Global Economic Outlook – The Long Shadow of Monetary Tightening

Economist

27 Sep 2023 • 10 minute read

Summary

• Inflation in advanced economies, particularly in services, is proving difficult to stamp out. The recent rise in oil prices further complicates the inflation outlook. Accordingly, central banks are signalling a long exit to the rate hike cycle, with interest rates stilling higher for longer.

• Impacts of higher interest rates are filtering through in the European and UK economies, where growth has stagnated over the last few quarters. In the US, while consumption has been supported by rising real wages and considerable excess savings, inflation-weary Americans are increasingly more cautious in spending.

• In China, recent data raised optimism that economic activity is stabilising following the announcement of incremental policy measures since June this year. Nonetheless, it remains to be seen if these measures are sufficient to restore consumer and business confidence enough to support a sustainable rebound in consumption and investment.

• In Japan, a weaker yen and the release of pent-up consumption demand have boosted the economy, but sustained gains would require real wage increases to create the virtuous cycle from income to spending.

The global economy has remained resilient through much of 2023, particularly in the US, Japan, and emerging markets. Nevertheless, the outlook is likely less favourable as the impact of monetary tightening and higher borrowing costs gradually filter through. In addition, higher oil prices and ongoing geopolitical tensions are persistent headwinds.

US resilience likely to fade

Household spending, the primary driver of economic growth in the US, showed relatively strong momentum across both goods and services in the past quarters. Consumer spending rose by a robust 0.8% month-on-month in July[1], its fastest pace this year, rising from a 0.6% increase in June. Some of the key drivers include rising real wages and excess savings from pandemic-era stimulus cheques (see Figure 1). Excess household savings have also cushioned the impact of higher interest rates on the economy, as households were able to pay down their loans and credit card debt in large numbers through their savings.[2]

Earlier this year, the Fed dampened the impact of higher rates on the banking sector by enabling record liquidity infusions through the newly introduced Bank Term Funding Program and the discount window. These measures have delayed the recession risks for the US economy.

Figure 1: Estimated US excess savings

Source: Federal Reserve of St Louis, Peak Re calculation

However, we expect these extraordinary conditions to fade. US consumers’ excess savings have already started declining. Some analysts expect the excess savings to have been completely exhausted by the end of the third quarter.[3] Businesses that had locked in borrowing at record-low interest rates before and during the pandemic will eventually roll over debts at higher interest rates. At the same time, small-to-mid-sized banks are tightening their credit standards, and overall bank credit growth has slowed sharply (see Figure 2). The slowing credit impulse is typically a leading indicator of an impending economic slowdown.

Figure 2: Total bank credit growth, all commercial banks (weekly, %YoY)

Source: FRED Economic data, Federal Reserve Bank of St. Louis

The US labour markets remain healthy but are showing signs of cooling. Non-farm payrolls have normalised to the pre-pandemic average. Growth in job openings has slowed, and participation rates are rising. These changes suggest lowering wage pressures going forward, though also boding unfavourably for private consumption.

PCE core, the Fed’s preferred inflation measure, peaked in March 2022 at 5.4% year-on-year but stuck above 4% for the last 16 months – well above the Fed’s target of 2% inflation (see Figure 3). The recent cooling of labour market conditions and consumer spending will help to dampen US inflation, notwithstanding the latest round of oil price increases. The relative pace of moderation between inflation and economic growth will largely dictate the monetary policy outlook in the coming quarters. The baseline scenario is that the Fed will be able to start loosening before a recession kicks in sometime in mid-2024.

Figure 3: US Core PCE inflation is stuck at high levels

Source: CEIC

Stagnation fears in Europe and the UK

In contrast to the US, the economic recovery in Europe has lost momentum in 2023. Eurozone and UK GDP grew by around 0.5% year-on-year in the second quarter of 2023, in contrast to 2.5% growth in the US. Both Europe and the UK are facing a consumption slump due to higher interest rates and the shock to real incomes.

Germany, the fourth-largest global economy, has seen its growth stagnate under 0.3% year-on-year over the last three quarters. In addition to the weak domestic consumption demand, external trade headwinds and a slump in energy-sensitive industries have dragged on growth. Weakness in the business sentiment indicators and manufacturing PMI in August suggests the outlook remains lacklustre (see Figure 4).

Moreover, stubbornly high Euro area inflation limits the deployment of monetary policy to stimulate the economy. The ECB hiked interest rates to 4% in mid-September, despite the slowing economic outlook, in order to help “the timely return of inflation to the target”.

Figure 4: German business climate index by sector (balance, seasonally adjusted)

Source: Ifo Institute for Economic Research, CEIC

China: Stabilising amid tougher external headwinds

In China, economic activity is showing signs of stabilisation following a series of proactive policy measures undertaken since June this year. Accordingly, retail sales expanded robustly by 4.6% year-on-year in August, against a more tepid rate of 2.5% in July, while industrial production rose 4.5% over last year versus a 3.7% rise in July.[4] Data including manufacturing PMI, exports, inflation and credit growth have also steadied.

