Global monetary policy in 2023. Interest rates, inflation and economic activity

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Global monetary policy in 2023 Interest rates, inflation and economic activity

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GLOBAL MONETARY POLICY IN 2023 INTEREST RATES, INFLATION AND ECONOMIC ACTIVITY

Contents

1

What next for the Fed? 

2

US interest rates are likely to plateau in Q1 2023

3

The hit to US economic activity has yet to appear

4

A strong US dollar will keep other currencies under pressure in 2023

5

Hawkish ECB raises recession and financial risks

5

Euro zone at risk of sovereign debt sell-off

6

European firms will face a greater risk of insolvency in 2023

6

Cost-of living crisis in Europe exacerbated by rising rates

7

Implications for global growth

8

© The Economist Intelligence Unit Limited 2023

GLOBAL MONETARY POLICY IN 2023 INTEREST RATES, INFLATION AND ECONOMIC ACTIVITY

Rising interest rates carry recession risk in 2023 The Federal Reserve (Fed, the US central bank) and the European Central Bank (ECB) have both embarked on their most aggressive monetary tightening cycle in decades in response to soaring inflation. The pressures appeared first in North America: headline inflation in the US outpaced that in other major developed markets for much of 2021 and early 2022, peaking at 9% year on year in June 2022, a 40-year high. The Fed was initially slow off the mark, but began raising interest rates more aggressively in May as it became clear that US inflation was driven by strong underlying demand rather than supply-side factors like high food and energy prices caused by the war in Ukraine. Peak inflation in the euro zone has come later, at a record high of 10.7% year on year in October, driven primarily by the region’s heavy exposure to Russian gas-supply cut-offs and the far-reaching impact of the war in Ukraine rather than a post-covid surge in domestic demand. By the start of 2023 the Fed had raised its benchmark fed funds rate by 425 basis points, and the ECB had raised its key interest rates by 250 basis points. More rate increases are coming, and we expect both regions to settle at peak interest rates by mid-2023. Although inflation is likely to ease steadily in 2023, we expect interest rates to stay at peak levels for some time—until mid-2024, at least— with important implications for GDP growth, bond yields, exchange rates and economic risks in both regions and the broader global economy. For now, we expect the Fed and the ECB to manage to tame inflation without prompting a deep global recession, but risks are high. Fed and ECB to raise rates until mid-2023 as inflationary pressures persist Headline inflation (%, year on year) US

Policy rates*

Euro zone

12

US federal funds rate†

ECB main refinancing rate

10

6 5

8

4

6

3

4

2

2

1

0 -2 2020

21

Sources: Eurostat; ECB; Federal Reserve; EIU.

22

0 2019

20

21

22

23

24

*EIU forecasts from Q1 2023 onwards. †US federal funds rate target range, upper limit.

What next for the Fed? The Fed moderated the pace of rate increases slightly in December to 50 basis points, following four consecutive 75-basis-point rises in previous meetings. Despite a flurry of strong economic data around the turn of the year, we expect the Fed to continue to slow the pace of rate hikes in early 2023, for a couple of reasons. Most importantly, we expect inflation to continue to trend down in year-on-year terms as base effects recede and as housing costs start to ease–most notably around mid-2023, once higher interest rates are fully priced into rental contracts. 2

© The Economist Intelligence Unit Limited 2023

GLOBAL MONETARY POLICY IN 2023 INTEREST RATES, INFLATION AND ECONOMIC ACTIVITY

Second, we expect signs of financial strain to become more pronounced, particularly on low-income households, convincing the Fed to pause and evaluate the impact of monetary tightening thus far. Signs of strain are already starting to appear. Although private consumption growth remains firm, households are saving less and borrowing more in order to maintain this. The savings rate (personal savings as a share of disposable income) fell to 2.2% in October, the second-lowest level on record and less than one-third of the pre-pandemic norm of about 7%. Meanwhile, credit card balances were up by 15% year on year in the third quarter of 2022, the fastest increase in 20 years. US savings rate has fallen to less than one-third of pre-pandemic norm (personal saving as a % of personal disposable income) Monthly savings rate

35 30 25 20 15 2015-2019 average of 7.6%

10 5 0

2018

19

20

21

22

Sources: US Bureau of Economic Analysis; EIU.

