China. So it's a combination of bad policy and bad luck.

Now they have to make up for it. But the problem is that if they raise the rates enough, they cause an economic and financial crash. And in my view, we are in a debt trap. There is so much private and public debt in the world, rising from 100% of GDP to 420% in advanced economies since the '70s, that you cause not only an economic crash but also financial crash that feed on each other.

Therefore, they'll have to wimp out. And therefore, we're going to live in a world of much higher inflation, around 5%-6% as opposed to 2%. That's where we're going.

JULIE HYMAN: Let's talk a little bit more about that potential financial crash. We talked to you back in the fall at our All Market Summit. And you talked about some of the same themes. Now, here we are in the new year. And most of the strategists, at least in the United States, are looking for a little bit of a gain in markets this year.

It doesn't-- from what you're describing, that doesn't sound like that's a scenario that you would be predicting. How bad is it going to be this year in equity markets?

NOURIEL ROUBINI: Well, if you believe in the softish landing scenario of a short and shallow recession with a couple of quarters of negative growth, say Q1 and Q2, then the market is a bit wobbly, but by the time that there is a slack in goods and labor market because of that recession, you have a drop in price and wage inflation, then the Fed doesn't go all the way to 5.25%, stays around 4.75%. And then they cut rates already in the second half of the year. And then you have a happy endings for growth and for the markets in the second half of the year. That's assuming that, actually, the markets are right.

First of all, the Fed is telling the markets, no way. Even if we're optimistic, inflation is going to be slightly higher than you expect. We're not going to have a real recession. We'll have a soft landing. Therefore, we have to go all the way to 5.25%, stay and hold until the end of the year, and then cut rates next year.

So there's already a massive disconnect between markets and the Fed. And the markets being ahead of the curve makes the problem of the Fed worse because the easing of financial condition, with stock market going higher, bond yields falling, the dollar weakening, credit spreads narrowing implies more growth. And it makes it harder for the Fed to achieve their inflation. And they have to tighten, actually, more being given this tug of war between markets and the Fed.

What I'm saying is that both the Fed and the market will be surprised on how sticky inflation is going to be once it gets around 5%-6%-ish. And then either they do much more, causing economic and financial crash, in which case the equity markets are going to be really sharply down because, in a severe hard landing from current level, equity prices will have to fall another 20%.

Or they wimp out. If they wimp out, then the market's going to rally. There'll be a Powell put for a little while. But then once you have a changing of inflation expectations, long rates rise. And then you still get, down the line, a crash of the stock market. You just postpone it by six months.

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