Global Economy: Not So Modest Recessions?

Economic activity indicators look more consistently recessionary in the UK and euro area than they do in the US, but US data continue to send warning signals of a downturn. China, for now, still looks to be struggling to build growth momentum under the weight of the zero-Covid policy approach, though there are some signs of easing in the policy. Increases in households’ cost of living, high business costs, increased economic uncertainty and interest rate hikes all continue to weigh on output in developed economies.

Meanwhile, as inflation remains at very high levels and with indicators of core and services inflation still rising in many places, central banks have little to relax about, even if some are signalling some slowing in pace after a period of rapid rate increases. With rates in, or entering, restrictive territory and financial conditions having tightened so much since the start of the year, activity indicators should come under even more pressure. Risks are rising that when recessions do come, they will not be so modest after all.

Housing market at the sharp end? In an environment of rising rates, it makes sense to look to the housing market for recession warning signs. US housing activity indicators have been weak for some time. In both the US and UK, private residential investment as a percentage of GDP looks around 4%, well above the post-financial crisis lows, though already lower than a few quarters ago in the US. A further substantial cooling in construction activity could weigh further on GDP in months ahead as higher mortgage rates cool the demand for housing (even if UK mortgage rates at least are down from their post-Truss mini-Budget highs). An annual fall in house prices seems a reasonable central case now for the UK in 2023.

However, the cooling in economies is stretching well beyond the interest rate sensitive housing/construction sector. Global trade indicators indicate a drop-off in demand for exports, employment indicators look less buoyant, indicators of business capital expenditure have weakened in recent months and consumer confidence remains weak across many economies.

For the UK, the forecasts for GDP growth in my last quarterly report (The three Rs: Recessions, rate hikes and really high prices) look too optimistic. In the UK, the economy contracted 0.2%Q in Q3 already with business surveys signalling a further Q4 slowing – consistent with a deeper 2H 2022 fall in output than I’d pencilled in. The fiscal backdrop also looks set to become less supportive, with more fiscal tightening expected to be announced in the November 17th Budget. Negative rather than flat annual GDP growth looks more likely now for 2023. The outlook will be clearer though once we have more clarity on fiscal policy.

Some risks of an earlier recession in the US: In the US, the recent deterioration in business surveys, alongside the tightening in credit conditions visible in the latest Senior Loan Officers survey suggests that recession may come sooner than many predicted (though I still have mid-2023 pencilled in for now, allowing more time for monetary policy tightening to affect the economy). However, current economic indicators in the US – especially business surveys – look less recessionary than they do in Europe.

Growing euro area concern too: In the euro area, although a recession still looks likely to me over the turn of the year, some recent indicators suggest the potential for a worse than expected outcome. Not only does inflation remain very high, crimping household real income where nominal wage growth has not picked up in the same way as in the US and UK, but credit conditions may be tightening quite rapidly. The European Central Bank’s (ECB) recent bank lending survey suggests that banks are expecting to tighten credit standards even more sharply in Q4 for firms. The unemployment rate indicators I track have been pointing upwards for several months now although the actual published unemployment rate, for now, remains very low by euro area standards.

Does that mean central banks are on the brink of pivoting? Not yet. We’ve already seen monetary policymakers in the likes of Australia and Canada slow the pace of hikes. US and euro area policymakers have signalled a slowing pace of tightening ahead and recent lower US inflation data looks consistent with that. As central banks move beyond policymaker estimates of neutral, it makes sense that we see central banks slow the pace and act more cautiously as they try to assess how tight monetary policy needs to be to force inflation to return sustainably to target. However, the inflationary backdrop means it is still a bit too early to expect a pause. A slowing in economic activity is an important precursor to slower domestic inflationary pressures. But, with inflation now having been so high for so long and likely still many months away from being anywhere close to target, central banks need bigger slowdowns than they otherwise would. Before they are going to be confident that inflation dynamics and inflation expectations are consistent with inflation targets, they need to act and sound more serious about tackling high inflation than they would against a backdrop of lower inflation.

Terminal rate risk: Against this backdrop and despite the softening in headline inflation, recent central bank communication and inflation data indicate that a 5% peak seems a more reasonable central case for the US terminal rate than something closer to 4% at least for the upper Fed funds target. 4% has already been reached and the Federal Open Market Committee are indicating that they still have more to do. Given euro area inflation data, the ECB rate forecast could outstrip my previous forecast (since it only builds in a further 50bp of rate hikes). However, with the economic backdrop worsening and a dose of fiscal tightening likely on the way, there is significant downside risk to a UK terminal rate forecast of 4.50% (see BoE hike 75bp despite a grim forecast economic outlook).

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