US interest rates are likely to plateau in Q1 2023 We expect the Fed to raise its policy rate by a further 75 basis points in total between January and May 2023, bringing the fed funds rate to a peak target range of 5-5.25%. However, the pace of inflation continues to pose risks to this outlook. If inflation does not subside as we expect in the coming months (we expect headline inflation to ease from an average of 7.1% in the fourth quarter of 2022 to 5.6% in the first quarter of 2023), we would expect the Fed to continue to raise policy rates well into 2023, posing new downside risks to growth. Even if the Fed pauses in May, as we expect, this tightening cycle is the most aggressive since the 1980s, when the Fed raised interest rates steeply in an attempt to end the stagflation that dominated the 1970s. The Fed will have raised its policy rate by 500 basis points in the 12 months to May 2023, more than double the pace of the last significant tightening cycle in 2004-06. We expect interest rates to remain at this peak level for at least a year, with the first rate cut coming in the third quarter of 2024.

3

© The Economist Intelligence Unit Limited 2023

GLOBAL MONETARY POLICY IN 2023 INTEREST RATES, INFLATION AND ECONOMIC ACTIVITY

US interest rates are rising at the fastest pace since the 1980s (effective federal funds rate, %)

20 18 16 14 12 10 8 6 4 2 0

1980

82

84

86

88

90

92

94

96

98 2000 02

04

06

08

Sources: Federal Reserve; EIU.

10

12

14

16

18

20

22

*Shaded periods indicate a US recession.

The hit to US economic activity has yet to appear Economic activity, and particularly private consumption, were resilient in 2022. However, the speed and magnitude of interest-rate rises will start to have a more noticeable impact on consumer spending in early 2023 as real incomes are eroded further. The drawdown in household savings and the rise in consumer debt will limit the capacity for spending growth this year. However, we expect the current strength of the labour market and strong nominal wage gains in 2022 (albeit below inflation) to cushion the blow to consumer spending, resulting in a softish landing. Overall, we expect the US to experience a mild technical recession in the first half of 2023 as consumer spending declines. Owing to a modest recovery in the second half, we expect annual growth to flatten to just 0.2% in 2023. Falling stock prices dented US households’ net worth in 2022 (quarter-on-quarter change in net worth of households and NGOs, US$bn) Total change

Corporate equity

Debt securities

Real estate

Other

10,000 7,500 5,000 2,500 0 -2,500 -5,000 -7,500 -10,000

Q3

2019

Q4

Q1

Q2

20

Q3

Q4

Q1

Q2

21

Q3

Q4

Q1

22

Q2

Sources: US Federal Reserve; EIU.

4

© The Economist Intelligence Unit Limited 2023

GLOBAL MONETARY POLICY IN 2023 INTEREST RATES, INFLATION AND ECONOMIC ACTIVITY

A strong US dollar will keep other currencies under pressure in 2023 After reaching a record high in 2022, the US dollar depreciated slightly against the euro and other major currencies in November and December as US inflation began to ease back and the ECB started to raise rates more aggressively, in line with the Fed. We expect to see another modest dollar depreciation in 2023 as inflation eases slightly faster in the US than in the euro zone and as the Fed-ECB interest-rate differential narrows further. Nonetheless, the dollar will remain strong by recent historical standards throughout 2023 and into early 2024, benefiting from its status as a safe-haven currency, as well as from higher interest rates than in other major economies. We expect a marked depreciation against most major currencies to take place only in late 2024, when safe-haven demand recedes, the global economic outlook stabilises and the interest-rate differential with other major central banks begins to narrow further. The US dollar will ease back from its 2022 peak as the interest rate differential narrows Fed-ECB rate differential* 2.0

EUR:US$ exchange rate* 1.25

1.6

1.20

1.2

1.15

0.8

1.10

0.4

1.05 1.00

0 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4

2021

22

23

24

Sources: Federal Reserve; ECB; EIU.

25

26

27

*EIU forecasts from Q1 2023 onwards.

