Economic Clouds Still on the Horizon Despite Positive Start to 2023
Key data in the early part of 2023 point to a near-term improvement in growth prospects in the world’s largest economies. US activity figures have generally surprised on the upside in the first months of the year, and labour markets remain tight across almost all G20 economies, including in Europe, supporting personal spending. Survey indicators have also strengthened from the troughs seen in late 2022. Indeed, more firms across the globe are reporting rising rather than falling output, with substantial increases in the US, China, Euroland and the UK. Meanwhile, consumer confidence has also started to improve. The improvement in activity and sentiment can be put down to the fall in world energy and food prices, thereby boosting purchasing power. That said, energy and food prices are still well above the levels seen prior to the Covid-19 pandemic, and as a result many lower-income households continue to face huge budgetary pressures.
Core Inflation Remains Too High For Comfort
Headline consumer price inflation and core inflation (excluding food and energy) are still running well above central bank targets, though headline rates have begun to decline in most economies. This is mainly due to the easing of energy and food prices. There continues to be a marked divergence in inflation rates across countries, with inflation still at relatively low levels in some Asian economies, including China and Japan, but extremely high in the likes of Turkey and Argentina. However, the general fall in headline inflation across the world has not been matched by a drop in core inflation as strong cost pressures and, in some sectors, higher unit profits continue to push up prices. Goods price inflation has begun to decrease in most countries, reflecting the broader downturn in the sector last year and the easing of global supply chain bottlenecks. In contrast, services price inflation has continued to rise, with higher energy and transport costs being passed through into retail prices, demand for services strengthening, and unit labour cost pressures remaining high amidst tight labour markets. As long as core inflation stays elevated, the risk to official interest rates will continue to the upside.
Central Banks Still Looking to Raise Interest Rates
The most recent policy meetings of the major central banks gave a clear message that they intend to stay calm and carry on raising interest rates. Although the Federal Reserve hinted that it might now be close to the peak in rates, other central banks remained more hawkish. Norway’s Norges Bank signalled the likelihood of further tightening in June while the SNB in Switzerland raised its inflation forecast and refused to rule out more rate hikes down the road. ECB “hawks” too want to see further tightening before the Summer and the Bank of England also believes it has more to do to combat inflation. The common thread running through much of central banks’ commentary has been that the problems in the US banking sector and Credit Suisse’s downfall are isolated issues. There may be some spill-over into tighter credit conditions, but they believe that they can compensate for this by scaling down their intentions for more rate increases as the year goes on. Furthermore, torn between the risks of repeating the errors made in the 1970s and those made in 2008, policymakers seem confident that they can deploy their balance sheets to stave off any liquidity issues in the financial sector while continuing to raise interest rates to tackle inflation. But bond markets seem to be taking a less sanguine view. Two-year yields have dropped sharply on both sides of the Atlantic in the past few weeks – moves that are reminiscent of March 2020 and August 2007, though they are now back off their recent lows. As well as that, Fed funds futures are now consistent with US rates having peaked and a first rate cut coming later this year. This looks inconsistent with the message that central banks are providing and equity markets are echoing. The bottom line is that the monetary authorities and risk assets appear confident that the banking sector’s problems will remain contained. The bond market on the other hand is not so sure, and neither am I.
US 2-Year Bond Yield %
US Recession Still Can’t be Ruled Out as Tighter Monetary Policy Bites
The resilience of the US economy despite the sharp rise in interest rates has baffled market analysts, with many wondering why growth hasn’t slowed more sharply in response to the Fed’s tightening of monetary policy. Is it the case that the monetary transmission mechanism has changed, or is it simply an issue of long and variable lags? In my view, it’s more likely the latter. If one looks at previous economic downturns, monetary tightening has first shown up in the money supply, housing, and corporate profitability, and that is consistent with the behaviour of the world’s largest economy over the past year. Typical lags would therefore indicate a recession this year. If the economy continues to conform to historical precedent, a recession will be likely before the end of 2023. If I am right it should show up next in the personal consumption of durable goods and in capex spending.
The average behaviour of cyclical variables before recessions
Source: ASR Ltd./Refinitiv Datastream
Ireland Likely To See Another Year Of Healthy Economic Growth In 2023
Provisional GDP data for 2022 showed that Ireland posted real economic growth of 12.0%, again outpacing that of the country’s EU peers. Ireland has been consistently at the top of the European growth league table since 2014. Last year saw not only strong contributions to growth from the multi-national components (information technology and pharmaceuticals) but also from core indigenous sectors like construction, hotels/restaurants and arts/entertainment. Modified domestic demand, seen as a truer indicator of activity in the Irish economy grew at a very healthy 8.2%. Furthermore, employment remains at record highs with 2.575 million people in work as of the fourth quarter of last year, the biggest number ever recorded. Early indications for 2023 are positive, with solid PMI readings, particularly for the services sector. Tax receipts are also holding up very well. As with most countries, inflation remains higher than desirable and many households continue to struggle with the cost of living. And a tight labour market may put upward pressure on wages, thereby keeping inflation elevated for some time to come. Still, the resilience of the economy is there for all to see, and another year of strong growth is on the cards, with a real increase in GDP of somewhere between 5% and 8%, which once more should be better than most/all of the EU. Meanwhile, modified domestic demand is projected to rise by 3% to 5%. However, if a recession does hit the US later in the year, that will have a knock-on effect on Ireland, though it’s impact is likely to be felt more in 2024 than in 2023.
2022 Annual GDP % Change in Constant Prices by Country
Alan McQuaid is a leading economist and media commentator. He has previously worked with the Department of Finance and several Irish firms including both Merrion Stockbrokers and Cantor Fitzgerald Ireland.