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Our views 06 January 2023

2023: Recessions, peak rates and lower inflation

5 min read

Compared to September, the GDP growth forecasts have generally been revised lower but still show modest recessions, especially compared to the falls in activity seen in the financial crisis (let alone during Covid).

Recession forecasts for major economies are driven by monetary policy tightening, households struggling against the weight of a high inflation environment and firms holding back on investment decisions in the wake of high costs and economic uncertainty. We are getting closer to a pause in central bank hikes, but aren’t there yet; Inflation may be falling now, but is still high, and a full return of inflation to central bank targets is not yet assured.

Activity growth: In recession already?

Global growth is being pushed down by struggles related to high inflation, an uncertain economic environment and by tighter financial/credit conditions. The strong dollar won’t be helping in many countries, exacerbating cost pressures. The global composite Purchasing Managers Index (PMI) business survey measure is already below levels where economists tend to start talking about global recessions. Given all the challenges the global economy faces though, it is surprising that growth signals aren’t weaker. The US looks set to record robust GDP growth rates in Q4 2022 on current now-casting estimates and PMI business surveys in the UK and Euro area are consistent with only very modest falls in activity.

Consumer key: We are unlikely to be through the worst for consumer spending growth. In Europe, some government support measures are explicit one-offs or planned to become less generous. Employment demand is already cooling; unemployment rates are likely to rise in 2023. Higher mortgage rates will feed through to consumers over time and weaker housing markets will weigh somewhat. However, real income growth should improve as inflation falls in 2023.

Rate driven recessions and the role of the labour market: Tighter monetary policy – both further tightening and the lagged effects of past tightening are set to drag on growth in 2023. But how much monetary policy drags on growth will partly be a function of the labour market:

  1. Tight labour markets, a degree of labour hoarding and likely relatively robust nominal pay growth should help the recession stay modest for now;
  2. However, if pay growth remains strong, hitting an inflation target may require central banks to slow the economy even more.

So how do economies avoid much tighter monetary policy and severe recessions? Wage growth should cool somewhat as the year progresses, taking the pressure off central banks. Wage growth is likely to both reflect and cause inflation in economies. To the extent that inflation falls – driven by weaker goods, food and energy inflation – that could also lead to lower inflation expectations and lower wage settlements. The forecasts below assume that headline inflation falls significantly in 2023, led by assumed lower energy inflation with 2022’s steep rises in oil and natural gas prices not expected to be repeated. Core goods Consumer Price Index (CPI) inflation should fall, helped by lower commodity prices and easing supply chain pressures.

Supply constraints on the labour market also seem likely to ease somewhat, taking some of the pressure of wage growth too. The high cost of living is likely to push some people into the labour force. To the extent that stocks of savings have helped some people stay out of the labour market, these are being eroded by inflation.

The China factor: How China could be crucial in how things play out

Having undergone a rapid loosening of Covid restrictions, a consumer bounce could drive much stronger than expected growth in 2023, just as major developed economies are in a downturn. Chinese demand could keep commodity prices and inflation supported…and therefore require stronger central bank hikes than we’d otherwise see. This is a risk scenario, rather than part of the central case, partly reflecting an assumption that a bounce in China demand will be consumer services focused.

Is the UK outlook really that bad? Recent forecasts from the Organisation for Economic Co-operation and Development suggested that the UK’s 2023 GDP growth outlook was the worst in the G20 bar Russia over the next two years. Is the UK really in a much worse place than elsewhere? For now, the (relative) gloom looks somewhat justified. Cost of living pressures remain intense in the UK, monetary policy has tightened significantly and the government have increased the amount of fiscal policy tightening planned for coming years. Mortgage rates may be off their mini-Budget highs, but remain elevated by the standards of recent years, the housing market appears to be slowing significantly, consumer confidence remains very weak. Strikes have become more disruptive for the economy and a poorly performing health service may be dragging on potential growth, alongside Brexit. Given this litany of challenges, my central case is that the UK entered a recession in the middle of 2022 that will likely run for several quarters.

Central bank policy outlook: How close to a pivot?

Pinning down how high interest rates will rise this cycle (terminal rates) is difficult but feels less like a moving target in an environment where inflation has now started surprising on the downside.

How far each major central bank needs to hike rates is a different question to how far they will hike rates, but all three likely want to feel confident that inflation is sustainably going to hit their target and a couple of months of falling inflation simply isn’t enough to pause. That naturally brings back into focus wages, and slack in the labour market as a driver of wages – a key driver of underlying inflation that major central banks will be focused on. However, while central banks can do a lot to influence the demand for labour, there’s much less they can do about the supply. Considerable uncertainties remain about the outlook there.

After the last round of central bank meetings, analysis and commentary, risks to my central bank forecasts have shifted. For the European Central Bank (ECB), while I am forecasting a sizeable fall in Euro area inflation in 2023, it doesn’t sound like inflation will fall fast enough to stop them hiking a couple more times given their recent hawkishness. A higher ECB terminal (refi) rate of 3.50% looks a more reasonable central case than my previous target. For the Federal Reserve’s upper end of the target band, I have raised my peak rates forecast to 5.25% in line with the dot plots. I think they aren’t going to be convinced they’ve ‘done enough’ for a few more meetings (likely after three 25bp rate hikes). For the Bank of England, I still see downside risk to my forecast peak for UK interest rates at 4.5%. However, I’m inclined to keep pencilling it in as the peak while domestically-driven inflation pressures still look relatively strong.

RLAM forecasts except 2022 policy rate (for which the source is Bloomberg). Note: US policy rate is the upper end of the Fed Funds target range. euro area policy rate is the refi rate.

Source: All data are RLAM forecasts except 2022 policy rate (for which the source is Bloomberg). Note: US policy rate is the upper end of the Fed Funds target range. euro area policy rate is the refi rate.

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