Where are we in the economic cycle, and what are the implications for monetary policy? This is perhaps the key current issue for financial markets. Attention is moving from a focus on inflation to what lies ahead for growth and the challenges this may pose for monetary policy.
Disinflation – modest growth, with low inflation – may prove to be the buzzword for the remainder of the year.
Let’s take growth, first. Last week the International Monetary Fund (IMF) released its latest forecast. In recent years their forecasts have proved a good barometer of the consensus.
After 3.5% global growth last year, they expect 3% both this year and next. Such a growth rate for the world economy is weak and is associated with some areas hovering close to recession. Despite this, the forecast for 2023 was revised up by 0.2% compared with April. It’s indicative of how sentiment has shifted positively since the start of this year.
Important, too, is the continued shift in where global growth emanates from. The IMF pointed out that around two-thirds of growth this year and next will be from the Asia Pacific – and that is despite China lacking the momentum many had expected it to have after its lockdown ended towards the end of last year.
After a strong bounce in the first quarter of 2023, China’s recent growth has been sluggish. Manufacturing is weak, mirroring a global trend. Youth unemployment (16–24-year-olds) is officially 21.3%, although a recent article in the Caixin magazine by a Beijing professor caused a stir when it suggested that if measured properly, this figure could be as high as 46.5%.
That if anything highlights how weak current demand is and suggests policy easing is inevitable. This recent picture fits with our view that while the trend for the Chinese economy is up, its future rate of growth will be far lower than previously, with more economic volatility.
If we include India and the US, the geographic footprint driving global growth would represent the Indo-Pacific. Indeed, India, which is hosting the next G20 meeting in early September, looks set to be the fastest growing major economy this year. Even so, given its population growth, its economic growth is disappointing. The IMF sees GDP expanding at a rate of 6.1% in fiscal years 2023 and 2024 and 5.9% in fiscal year 2025. Double-digit growth rates are where India could be.
For financial markets, the good news is the continued resilience of the US, highlighted by its jobs market. But in the US, there are enough suggestions that monetary policy tightening plus a credit crunch in the aftermath of the regional banking crisis will temper immediate growth prospects. Hence, current market thinking is focused on disinflation.
Against this backdrop, western Europe remains the weak spot of the global economy. Its major economies, including the UK and Germany, remain weak. The good news, though, is that the jobs picture is solid in the UK and has improved in the euro area, and that as inflation decelerates spending should receive a boost.
Easing inflationary pressures
Indeed, the good news is that inflationary pressures are easing across western economies. Headline rates are falling. Oil and commodity prices are soft. Admittedly there are still concerns about future food prices given geopolitics, the impact of El Nino, and second-round inflation effects – in terms of wages and corporate margins.
These need to be watched closely. For the UK, where inflation is currently higher than in other major economies, there should be good news on headline inflation over the remainder of the year.
As we have stressed before, core inflation is proving stubborn in many countries, suggesting inflation may not settle at 2% post this crisis, but perhaps slightly higher. That may raise questions as to how tough central banks may wish to be in proving their anti-inflationary credentials.
In turn, for markets, the key is what this means for monetary policy. Has monetary policy already tightened too much and is there further tightening to come and if so, by how much?
The most significant recent development was the Bank of Japan’s shift away from ultra-cheap money. Its approach to tightening is clearly going to be gradual. Meanwhile, the US Federal Reserve, European Central Bank and Band of England remain cautious, but are nearing the end of their tightening cycle.
Focusing on monetary policy
This time a year ago, I felt the whole stance of policy in the UK was wrong, arguing then that there was a strong case for a tighter monetary policy. Now, UK monetary policy has clearly been tightened sufficiently. Last week, it was reported that even the Chancellor’s group of economic advisers were now criticising the BoE. But the time to criticise was two and a half years ago, when monetary policy was clearly on the wrong track and was exacerbating inflation.
Now, if anything, there is less reason to criticise, with the BoE having done the right thing by hiking. In fact, the monetary policy decision now is a more finely balanced judgment call. Given second-round inflation affects the BoE appears to have a bias to hike and may only decide to halt once it is convinced that core inflation is heading down (it fell last month on a year-on-year basis but is still high) or the labour market is softening.
I think policy rates should be left on hold, as inflation is easing and previous tightening is still feeding through, and the economy is seeing only modest growth, with recession possible and especially if policy tightens further.
As inflation decelerates, spending should be helped. Also, so much focus is placed on policy rates that the importance of how central banks use their balance sheets can be often overlooked.
That is, quantitative tightening (QT) represents a significant tightening of policy in its own right, in turn keeping yields higher than they might otherwise be. This looks set to continue, even if policy rates peak.
Interestingly, the monetary policy debate has already started to shift towards policy easing across a number of emerging economies (although this definition continues to look more out of place by the day). China has already eased, albeit gradually, with a focus on adding liquidity, and small cuts in rates. But monetary policy easing is likely elsewhere.
Many emerging economies were far more prudent in their monetary policies before the pandemic. Alongside China, two of the most interesting to keep an eye on might be Chile and Brazil, as they were early to tighten as inflation took hold and might perhaps be early on the way down.
Indeed, this focus on emerging economies is vital for understanding global growth dynamics and where we are in the economic cycle, and why disinflation may be the new buzzword over the remainder of this year.