Stronger than expected performance by global economy in 2023
The world economy has performed better this year than generally anticipated at the beginning of 2023, though the upturn has been modest and significant downside risks remain. The fall in energy prices in the first half of the year has clearly helped to lower headline inflation rates across the globe, thereby easing the pressure on consumers to some degree. The outlook has also been helped by the faster than expected re-opening of the Chinese economy following the prolonged Covid lockdown. However, the recovery in the world’s second largest economy has not been as strong as many thought, with some recent signs of a slowdown, which if sustained, could weaken economic growth in China’s trading partners worldwide and negatively impact global business confidence.
But the key concern is that core inflation, which excludes volatile food and energy prices remains sticky and the impact of tighter monetary policy is more and more being felt around the world. And if core inflation stays elevated for longer than anticipated, then it is likely that more rate hikes will be needed down the line to bring price pressures under control, resulting in a further hit to already stretched household budgets. One of the main problems for central bankers is that the strength of the impact from the rate increases so far is hard to judge, especially after an extended period of very easy policy and the speed at which official interest rates have subsequently been increased. And of course another worry for the global economy is the ongoing conflict between Russia and Ukraine, which could easily at any point again disrupt global food and energy markets. However, despite all the uncertainties, it now looks at this point in time that the world economy will see a “soft landing” rather than an outright recession, which many had predicted.
Underlying inflation remains too high for comfort
Headline inflation rates around most of the world have decreased in recent months due mainly to the drop in energy prices, even though food product and services prices have continued to rise sharply. But core inflation remains stubbornly high in many countries. Services rather than goods dominates core inflation and price inflation on this metric tends to depend on less variables than goods, with labour costs being a key driver. To some degree, the bounce back in services price inflation reflects the ongoing normalisation of demand patterns following the sharp downward shifts seen in the first year of the pandemic. Demand for services has now rebounded, converging towards the pre-Covid path in many countries, while the earlier surge in goods demand, particularly for consumer durables, has fallen back. The significant jump in inflation in 2021-22 has led to a decrease in real wages across the globe. Against that, continued employment growth and fiscal policy support have helped to limit the overall decline in household disposable incomes, particularly in Europe. The underlying weakness of household incomes, and the associated pressures on consumer spending, have prompted concerns in some quarters that the high rates of inflation seen in the past eighteen months or so have been due in part to firms raising their profits rather than simply passing on higher input costs.
All in all, it appears that headline Inflation has peaked for now, and many in the financial markets expect it to fall back towards 2% over the next year or two and remain there even allowing for the recent rebound in oil prices. However, we are not so sure. Further declines look possible in the short-term but the medium-term outlook is more difficult to gauge. Indeed there is every chance that the world economy could be facing into more frequent inflation shocks, coming from a number of sources, including climate change and US-China tensions. Over the last year-and-a-half, underlying inflation has consistently proven to be higher than projected. At the end of the day, the large shocks that have impacted the global economy and the range of factors contributing to higher inflation, both on the demand and the supply side, make it hard to assess the speed at which inflationary pressures may recede on a sustained basis.
Central Banks need to remain vigilant
As widely projected, the Federal Reserve left US interest rates unchanged at its September meeting, but signalled that it’s open to additional rate increases in the future, if required, to combat stubborn inflation. The American Central Bank has already raised rates 11 times in the last 18 months, most recently in July. That’s the most aggressive series of rate hikes since the early 1980s, and leaves the Fed’s benchmark borrowing cost between 5.25% and 5.50%. Clearly, a lot will depend on what happens on the data front in the coming months. However, a rate cut looks a long way off at this stage. Meanwhile, over in Europe the ECB raised rates at its most recent gathering. The European Central Bank increased its main refinancing rate by 25bps to 4.50% and its deposit rate by a quarter point to 4.00%, the highest levels since the adoption of the euro back in 1999. But with the Eurozone economy struggling, the ECB hinted that the latest hike, its 10th in a 14-month long battle against inflation, could be the last in the tightening cycle, though that may be wishful thinking on its part. With UK headline inflation falling to its lowest level in eighteen months in August, the Bank of England at its September 21 announcement ended a run of 14 straight rate increases, but with the Monetary Policy Committee tightly split 5-4 on the decision, there’s every chance the base lending rate won’t peak at its current level of 5.25%, especially as inflation at 6.7% is still the highest of the G7 countries, and well above the Bank’s 2.0% target.
Central bankers face difficult decisions but the reality is that monetary policy will need to remain restrictive until there is clear evidence that underlying inflationary pressures are under control. This may result in additional rate increases in economies in which high core inflation proves persistent. The worry then is that significant additional monetary tightening raises the chances of abrupt asset repricing and risk reassessments in financial markets.
Ireland rebounds in second quarter following technical recession
The most recent figures from the Central Statistics Office (CSO) showed that Ireland’s economy as measured by GDP rose by 0.5% on a quarterly basis in the April-June period. This was a positive development following two quarters of contraction (the definition of a technical recession) in national output. Meanwhile, modified domestic demand, which excludes some of the activities of the multinational sector, and thereby gives a better indication of what is happening in the domestic economy, rose by 1% in the quarter. In the second quarter there was a drop in exports across all the multinationals, implying weaker global demand, but against that, there was a strong jump in industrial output, suggesting that the multinationals may have been stockpiling in the second quarter and exports could recover later in the year. Despite the quarterly increase in both GDP and modified domestic demand in the April-June period, they were both down on an annual basis and indeed economic growth was basically flat in the first half of the year, a sign that at least temporarily, Ireland is moving to a more modest rate of national output after years of very strong expansion.
Still, it is hard to reconcile the GDP numbers with the latest labour market data, showing record employment of over 2.643 million in the second quarter and the jobless rate hovering just above 4.0%. However, the National Accounts data along with the corporate tax figures again highlight how the ups and downs of the multinational sector can distort the headline picture of the Irish economy at any given time. But, the strong labour market suggests that the domestic economy will do well in 2023 and the record numbers at work should ease the burden on households to some degree from the huge rise we’ve seen in the cost of living over the past couple of years. Income tax relief and increases in social welfare benefits in Budget 2024 along with recent price reductions from the main domestic energy suppliers should help boost disposable incomes in the run up to Christmas. Looking ahead to next year, economic growth is likely to remain low by recent historical standards though the labour market will continue to be strong.
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.