Hawkish ECB raises recession and financial risks At its most recent monetary policy meeting, on December 15th, the ECB similarly slowed its pace of monetary policy tightening by raising interest rates by 50 basis points, following a 75-basis-point increase in October. However, the bank revised its inflation projections substantially upwards and adopted a more hawkish stance. Inflation across the euro zone declined to 9.2% year on year in December, from 10.1% in November, and the ECB expects price growth to remain above its 2% target for an extended period. Following a cumulative 250-basis-point increase in policy rates since July, we expect the ECB to sanction another 150 basis points of increases in 2023 (50 basis points in both February and March, and 25 basis points in both May and June). Short-term interest rates will settle between 3.5% and 4% by mid-2023. We forecast that the ECB will have raised its policy rates by 400 basis points in the 12 months to June 2023, more than double the pace of the last significant tightening cycle in 200508. We expect interest rates to remain at this peak level for at least a year, with the first rate cut coming in the third quarter of 2024, in line with the Fed. We currently expect euro zone output to stagnate this year, but aggressive monetary policy tightening raises the risk of recession and financial fragmentation among euro zone members in 2023. 5

© The Economist Intelligence Unit Limited 2023

GLOBAL MONETARY POLICY IN 2023 INTEREST RATES, INFLATION AND ECONOMIC ACTIVITY

Euro zone at risk of sovereign debt sell-off Tightening financial conditions in the euro zone will cause a widening in sovereign risk spreads. The ECB has announced that it will start to reduce its €5trn bond portfolio (quantitative tightening) by €15bn a month from March 2023. In recent years the ECB has absorbed the bulk of new public debt issuance, which has helped to insulate governments from market pressures. With large fiscal deficits– as governments extend fiscal stimulus to cushion the impact of high energy prices–and rising funding costs, there is a moderate risk that investors could start to lose faith in the fiscal sustainability of some countries, especially the highly indebted southern European countries such as Italy. This could trigger a sharp sell-off in sovereign bond markets, fuelling the risk of contagion to financial markets. Euro zone yield spreads set to widen as the ECB starts quantitative tightening Spreads in long-term government bond yields between selected euro area countries and Germany (percentage points) Italy

Greece

Cyprus

Composite indicator of systemic stress (0=no stress), euro area

3.0

0.6 0.5

2.5

0.4

2.0

0.3

1.5

0.2

1.0

0.1

0.5 0 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan

2022

2023

0 2008 09 10 11 12 13 14 15 16 17 18 19 20 21 22

Sources: Refinitiv; ECB; EIU.

The key question is whether the ECB would intervene in such a scenario with its new emergency bond-buying programme (the Transmission Protection Instrument). According to ECB guidelines, this instrument would be used only in cases of acute volatility in the bond market that are not driven by national “policy errors”. However, we believe that the bank would intervene in response to any crisis that endangered the financial stability of the euro area (not our core forecast).

European firms will face a greater risk of insolvency in 2023 Higher interest rates will raise costs for firms on interest payments on their debt, especially for firms with a large share of debt negotiated at a variable interest rate or a short maturity. According to Banque de France (the French central bank), firms based in Italy and Spain have a much higher share of variable-rate and short-term debt than those in France and Germany, and will therefore be exposed sooner to the current ECB tightening cycle. Only 47% and 62% respectively of the total outstanding corporate debt in Italy and Spain had a fixed rate as at end-2021, compared with 80% in Germany and 83% in France. In France and Germany the median maturity of corporate debt is also longer, at 3.5 years in France and 3.4 in Germany, compared with only 2.1 years in Italy and 2.6 in Spain. According to the latest ECB financial stability review, energy-intensive firms whose competitiveness has been eroded by higher input costs and which are more likely to have taken on additional debt 6

© The Economist Intelligence Unit Limited 2023

GLOBAL MONETARY POLICY IN 2023 INTEREST RATES, INFLATION AND ECONOMIC ACTIVITY

Italian and Spanish firms are most exposed to rising interest rates Share of variable-rate debt of non-financial corporations (outstanding debt as a % of initial debt)

60

Median maturity of companies’ debt at end-2021 (years)

4.0 3.5

50

3.0

40

2.5

30

2.0 1.5

20

1.0

10

0.5

0 France

Germany

Spain

Italy

0 France

Germany

Spain

Italy

Sources: ECB; Banque de France; EIU.

recently to cover their operational costs are particularly at risk of debt-servicing issues. Small and medium-sized enterprises (SMEs), whose profits have struggled to recover since the covid pandemic, are also vulnerable. In the third quarter of 2022 the number of bankruptcy declarations in the euro area increased by 19.2% quarter on quarter, reaching levels that were last recorded in the fourth quarter of 2017. We expect a further pick-up in corporate defaults in 2023, especially as the generous covid-related government support measures are gradually withdrawn, but not to the levels seen during the 2007-09 global financial crisis. The number of bankruptcies in the euro zone is on the rise

(declarations of bankruptcies in the euro area, seasonally adjusted quarterly data, 2015=100)

100 90 80 70 60 50

Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3

2015

16

17

18

19

20

21

22

Sources: Eurostat; EIU.

