Recession not inevitable, but the odds-on outcome next year: BNY Mellon’s Jake Jolly
Major central banks this week signaled their willingness to countenance a global recession in 2023 as they promised to raise borrowing costs further in their ongoing battle against sky-high inflation.
After each increased rates by a half percentage point, the heads of the Federal Reserve, the European Central Bank and the Bank of England all said more increases are likely next year even as they acknowledged that their economies were weakening.
The mounting risk is that an even greater tightening of monetary policy on top of the biggest squeeze in four decades will undermine demand and hiring so much that it forces the world economy to slump next year, so soon after the pandemic-driven contraction.
“We're just on the edge of a global recession,” said Ethan Harris, head of global economics research at Bank of America Corp.
The fastest inflation rate since the 1980s has altered what economists call the “reaction function” of policymakers including Fed Chair Jerome Powell. Normally, they'd be expected to ease credit as economies crumbled to limit damage to households and corporations.
But with price growth well above their two per cent targets, central bankers are moving in the opposite direction, even in the face of economic contractions. And they're insisting rates will stay higher for longer to stamp out inflation – though many investors are betting that stance won't persist as economies buckle and unemployment rises.
“There's a growing sense among the central banks that they'd rather risk doing too much,” Harris said. “They don't want to underdo it and have to come back and hike again later.”
The danger is that central bankers will make the opposite mistake to their one last year.
Back then, they underplayed the dangers of mounting price pressures in economies still struggling after the pandemic. That allowed inflation to get out of control, prompting this year's rapid reversal with huge rate hikes.
Perhaps chastened, officials are now vowing to maintain their inflation fight even though price pressures may be starting to come off the boil, especially for goods, as economies slow and supply chains unclog.
They remain particularly worried about price expectations ratcheting up and elevated pressures becoming embedded in their economies, much as happened in the 1970s.
“The longer the current bout of high inflation continues, the greater the chance that expectations of higher inflation will become entrenched,” Powell said on Wednesday.
President Christine Lagarde declared a day later that the ECB has “longer to go” too.
One exception is the Bank of Japan which is expected to maintain its ultra-loose policy settings next week.
A new worry globally is authorities underestimating how quickly inflation can fall as growth slows and supply chains mucked up by Covid-19 unclog. The threat is that their strict stance could make an already dire situation worse, deepening downturns that central bankers hope will be short and shallow.
“If 2022 was a year of the inflation surge, rising rates and falling equity market multiples, 2023 is going to be a year about the macro cycle,” Joe Little, global chief strategist at HSBC Asset Management, wrote in a report. “We have likely reached peak central bank hawkishness as the headline inflation rates begin to cool.”
BOE officials openly reckon the U.K. is already in a recession, and their ECB colleagues assume the euro region succumbed to one this quarter. Both economies have been hammered by soaring energy costs driven by Russia's invasion of Ukraine.
The US is less exposed to the fallout from the war, but it's still in a danger of a downturn as higher inflation and rates impact the economy. Although Powell has shied away from saying a recession is in the cards, two of his colleagues penciled in a contraction in gross domestic product next year in projections released this week.
While all three central banks are poised to raise rates further in 2023, the increases aren't likely to remain as uniform as this week.
Powell left the door open to the Fed scaling back to a quarter-point hike in February, while Lagarde told markets that they're underestimating the ECB's resolve. She suggested at least two more half-point steps are coming, and announced plans to start reducing a stash of nearly €5 trillion (US$5.3 trillion) in bonds.
Meantime, BOE rate cuts are moving into focus. While a majority voted this week to raise by a half point to 3.5 per cent, two of officials opposed a hike and hinted that policy should soon be eased. They believe three per cent is “more than sufficient to bring inflation back to target, before falling below target in the medium term,” the meeting minutes said.
A key focus for all three central banks is the jobs market. Unemployment in major developed economies, at 4.4 per cent in the third quarter, is the lowest since the early 1980s, according to the Organisation for Economic Cooperation and Development. That's pushing up wages, increasing pressure on companies to jack up prices.
They also need financial markets on their side. If they ease further that unwinds some of the higher borrowing costs
“The overall message for 2023 seems clear: central banks will push back on higher risky assets until the labour market starts to turn,” George Saravelos, global head of foreign-exchange research at Deutsche Bank AG, wrote in a report on Friday. “The world's two biggest central banks – the Fed and ECB - have given a clear message: financial conditions need to stay tight.”
The complexion of inflation each central bank faces is different. In the U.S., “it's all about the labor market,” former New York Fed President William Dudley, now a senior adviser to Bloomberg Economics, told Bloomberg Television.
In the euro region, much of the inflationary impulse comes from energy-supply disruptions, with pent-up demand following the pandemic and the euro's depreciation adding to momentum.
While government price caps are easing the pain for businesses and households, expectations for future inflation are rising. The ECB sees wages growing at rates well above historical averages over the next three years.
The U.K. seems to have the worst of both worlds: Europe's energy price shock and US-style tight labor markets. Wholesale natural gas prices have risen sevenfold since mid-2021 and employment is 200,000 below pre-pandemic levels. Workers have retired early or dropped out due to ill-health.
With vacancies still abundant, labor shortages are driving up wages. Regular private-sector pay is now growing at 6.9 per cent, the fastest this century barring the pandemic.
“It looks to me like the Bank of England has the biggest inflation problem,” Dudley said.
Even so, he reckons the ECB has the hardest job because of the region's exposure to Russian energy supplies, and the vagaries of the winter weather.
“They're worried about inflation,” he said. “On the other hand, they're worried about the energy-price shock and what that could do to economic growth. So I would not want to be in their shoes.”