Economic Outlook 2023 : Inflation cooling, Economies slowing

Economist

29 Dec 2022 • 10 minute read

The global economy is slowing, and risks to growth are developing to the downside. This is most evident in the manufacturing sector, where global manufacturing purchasing managers’ index (PMIs) have dipped into contraction for the largest economies (Figure 1). Consumer confidence (Figure 2) has fallen as disposable incomes in advanced economies have taken a hit from high inflation. Interest-rate sensitive sectors, like housing, are suffering as central banks have responded to above-target inflation with aggressive monetary tightening.

The tightening in global financial conditions and a slowdown in personal consumption in advanced economies are expected to weigh on businesses broadly, implying a weak outlook for global growth in early 2023. The downturn in big tech companies’ profitability is one example, which has the potential for large spill-over effects on the electronics value chain globally.

Major central banks are signalling that they will continue to prioritise inflation control over growth, until inflation trends back closer towards their targets. Members of the US Federal Reserve Board have indicated that they expect the pace of rate hikes to slow, but do not expect a policy pivot while they wait for the effects of previous rate hikes to filter through to inflation[1]. For 2023, we expect inflation to moderate and the focus to turn to the economic growth slowdown in major advanced economies.

Figure 1: Global manufacturing PMIs are in contraction for the largest economies	Figure 2: Consumer confidence is in decline for major economies

Source: CEIC, S&P Global, NBS	Source: CEIC, US conference board, DGECFIN, NBS

What’s happening with inflation?

Several key inflation indicators are beginning to turn around. Headline inflation has started decelerating in many advanced economies, driven by lower energy and commodity prices (Figure 3). Brent crude is below USD 90/bbl[2], while the TTF benchmark European gas price is down to below EUR 120/MWh, from a high of around EUR 340/MWh in August[3]. The Food and Agriculture Organization (FAO) of the United Nations’ food price index shows food price inflation slowed significantly from its peak in April (Figure 4).

Figure 3: Headline CPI inflation has started to decelerate in several economies…	Figure 4: …driven by lower energy and food prices

Source: CEIC	Source: CEIC, FAO, US EIA

Regarding the drivers of core inflation, supply-side constraints are easing alongside the reopening in most economies. Shipping costs or freight rates are almost back to pre-pandemic levels in some categories, after having increased by more than five-fold in mid-2021 (Figure 5). Easing bottlenecks are also reflected in declining backlog orders, and rising inventories in the global PMI surveys. As shown by the easing trend in the producer price indexes (PPI) for several countries, factory gate inflation has also slowed in the last few months (Figure 6).

While these indicators could point to an impending peak in inflation, it may still take some time for inflation rates to trend back to central banks’ long-term inflation targets. Feedthrough from headline to core inflation can be long drawn. Unlike manufacturing prices, services inflation is still accelerating in many advanced economies. Central banks are also concerned about an anchoring of high inflation expectations, after the price shock of the last two years. A key policy concern is on wage growth, amid tight labour markets. In the US, November 2022 payroll data showed that average hourly earnings have risen by 5.1% year-on-year.

Figure 5: Freight rates have declined to pre-pandemic levels in some categories	Figure 6: Factory gate prices are easing

Source: US Bureau of Transportation Statistics	Source: CEIC

This suggests that inflation could still take more than a few quarters to reach comfort levels for global central banks. As a result, monetary policy in key markets is likely to remain highly restrictive through most of 2023, restraining economic growth, until demand slows sufficiently to bring core inflation sustainably lower.

Major advanced economies in contraction

The probability of recession in major markets is still elevated. The Federal Reserve Bank of New York’s US recession probability indicator[4] (twelve months ahead, based on the US 10-year bond yield minus 3-month bill rate) has risen to 38% for November 2023, bringing it close to levels when previous US recessions have occurred (Figure 7).

