Central banks face tightrope act

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Global outlook

Global economic activity is experiencing a broad-based slowdown with price pressures broadening from headline to core measures of inflation. High inflation, tighter policies and high uncertainty are hurting economic prospects. We observe a sharp discrepancy between hard data pointing to still-resilient economies, and leading indicators declining for several consecutive months indicating that large, advanced economies may already be in contractionary territory.

After aggressively front-loading their tightening path to constrain aggregate demand, central banks around the globe started to reduce the pace of their tightening. In many regions, headline inflation may be close to peaking thanks to a decline in energy and commodity prices, an easing of supply constraints and the global economic slowdown. However, inflation has broadened and risks are becoming entrenched, with price increases in sticky areas such as wages, rents, and service prices. Central banks around the world need to keep a steady hand, with monetary policy focused on taming inflation to avoid fuelling expectations of higher inflation in the future.

Growth forecasts for the global economy have been downgraded several times, while inflation expectations have been rising. The IMF expects global growth of 3.2% for 2022 and 2.7% for 2023, and warns of looming risks of recession. Further downgrades are possible. Inflation will remain elevated for longer at 8.8% in 2022, before dropping back down to 6.5% in 2023.

The situation is heterogeneous across regions

While we are observing a synchronised economic slowdown and monetary tightening on a global scale (with a few notable exceptions), countries are presenting different economic outlook and inflation dynamics.

US

The US economy rebounded in the third quarter and will likely expand in the fourth quarter. Economic data ise mixed, but points to a softening momentum. The labour market is at full employment, wages are rising at a healthy pace with solid personal income and spending, but leading indicators suggest that the US economy may soon contract. Headline inflation has probably peaked, but strong employment continues to fuel private demand and core measures of inflation.

The Fed’s aggressive monetary tightening has boosted the Fed funds to a combined 3.75%. To avoid a sharp economic contraction, the Fed will reduce the pace of its tightening path – this has gained traction, but restoring price stability will require constraining further aggregate demand and higher unemployment. The Fed will tighten its policy further and maintain rates elevated for an extended period.

Because of the lagged effect of monetary policy, we expect a significant economic slowdown going forward. However, the policy front-loading has allowed the Fed to gain time and some breathing room. The Fed seems in a better position than other central banks to control economic developments and inflation, and can count on a resilient economy and a solid level of employment.

Eurozone

The Eurozone economy is suffering from historically high inflation, a weakening economy and energy shortages. Europe has been hit hard by the war in Ukraine, the ensuing sanctions and trade disruptions, and remains particularly vulnerable to developments in the energy markets.

After the summer bounce, economic activity is slowing with the industrials sector suffering from high energy prices and weaker global demand. Surveys of economic activity have been in contractionary territory for several months. The labour market is healthy, but consumer confidence is suffering from the sharp squeeze of real disposable income. Despite recent improvements on the energy front and solid fiscal support, a technical recession during the winter appears very likely.

Inflation is broadening and becoming more persistent. After raising rates by a total of 2%, the ECB policy rate is hardly restrictive at 1.5%. Despite the ECB’s stated determination to bring inflation back to target, the rapid deterioration of the Eurozone economy and political tensions could force the ECB to step down the pace of policy tightening. Fiscal policy is becoming expansionary, but with inflation elevated and a looming recession, the harmful stagflation-like scenario of 2022 could last some more time.

China

The 20th National Congress of the Communist Party of China has confirmed the leadership of Xi Jinping for a third five-year term. The new term will be marked by Xi’s tight grip on power, prioritising national security, economic and technological self-sufficiency, and a robust approach to China’s relationship with the West.

The Chinese economy has been slowing down for some time, hampered by regulatory tightening, recurrent Covid outbreaks and strict lockdowns in large economic zones. The economy rebounded during the third quarter thanks to policy support and a bounce on the supply side, but domestic consumption remains weak, and credit growth is soft amid Covid restrictions and rising unemployment.

The real estate sector is in a deep crisis burdened by over-investment and over-leverage. Policy accommodation will continue to stimulate growth, and the authorities are starting to recalibrate the zero-Covid policy. Further steps to relax Covid-related restrictions and policy support will be needed in 2023 to revitalise an economy burdened by excessive leverage and weakening domestic and international demand.

Where is the global economy headed in 2023?

The global economy is facing very uncertain times and economic projections are extremely complicated. The outlook for 2023 will largely depend on inflation developments, the resilience of economies, and the way in which authorities will manage their macroeconomic policy mix.

Elevated price pressures remain the most serious economic threat for the global economy. Global headline inflation will likely peak, but inflation is becoming entrenched with the price of services, rents, and wages potentially increasing further and remaining elevated for longer than expected.

Several central banks announced a step-down in their tightening path or have already moved to a more moderate pace of tightening in order to first observe the full impact of the measures taken so far. Monetary policy should maintain its course to restore price stability and avoid fuelling expectations of higher inflation in the future. Fiscal policy should provide relief to cushion the effect of higher energy prices, but should not counteract monetary tightening and should aim at progressively reducing the debt burden. However, the risks of policy missteps have increased sharply. Policymakers are confronted with the risks of doing too much or doing too little. Over-tightening could push the global economy into a harsh recession or trigger a financial crisis, while under-tightening would cause entrenched inflation, a de-anchoring of inflation expectations and greater costs due to bringing inflation under control. Central banks will be careful to avoid a recession, but we expect them to err on the side of overtightening.

Concerns about financial stability may also influence policy decisions. Years of extremely low interest rates have prompted a staunch search for yield in the riskiest parts of the system and the use of leverage to increase returns. Rapid and forceful policy tightening exposes markets to large financial stability risks. A major financial stability accident could force central banks into an early policy pivot, but such an event would be far from positive for the global economy.

As monetary policy acts with a lag, we will see the full effect of the aggressive front-loading of monetary policies during the coming quarters. Global growth will continue to slow down in 2023, dampened by high inflation, tight economic policies and uncertainty. Because of the synchronised global slowdown, high debt level and tight policies, it is difficult to see where the impetus for a vigorous recovery will come from.

Our base case scenario for 2023

We expect core inflation to decline only progressively to levels closer to central banks' medium-term objectives. With inflation elevated and policy rates remaining restrictive, we expect the global economy to enter a shallow recession with a couple of quarters of negative growth (technical recession), followed by a period of dismal growth hampered by persistent inflation and tighter policies.

However, there are considerable differences across regions. The Eurozone and the UK may already be in a recession, the US may narrowly escape one depending on the future path of the Fed’s monetary policy, while growth in China will largely depend on the reopening process and its ability to manage the property market crisis. Emerging economies in Asia and Latin America seem to have managed inflation risks and may be positioned to support global growth in 2023.

We see the risks of a deeper recession as moderate as labour markets remain solid, consumer and business balance sheets are healthy, banks are in a much better shape than after the global financial crisis, and central banks will be careful in their tightening path to avoid a sharp contraction of economic activity.

Risks for the base case scenario
There are several downside risks to this scenario. A de-anchoring of inflation expectations could force central banks into more aggressive tightening. Tight financial conditions may induce a financial stability crisis or emerging market crisis. Major macroeconomic policy mistakes, or further geopolitical crises, could tip the global economy into a sharper and longer-lasting recession than expected.

There are also some upside risks to this scenario. Tighter financial conditions could work their way through the economy, weigh demand down and subjugate inflation earlier than expected; a rapid resolution of war in Ukraine with a subsequent improvement of the energy crisis in Europe and an easing of geopolitical tensions, combined with China’s decision to progressively ease the strict zero-Covid policy, could cause a faster and more powerful economic recovery in 2023.