Cost-of-living crisis in Europe exacerbated by rising rates European households’ debt-servicing capacity will also suffer from the combination of very high inflation–eroding real disposable income and savings–and rising interest rates. Furthermore, unemployment is set to tick up in 2023 (albeit from historically very low levels). The impact of monetary tightening on mortgages will be a key factor to watch. Italy and Spain’s housing markets are among the most exposed in the region to the current ECB tightening cycle, given their large percentage of mortgages on variable-rate contracts (according to the ECB, only 25% of outstanding loans to 7

© The Economist Intelligence Unit Limited 2023

GLOBAL MONETARY POLICY IN 2023 INTEREST RATES, INFLATION AND ECONOMIC ACTIVITY

households are at fixed rates in Italy and Spain, compared with about 90% in France and Germany). But the Spanish government has recently approved mortgage-relief support for vulnerable households, and mortgage holders in both Italy and Spain will be able to switch to fixed-term contracts without additional fees. Households and firms in the euro area are facing a sharp rise in borrowing costs (composite cost of borrowing indicators; % per annum; monthly data) Households’ cost of borrowing for house purchases

Non-financial corporations’ cost of borrowing

4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0

2011

12

13

14

15

16

17

18

19

20

21

22

Sources: ECB; EIU.

Implications for global growth For now, we expect monetary tightening by the Fed and the ECB, the two major central banks, to narrowly avoid prompting a global recession in 2023. Economic stagnation in the US and the euro zone in 2023 will be offset by firmer growth elsewhere, particularly China. However, significant risks to this outlook persist, primarily related to inflation. Despite declining headline inflation rates, core inflation remains high in both the US and the euro zone (5.7% and 5.2% respectively in December). Central banks are waiting to see signs of labour-market weakness before pausing their tightening cycles, but these have not yet materialised. This increases the risk that the banks will over-tighten in early 2023, before any labour-market softening appears, resulting in a deeper recession later in the year. Core inflation is very high in both the US and the euro zone, while the labour market remains strong Core inflation (excluding food and energy; % year on year) US

Euro area

7

Unemployment rate (%) US

Euro area

16 14

6

12

5

10

4

8

3

6

2

2020

8

21

22

4

1

2

0

0 2020

21

22

Sources: Eurostat; US Bureau of Labour Statistics; EIU.

© The Economist Intelligence Unit Limited 2023

GLOBAL MONETARY POLICY IN 2023 INTEREST RATES, INFLATION AND ECONOMIC ACTIVITY

A potential second spike in headline inflation in both the US and the euro zone–which could be driven by another jump in global commodity prices related to the war in Ukraine or China’s economic reopening after the lifting of its zero-covid policy–could also trigger a more aggressive tightening cycle than we currently expect. Even tighter monetary policy by the Fed and the ECB would prompt a more severe decline in asset prices and a collapse in consumer spending, resulting in a deep global recession. Other central banks in both the developed and the emerging world would be forced to follow suit, weighing on growth across the board and increasing debt pressures. An additional risk could come from the Bank of Japan (BOJ, Japan’s central bank), whose monetary policy decisions will also be significant for investors in 2023. The BOJ, which has one of the loosest monetary policy settings in the world, took a tentative tightening step in December when it decided to tweak its yield-curve-control measure, raising the risk that it would abandon its ultra-accommodative stance altogether. We expect the BOJ to make further yield-curve adjustments in 2023. This will attract Japanese capital from overseas markets into Japanese government bonds and other yen assets. Given that Japan is the world’s largest creditor, a shift towards policy normalisation by the BOJ could send a ripple effect through global financial markets, pushing up borrowing costs, especially in the US and the euro zone, and raising the risk of a global recession.

9

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