5 February 2023
After a bruising 2022, global financial markets now have fully embraced the propect of a “soft landing” for the global economy. Even the IMF has revised up its 2023 GDP growth forecast following China’s post-Covid opening, declining European natural gas prices, and signs that world-wide inflation may have peaked.
In the United States, most importantly, this optimistic appraisal is not unwarranted. The US Federal Reserve has faced a difficult balancing act to lower inflation to its 2% target. On the one hand, raising interest rates too much risks an economic recession. Alternatively, moving too slowly may lead to a sustained period of stagflation: weak growth and persistently above-target price increases. The Fed’s “landing zone” for the economy is narrow: to reach the inflation target will require an extended period (up to three years) of below-trend GDP growth in the 1% to 2% range. As Goldilocks might say, neither too hot, nor too cold!
After threatening its long-term credibility by insisting inflation was “transitory”, the Fed’s subsequent interest rate hikes have succeeded in slowing economic growth into the desired range. Indeed, GDP has decelerated from 5.9% in 2021 to 2.1% last year. As a result, inflation has cooled from 7% to 5% during the past six months. More importantly, after peaking at 5.4% “core” prices gains (excluding food and energy) have moderated to 4.4%. Not surprisingly, markets are celebrating.
However, what could derail this “soft landing”? I expect returning US inflation to its target will be more complicated than markets now believe: price growth will remain above the goal even at the end of 2024. Indeed, I still believe the possibility of a mild US recession beginning late this year and continuing into early 2024 remains above 50%. It is also important to consider the risks confronted in other G7 economies. Despite still accelerating inflation, I am relatively confident the European Central Bank (and Bank of Japan) will achieve their inflation goals by the end of 2024, but not the Bank of England. (I will consider global asset allocation implications next time).
What Could Go Derail the Soft Landing?
To make a long story short, the continued tightness in US labour markets complicates the achievement of the Fed’s inflation target. Indeed, the very low 3.4% unemployment rate captures the headlines. However, the US central bank’s favourite gauge — the unemployment to job openings ratio — measures the imbalance between labour supply and demand. By this measure, the labour market is the tightest in decades (Chart above). To be sure, the recent decline in job vacancies raised hopes that labour demand may be cooling. But, these hopes are likely to have been dashed by January’s blow-out non-farm payroll report.
Not surprisingly, wage growth has accelerated (Chart above): average hourly earnings were up 6% in mid-2022. Again, however, pay increases have moderated recently (surprisingly to me), e.g. the employment cost index has declined in each of the past 3 quarters. However, I suspect additional wage moderation will require slower economic growth and higher unemployment. Even current 4-5% compensation gains are far from consistent with 2% inflation. Of course, higher labour productivity would warrant high pay awards. However, worker efficiency actually declined 1.2% in 2022. Achieving the inflation target will require wage growth of 2-3% unless profit margins are squeezed significantly.
The Chart above illustrates the recent moderation in “core” inflation stems from slowing goods prices. Meanwhile, service sector inflation is accelerating, up 7% in December. This transition reflects the shift in the American households’ spending patterns. Initially, following the end of the Covid lockdown, pent-up demand for consumer goods soared. More recently, outsized service sector demand, especially in travel and hospitality, is leading to much higher prices. Robust demand for services complicates the fight against inflation: the sector accounts for 80% of GDP and rising wages are its largest cost item.
Fed Credibility and Recession Risks
After rightly questioning the Fed’s commitment to lowering inflation initially, financial markets are now complicating the central bank’s pursuit of this goal. Indeed, following last year’s sharp rise, long-term inflation expectations have declined towards the 2% target. And, despite continuous Federal Reserve interest rate hikes, financial conditions (FCI) have actually become less restrictive in recent months (Chart above). If “core” inflation eventually becomes sticky, as I suspect, the Fed may need to convince markets that financial market conditions must remain tighter for longer (with the FCI closer to the 0 level).
