By Nikolaj Schmidt, chief international economist at T. Rowe Price
Over the past few months, it has seemed like economists have been in a race with interest rate markets to see who can be fastest to change their monetary policy outlook. As interest rates go up and central banks indicate an acceleration of tightening, predictions of a recession are starting to make a comeback.
With the US Federal Reserve expected to hike rates up to seven times in 2022 and begin a balance sheet runoff, it is not difficult to see why some investors are worried about the spectre of overtightening. While inflation remains elevated, the Fed and other leading central banks are unlikely to become more dovish. However, even though this may lead to a bumpy ride through the first half of this year, predictions of a recession in 2023 are premature.
Four headwinds to growth
The global economy faces several headwinds that will hit growth hard over the coming months. First, inflation has been rising faster than wages, causing real income growth to flatline across the world. Unsurprisingly, retail sales indicate consumers have lost their mojo. Given the additional pressures of broad‑based inflation and rising oil prices, this headwind appears likely to continue over the next quarter or two.
Second, fiscal consolidation will deliver another blow to US household incomes, as the failure to pass the Build Back Better fiscal package will see the expiration of the Child Tax Credit. These hits to household income come at a time when the consumption of goods is bloated and already in need of an adjustment.
Third, during the second half of last year, financial conditions turned from a tailwind to a headwind – one that has accelerated amid growing inflation concerns. The tightening of monetary policy by the world’s central banks has been synchronised, but completely uncoordinated. When that happens, it usually ends up with financial conditions being tightened excessively.
Finally, Europe, battered by sharply rising energy prices, is confronted with a war on the continent. Rising uncertainty tends to weigh on activity the same as a monetary tightening. Russia’s invasion of Ukraine, and the Russian sanctions, are likely to cause long-term disruption. Given the pivotal role of Russia in the European energy supply chain, it is only too easy to see how additional uncertainty will deliver another blow to household and business wallets.
Why recession is unlikely
If all these concerns are weighing on the outlook for growth, then why do I think warnings of a recession in 2023 are premature? Recessions usually originate as the result of the interaction of two forces – a shock, which often takes the form of an aggressive tightening of monetary conditions, and an amplifier, a real economy imbalance as the economy grows above potential for some time. The interaction between these two forces creates a negative feedback loop, which tends to push us into a recessionary tailspin.
Central bank tightening means we have a fertile ground for the shock – indeed, this is one of the reasons I expect a near-term growth scare. However, the economy probably has not accumulated a sufficiently large real economy imbalance to create a negative feedback loop.
After a decade of deleveraging by the private sector, there were no major imbalances prior to the Covid shock and there has not been a capex boom since. Household consumption of goods is above the historic norm and in need of adjustment, but this is unlikely to tip the economy over the edge. While labour markets are tight and will likely cause a slowdown in global growth, consumer and corporate balance sheets are strong.
Other factors should also boost the global economy’s resilience. Capex, for example, has fallen meaningfully below trend since Covid, which suggests there is some pent‑up demand. Additionally, supply chains should begin to normalise as we progress through 2022, which will provide another fillip to production and, most likely, to demand.
More market volatility ahead
Could I be wrong? Yes. My most obvious concern is the interaction between inflation and the labour market. Inflation and wage pressure may prove to be so stubborn that the only way for the central bank to return to inflation targets is via a recession to restore substantial slack in the labour market.
Where does all this leave financial markets? The combination of high inflation, central bank tightening, and slowing growth will not be welcomed by risk assets, which I expect to remain volatile throughout 2022 – or at least until central banks are convinced inflation has returned to a trajectory compatible with inflation targets.
Tighter monetary policy combined with slowing growth will likely result in a further flattening of the yield curve in the core economies – most likely characterised by a resilient front end and, in the near term, a rally in long yields.
