A peculiar slowdown

First stop, the US, where consumers have not only been borrowing more, turning to credit cards, they have also been dipping deeper into their savings. The surplus savings that carried over from the pandemic have eroded quite a bit. It is very likely that many lower-income households have worn out any safety cushions they may have built up. Credit terms are tightening, and housing investment has already suffered. Business surveys, like businesses’ investment plans, are trending downward. Yet the consumer financial situation is healthy; the labour market is still tight; housing inventories are low; mortgage lending terms have improved (in that they are less ‘lax’); and fixed-rate mortgages are prevailing. These factors will not be enough to avoid a recession – but they should help to damp it. It will still depend on how quickly inflation decelerates and, by extension, what happens with monetary policy. Under the combined effect of slowing demand and improving supply chains, our scenario is based on headline and core inflation both closing in on 3% by the end of 2023. Yet it also calls for growth to move below its long-term trend in 2023 (1.3%) and 2024 (0.6%).

In the Eurozone, economic activity is clearly flagging, but in terms of higher prices on commodity imports, it has been more resilient than expected. Of course, this resilience has its drawbacks: (1) while growth was only very slightly negative in Q422, this is largely an illusion: weakening domestic demand, hurt by falling consumption and investment, has been obscured by a distinctly positive contribution from net exports, much of which is explained by the normalisation of energy purchases; and (2) if recession has been avoided, it is because consumption fell off somewhat as the savings rate eroded, absorbing the (ultimately modest) loss in consumer purchasing power. Despite the normalisation in the savings rate (now lower than its pre-pandemic level in each of the Eurozone’s large economies), the surplus savings accumulated since Covid continue to increase, except in Spain and Italy where they are beginning to erode.

The growth scenario now depends on whether the opposing forces currently at work will balance out, with inflation supposedly decelerating but monetary and financial tightening pairing up with a negative fiscal stimulus. Most indicators suggest that we have already reached peak inflationary shock. The decline in inflation is now being brought on by energy prices, whereas the other components are still being stimulated by the delayed effects of energy costs being passed on. Our central scenario calls for a downturn in headline inflation (which is expected to fall from 9.2% to 4.2% YoY between the end of 2022 and the end of 2023) and core inflation (from 5.2% to 3.6%), which nonetheless leaves a high average rate (5.9% for headline and 4.9% for core inflation). The scenario depends on a soft landing (GDP growth at 0.6% in 2023) followed by slow acceleration in mid-2024, though this means that growth (1.2% in 2024) would not return to potential by the end of 2024. This scenario is littered with downside risks (a sharper decline in the labour and credit markets), but there are upside risks too (households dipping into surplus savings).

In China, after the post-reopening catch-up phase, growth (3% in 2022) is expected to normalise, with an economic landing brought on by limited potential in terms of exports and investments in construction as well as persistent difficulties in rebalancing growth and investment towards private consumption. Our scenario calls for 5.2% growth in 2023. The global demand forecast could darken in H2, and economic growth in EMs could remain virtually stable (about 3.5% in 2023) despite China’s acceleration.

In terms of monetary policy, just because banks are in trouble does not mean that central banks should turn away from their pet priority of reducing inflation. Financial stability will not be achieved at the expense of price stability. The latter continues to argue for monetary tightening even though we are close to the end, whereas managing liquidity requires specific instruments. 

In the US, our scenario still hinges on a final 25bp hike in May, bringing the target range to its terminal level of 5.00-5.25%, followed by a pause until the end of the year. The Fed is expected to stay focused on special liquidity management tools to handle any banking sector troubles. These troubles will likely spell a tightening in credit terms, making the Fed’s work easier and obviating the need for any additional increase in key rates. But the Fed is not expected to begin cutting rates until 2024, at a pace of 25bp per quarter, for a total of 100bp for the year. In the Eurozone, inflation remains very high and core inflation is showing signs of stickiness. Despite the tension on banks, the ECB is also expected to continue tightening its monetary policy – by another 75bp – bringing the deposit rate to its terminal rate of 3.75% in the summer. 

Anticipating an early end to monetary tightening, justified by the financial stability goal, the bond markets celebrated excessively. More patience is needed before interest rates start down a slight slope: wait until inflation rates approach the central banks’ targets and the end of monetary tightening comes into view. It won’t be much longer now. Lastly, central to the FX scenario, the USD could suffer slight downside pressures. In the US, where key interest rates are due to peak soon, the recession is mild but indisputable, and the debt ceiling threatens to cause new blockages. The USD, already a bit tarnished, is starting to lose its appeal. Mostly, this is expected to benefit the other safe havens like the JPY, the CHF and the EUR.