Renewed signs of recession would spoil the markets’ upbeat mood. Indeed, despite data volatility, US GDP growth is now in the tepid 1-2% range. Indeed, interest-rate sectors, e.g. residential investment and now capex, are already weak. The US consumer’s resilience — real spending advanced a healthy 2.8% last year — will fade in 2023, reflecting weaker income growth and low savings (the Covid winfall has been largely spent). Moreover, after accounting for one-third of US GDP growth last year, inventories will be a drag in 2023. Likewise, weak global growth will be a headwind for the external sector.
Tight labour markets, rising wages, and higher service sector prices will eventually complicate the achievement of the 2% inflation target. Specifically, while core inflation will ease towards 3.7% by June 2023 (compared to 4.4% in December 2022), underlying price gains will remain at 3.25% in December 2023, and remain in the 2.5%-3% range at the end of next year (the Fed’s forecast is 3.5% and 2.5% in 2023/24 respectively).
Eventually, the Fed will need either to prioritise its inflation target or to minimize the risk of recession. I suspect Chairman Powell (and team) will not want to go down in history as the group that jeopardised the Fed’s hard-won track record of low inflation. As a result, I expect the Fed will either tighten monetary policy more than expected, or keep interest rates higher for longer. Currently, markets expect that after peaking in May, the Federal funds rate will begin declining before year end, and fall 175bp by the end of 2024. Monetary easing is likely to be delayed until next year, with rate cuts totalling 125bp in 2024. The yield curve’s inversion is also a reliable recession harbinger, especially in the context of rising real interest rates (next Chart).
If so, the risk of recession towards the end of the year will grow. Indeed, the Chart below illustrates that recessions occur whenever the unemployment rate sustainably declines below 4%. I expect the jobless rate to rise will rise towards 4.5% during the next 18 months. US GDP will grow 0% and 1-1.5% in 2023/24 respectively (the Fed projects 0.5% and 1.6% respectively).
G7 Inflation Risk: United Kingdom Stands Out
European central banks also lifted interest rates last week to confront inflation risks. But, important differences exist among the G-4 countries. To be sure, labour market conditions are tight in all countries. However, wage growth has remained more modest in the Eurozone, and the UK has experienced the largest pay hikes (Chart above).
Even though Eurozone unemployment is at multi-decade lows, the region’s 6.6% jobless rate still remains well above 3.4% and 3.7% in the USA and UK respectively. In addition, Europe is benefiting from a stronger post-Covid recovery in labour force participation (Chart above). Despite the pandemic-era interuption, Europe has experienced a secular improvement in its employment rate, especially amongst female workers. In contrast, the US participation rate has been declining for the past two decades, and is lower than in Europe. In the UK, like the USA, the level of employment and participation remain below pre-Covid levels, as older workers have not return to the workplace. As a result, Eurozone wage demands should remain more modest than in other nations.
To be sure, Europe faces formidable inflation risks. Indeed, headline CPI advances exceed those in the USA. Moreover, as in America, Eurozone service sector inflation is accelerating, although more modest compensation growth should help limit the damage (Chart above). Europe should also benefit from YOY deceleration in energy costs in the period ahead (although renewed Ukraine tensions could derail this benefit). In the UK, wage growth could add to price pressures for services, although lower food and energy quotes should lower headline readings in coming months. In Japan, modest service sector inflation will offset pressures in food, energy, and goods, which all should moderate in the period ahead.
What are the policy implications? In Europe, I project core CPI to decline to 2-2.5% by the end of 2024 (5.2% in December 2022). Financial markets expect the ECB to cap rates at 3.5% , before declining to 2.6% by the end of next year. This may prove a bit optimistic: I anticipate short-term rates to rise to 4% before declining next year towards 2.5-3%.
Arguably, the Bank of England confronts the most complicated outlook. On the one hand, GDP prospects are the weakest amongst the G-4, while rapid wage gains and weak productivity growth create the most unfavourable inflation environment. Indeed, inflation will only decline to 4.8% and 3-3.5% in 2023/24 respectively (well above the 2% objective). Markets expect base rates at 4% (currently 4%) and 3% at year end 2023/24 respectively. Unless the Bank of England is prepared to risk a prolonged period of above-target inflation (and the possibility of stagflation), interest rates could be 100bp higher than these current market projections.