The US Conference Board is forecasting three quarters of negative growth in 2023[5], and have pegged their annual real growth forecast for the US at 0% for 2023. In Europe, the European Commission is projecting a technical recession spilling over from end 2022 into early 2023 and has revised down its 2023 real growth forecast for the euro area to 0.3%[6].

However, unlike recent recessions, the impending contraction in 2023 is likely to be coupled with elevated inflationary pressures, as economies are still recovering from supply side shocks. Both the US and Europe are also seeing wages increases on the back of tight labour markets. This means that monetary policy response to slowing growth in 2023 could be more restrained, as opposed to the significant monetary easing seen in previous recessions.

The US treasuries futures market expects the Fed’s policy rate to peak in May 2023 at 4.9%[7], before being trimmed by roughly 0.5% towards the end of 2023. However, this seems more optimistic than what policymakers are signalling so far. The Fed’s December 2022 projections[8] showed that members expected PCE core inflation to remain above its 2% inflation target until 2025, and median expectations are for another 75bps of rate hikes in 2023.

Figure 7: Probability of US recession predicted by US treasury spread (12 months ahead)

Source: Federal Reserve Bank of New York

What does this mean for Asia?

The potential for inflation turn-around in developed markets, a slower pace of US rate hikes, and an easing USD should mitigate the capital outflows from emerging Asian economies in the coming quarters.

We think a bottoming out of China’s economic growth could provide an anchor for Asia in the second half of 2023. However, a slowdown in demand from advanced economies still represents a strong headwind for export-oriented economies including China, South Korea and Taiwan. Exports growth is already beginning to buckle, and the outlook would remain challenging in the first half of 2023. Korea and Taiwan would also be particularly vulnerable to a global tech sector downturn, given their high exposure to electronics and semiconductor exports.

Japanese growth will be weighed down by these factors too, and the benefits of a weaker yen on exports could dissipate in 2023. However, the reactions of businesses and monetary policy to the exceptional increase in headline and core inflation will be important to monitor.[9] 2023 could be a crucial year where the Bank of Japan (BOJ) regains more two-way flexibility in its monetary policy.

Inflation has remained relatively subdued in the more domestically oriented economies in South and Southeast Asia, such as India and Indonesia. Concerns around capital outflows should abate, allowing monetary policy to become more accommodative sooner, supporting growth. The region is also benefiting from a restructuring of global supply chains, which brings in more investment into these economies. In India, the domestic momentum looks resilient, and the economy should further benefit from a weakening in global commodity prices. (see more details in: China and India economic outlook)

Concluding remarks

While inflation should start to stabilise in 2023, risks are building for an inflationary recession in major advanced economies. Financial conditions are likely to remain tight as central banks will continue to prioritise lowering inflation back towards targets and knocking down inflation expectations. The resulting softness in advanced market growth is likely to impact Asia through slowing external trade and foreign investment.

We expect to see a divergence within Asian economies. Slowing external demand and poor tech sector outlook would be a drag on growth in major exporting markets including China, South Korea, Japan and Taiwan, while the more domestically-oriented economies in South and South East Asia (such as India and Indonesia) should be relatively shielded from the global drags. An easing in the USD and a decline in global commodity prices should alleviate capital outflows from emerging Asia, allowing Asian central banks to turn accommodative sooner than their advanced market counterparts, to support growth.

[1] Minutes of Federal Open Market Committee, November 1-2, 2022

[2] US Energy Information Administration data

[3] Intercontinental Exchange Futures data on TTF Dutch futures prices

[4] Federal Reserve Bank of New York, The Yield curve as a Leading Indicator, Updated December 04, 2022

[5] The Conference Board, Global forecast update, December 14, 2022

[6] European Commission, Autumn 2022 Economic Forecast: The EU economy at a turning point

[7] US FRA-OIS data, Bloomberg, as of December 15, 2022

[8] FOMC Projection materials, December 14, 2022

[9] Headline CPI inflation in Japan has risen to 3.8% in October 2023, from 0.5% in January.

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