Monetary policy measures, in particular, have stepped up in recent months, thus contributing to the improving sentiment. These measures included interest rate cuts, liquidity infusion through RRR (required reserve ratio) cuts for banks and an easing in macro-prudential restrictions on mortgage borrowing.

Nonetheless, China still needs to contend with big-picture issues of deleveraging the debt-fuelled segments of the economy and addressing the impact of supply chain relocations. Furthermore, stabilising China’s property market, which contributes about 30% to China’s GDP[5], is key. In August, property investment contracted 8.8% year-to-date, from – 8.5% in July. Housing new starts dropped – 24.4% year-to-date in August, while housing sales stayed soft.

Further policy support may be needed to stabilise the property sector and kick-start broader investment in the economy. While the appetite for a large-scale fiscal stimulus seems low, we expect incremental measures to ease liquidity and credit conditions, promote consumption and support infrastructure investment.

Japan: Upside surprise, but recovery is fragile

Japan has seen upside surprises in growth and inflation this year. In the April-June quarter, the economy grew by a steady 1.2% over the previous quarter, with significant contributions to output from net trade and a rebound in tourism. Both segments are arguably supported by a weaker yen, a result of the widening yield gap due to the US Fed’s aggressive tightening and the Bank of Japan (BOJ)’s continued ultra-accommodative policy stance.

On the other hand, Japan recorded a slowdown in private consumption in the second quarter after five consecutive quarters of solid growth. The post-pandemic consumption boost is unlikely to be sustained if real incomes decline. Indeed, despite historic nominal wage increases in 2022-23, Japan still recorded a 16 straight month of decline in real wages in July. Moreover, private sector capital expenditure has slowed, indicating shaky domestic growth.

Strong exports may be untenable amidst a slowdown in global demand, and with the Chinese economy, the receiver of 20% of exports from Japan, still in the doldrums. While the BOJ’s monetary policy remains supportive, more needs to be done in terms of structural reforms and wage gains to drive the virtuous cycle of income to spending.

On the positive side, inflation expectations among Japanese consumers have risen, providing Japan the opportunity to emerge from multiple decades of deflation. Headline CPI inflation has increased to above 2%, although this was largely driven by higher import prices and a weaker yen, as opposed to a closing of output gaps.[6] The BOJ continues to expect inflation to normalise and trend lower in 2024. In view of these uncertainties around the growth and inflation outlook, it may be too early for the BOJ to consider an exit from its negative interest rates until steady increases in wages and prices are observed.

Figure 5: Real earnings growth in Japan is depressed, while real wage increases in the US are supporting private consumption

Source: FRED Economic data, Japan Ministry of Health, Labour and Welfare, UK Office of National Statistics, Eurostat, CEIC

Asian Emerging Markets ex-China: Pacing Ahead

Meanwhile, emerging markets continue to outperform developed economies. According to IMF estimates, around 70% of the global growth this year is expected to come from Asia[7], of which Asia ex-China will contribute about 33%. Most Asian emerging markets continue to see robust growth driven by private consumption, especially in India and Indonesia. The ongoing supply chain relocations have proved positive for investment into the South and Southeast Asian economies, where low labour costs are supportive of the transition. Correspondingly, these economies are witnessing a structural increase in exports. Among the Southeast Asian economies of Thailand and the Philippines, a post-pandemic tourism rebound has supported services exports as well.

Asian economies have been relatively shielded from the high inflation that developed markets are experiencing, and most have averted significant impacts from high advanced market interest rates in this economic cycle. Moreover, the region’s fundamentals of low indebtedness, supportive demographics, rising investment from supply chain restructuring and improving productivity keep us positive on the growth outlook for emerging Asia.

Summary

Inflation in developed markets will likely stay elevated over the coming quarters. Interest rates are expected to remain higher for longer, whilst the impacts will filter through to dampen growth, the labour market and prices. While a slowdown in advanced market growth is expected, we do not expect an outright recession in our baseline scenario, even though the risk of technical recessions is increasing. The impact on real incomes is emerging as a key differentiator for healthy consumption growth and demand – notably in the US. A rise in real wages, for example, would be a key structural change that could help the Japanese economy exit decades of deflation.

[1] Reuters: US consumer spending accelerates; declining savings a red flag,1 September 2023

[2] Federal Reserve: Excess Savings during the COVID-19 Pandemic, Aditya Aladangady, David Cho, Laura Feiveson, and Eugenio Pinto, 21 October 2022

[3] See “Excess No More? Dwindling Pandemic Savings”, Federal Reserve Bank of San Francisco, 16 August 2023.

[4] National Bureau of Statistics data release 15 September 2023

[5] This takes into consideration the footprint of the real estate sector through the whole supply chains and its inputs. See “China’s real estate sector, size does matter”, Caixa Bank Research, 17 January 2022.

[6] Bank of Japan, Outlook for Economic Activity and Prices (July 2023)

[7] IMF: Asia Poised to Drive Global Economic Growth, Boosted by China’s Reopening, 1 May 2023