Notwithstanding the Russia/Ukraine conflict, last year was one that saw the persistence of high inflation dominate almost all other stories, resulting in a very aggressive monetary policy response by global central banks.
At this juncture, it’s tempting to say that 2023 will see many of the 2022 economic/market trends shifting into reverse. Last year’s world economic slowdown should help bring inflation down, allowing central banks to stop tightening at some point during 2023. Recent falls in gas and electricity prices could make Europe’s energy crisis more manageable. And China might finally be relaxing its Covid policies and getting on top of its housing market downturn. However, there are a number of complicating factors. (1) Monetary policy works with long and variable lags, and the effects of last year’s tightening are still to completely feed through to the real economy. (2) Even if inflation starts to decline over the next twelve months, the extent of that fall remains uncertain. After misjudging inflation so dramatically in 2021 and 2022, central banks could treat initial signs of inflation moving into retreat with some scepticism. (3) The outlook in China is too unpredictable. Enforcing strict Covid rules has probably prolonged the property market downturn over the last year. Easing those rules might help to support consumer confidence and housing demand in 2023. But if the most recent Covid outbreak spreads, it might achieve precisely the opposite. (4) Europe could still enter 2023 in a weaker position energy-wise than it started 2022.
Mild US Recession
Despite better than expected US Q4 GDP figures I still think that a recession looks more likely than not in 2023. The yield curve has now inverted on almost every definition possible, the money supply is contracting and credit growth has started to slow. But the key question is how severe the downturn will be? I like to rely on rules of thumb such as the tendency for recessions to be deeper and more drawn out when the banking system is impaired. And because of the relatively well capitalised banking system, I believe the recession could be shallower than average.
China: Darkness Before The Dawn
With the end of the zero-Covid policy, global investors may be increasingly hopeful of a Chinese rebound in 2023. But it’s probably going to get worse first. In 2022, increased infrastructure spending nearly offset the contraction in property investment. But with issuance of local government bonds (used to finance infrastructure) having dried up, support to economic growth from this source is expected to weaken before real estate investment picks up in response to the recent policy support for developers. Furthermore, people staying at home to avoid the ongoing Covid wave is not an environment in which personal expenditure is likely to flourish. As such, I feel that China’s near-term outlook remains cloudy but the economy should rebound after the virus becomes endemic.
Mounting Pressure On Consumer Spending
Higher debt servicing costs are clearly not the only concern for households at the moment. Energy bills have surged (particularly in Europe), and food prices are rising almost everywhere. Government support will provide help for those parts of society that are most vulnerable, but easing the pain felt by the majority of households will ultimately require a strong recovery in real labour incomes. The reality is that central banks are actively seeking to restrict economic growth in order to bring down inflation. Not taking risks with inflation means implementing monetary tightening to the point at which unemployment starts to rise. Higher unemployment will then impact negatively on overall disposable income and the level of personal spending as a result.
Inflation Will Fall In The Near-Term
It now looks as though the annual rates of both headline and core inflation have peaked in the US and are close to peaking in the Eurozone, UK, and Japan. Part of this reflects more favourable base effects as we head into 2023 and part of it reflects the clear disinflationary trend that has emerged in global goods prices in recent months. But the broader trend behind all of this is the slowdown in world nominal GDP growth. Monetary policy now looks tight enough to maintain the slowdown that is underway. However, there’s clearly a lot of uncertainty about how quickly inflation will decline. Wages tend to be a sticky element of the inflation process and the tightness seen in labour markets over the last 18 months or so could take some time to ease off – particularly if the recession is on the milder side of average, as I expect. My gut feeling is that the global economy has now entered a higher inflation regime. The disinflationary trends following the world financial crisis appear to have faded; the increased frequency of negative supply shocks related to climate change and frictions in global supply chains could periodically push inflation higher; and the likelihood of fiscal responses to these shocks could reinforce their inflationary impact. But periods of disinflation will undoubtedly still occur within that regime. The next year or so looks likely to be one of those periods.
Central Banks Will Continue To Raise Interest Rates In The Near-Term
Last year saw one of the most aggressive rounds of monetary tightening in post-war history. Global central banks have still not hit their terminal rates but are probably not far off. The Federal Reserve, ECB and Bank of England have again raised rates at the start of 2023 and I see a further increase in rates of 25-50bps across the board before the end of the first quarter. At that point, unemployment is likely to be rising and inflation should be coming down in most developed economies. But, after a year in which central banks’ hawkishness has surprised financial markets, a key question is how their reaction function will evolve as monetary tightening comes to an end. Will the aggressiveness seen on the way up apply on the way down too? That seems quite doubtful to me. In fact, it is very possible that the tendency in the past to tighten cautiously and ease anxiously will be flipped on its head. Central banks believe restoring price stability is a prerequisite to meeting their employment goals. In other words, they see no medium-term trade-off. This makes a policy of deliberate disinflation quite likely, with rates being lowered more gradually than policy rules would otherwise imply.
Ireland Likely To See Significant Slowdown In Economic Growth In 2023
Despite all the doom and gloom across the world in 2022, the Irish economy continued to perform extremely well. Employment remains at record highs with over 2.5 million people in work as of the third quarter of last year. The most recent detailed data show that on a quarter-on-quarter basis, Irish GDP growth was higher than the rest of the EU in the July-September period and provisional estimates for the whole of last year indicate that Ireland once again topped the EU growth league table, where it has been consistently since 2014. However, things are likely to take a turn for the worse in 2023 as the combination of slowing global demand, weakness in the IT sector, and higher interest rates/energy costs impact on the economy. Unemployment is likely to rise and real GDP growth is set to fall back to low single digits from double-digit growth in the two previous years but Ireland should once again outperform most of its EU peers.
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.