Concerns over global inflation could soon morph into concerns over global growth, with limited space for countercyclical policy support.
With almost 95% of the world’s central banks hiking their policy rates in the most aggressive and synchronized global rate hiking cycle in a generation, it is not surprising to us that cracks are starting to appear in the global economy. We expect the US and European economies to fall into a mild recession.
Also, unlike past global growth slowdowns, this time we see less scope for policy support to trigger a quick rebound, as underlying inflation is still too high for central banks to drop their guard and cut interest rates sharply, while public debt is now too high for governments to risk another large fiscal expansion without a rise in bond yields. In emerging markets, we see growing investor discrimination among those countries that have relatively healthy fundamentals – current account surpluses, adequate FX reserve cover, low inflation and positive real rates – and those that don’t.
We continue to believe that India and Southeast Asia are set to be among the world’s fastest growing economies this decade and expect market re-pricing to shine an increasingly positive light on these emerging economies.
Recent economic data in the US have been strong. However, we expect this region to enter a recession in Q4 2023, led by cooling labor markets. This recession view is critical to our monetary policy and inflation outlooks.
In our view, the July rate hike was probably the last one in the current hiking cycle, though recent strong data raise the risk of one more hike before year-end. An ongoing disinflationary trend is likely to continue in the medium term, leading to a rate-cutting cycle starting in March 2024. There are three main causes contributing to disinflation. The first is used vehicle prices, which are volatile but should remain weak, given tighter credit conditions in the auto markets. Additionally, continuing rent disinflation and moderating wage growth also support our disinflation outlook. With both the number of workers leaving their jobs for better opportunities and already-high wages declining, wage inflation continues to moderate.
The ongoing disinflation cycle will likely be reinforced by an expected recession. Businesses and households have both been feeling the effects of tightening credit conditions recently. Banks have continued to tighten lending standards, and high yield corporate bond default rates have started to pick up.
The risk to our economic outlook is a soft-landing scenario, a combination of continuing disinflation and a resilient economy. In that case, the Fed might push back the timing of rate cuts in 2024 or the size of its cuts might be smaller than we currently expect.
Based on economic forecasts, we expect the euro area to enter a recession in Q3 2023 and for it to last three quarters, while we believe CPI inflation is likely to fall and interest rates have broadly peaked. Looking further ahead, we expect Europe’s headline inflation to fall to just under 3.3% by the end of this year.
Economists also believe central banks will respond to reduced inflation by cutting interest rates back to neutral, all of which is an ideal and perfect end to the current cycle.
However, this outcome doesn’t come without sizable risks. One of the risks is the greater chance of a recession. In the UK, a key reason for this is the number of people who are now on fixed rate mortgages. When these mortgages refix, they are doing so at much higher interest rates, which might lead to weakness in consumer spending over the next few years.
A second risk is recession pulling inflation down more sharply. When there is weaker economic growth, there is greater slack in the economy, which in turn pulls down on inflation. Inflation here depends on three things: inflation numbers in the past, shocks such as commodity prices and exchange rates, and crucially the output gap.
The third risk is structural changes and their influence on economic growth and inflation. Economists’ expectations of trend economic growth have been falling. With weak economic growth, demand growth needs to be contained to prevent an inflationary outcome.
Finally, risks to our inflation outlook stem from fuel prices and raw food commodity prices. Persistently low unemployment may support strong wage growth, higher than we currently expect.
There has been a long-term relationship between Japan’s CPI inflation and wage growth. Over the past 40 years, CPI inflation has been just half the growth of nominal hourly wages. Based on this relationship, of Japan’s 3% inflation, hourly wage growth contributes only 1-1.5%, according to most recent data, which is why the Bank of Japan argues that inflation has yet to be stable or sustainable, unless there is further hourly wage growth of at least 4%.
In gauging policy management by the BOJ, whether a virtuous cycle between wages and prices is formed matters critically; this, in turn, requires corporate inflation expectations rising and becoming anchored.
Japan’s CPI inflation has started to slow and should be lower towards the end of 2024 due to declining contributions from food and resource prices and the diminishing impact of a weaker Japanese yen. Thereafter, assuming wage growth sustains, inflation will also become more sustainable. Under the circumstances of slowing inflation in the near term and a shallow GDP contraction towards the end of this year and the beginning of next year, it will likely take the Bank of Japan some time before it can abandon its yield curve control and negative interest rate policies, which we believe will be abandoned in Q4 2024 and in 2025 or later, respectively.
Japan is currently going through some structural changes, which could lead to increased labor mobility and improved capital efficiency in the longer term. Demographic factors such as low birthrates and an ageing population, as well as pressure from markets, are driving these positive changes.
We should also be mindful that uncertainties regarding Japan’s economy include effects on exports arising from the US and China economies, slower-than-expected consumption with declining real wages, corporate price- and wage-setting behavior and global resources and food prices.
The external environment looks challenging for Asia, but domestic fundamentals are in good shape.
In the next 6-12 months, we expect the growth cycle to slow.
We see early evidence of the export downturn bottoming out, mainly because of the semiconductor cycle, which looks like it might improve. This should be partly offset by our house view of US and Europe recessions and a sluggish China. In aggregate, the three countries that stand out as being most exposed to China are Australia, Singapore and Malaysia.
We also expect a slowdown is domestic demand: across Asia, it has been relatively resilient, but going forward, the export slowdown could start spilling into domestic demand through various channels, from goods and services to investment and labor markets.
The other potential risk for Asia in the next 6-9 months is a rise in food inflation. Two things to be mindful of are El Niño and food protectionism. El Niño has begun and is expected to strengthen as the year progresses, which could impact crop output this year. This, coupled with India’s ban on all rice varieties, means that these bans could be expanded to cover other products. So far in Asia, rice prices have increased, leading to spillover effects on emerging economies such as the Philippines. Even as food inflation risks pick up, the good news for Asia is that various other measures of core inflation are coming down.
This means that the rate hiking cycle in Asia is likely over, and we expect an extended pause on policy rates this year for most economies, followed by rate cuts starting in H1 2024 in South Korea, India, Indonesia and the Philippines.
Over the medium term, we remain positive on Asia, with stronger economic fundamentals, pro-reform governments and new growth opportunities. Currently, investors are focused on global risks, but as the attention shifts back to returns, we expect Asia to attract more capital inflows, in line with its growing weight in the world economy. India and Southeast Asia are likely to be the fastest growing economies this decade.
Head of Global Macro Research
Senior US Economist
Chief UK & Euro Area Economist
Chief Economist, Japan
Chief Economist, India and Asia ex-Japan
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