September 02, 2022 | 13:25
Global Outlook: Back to School, Back to Reality
Global Outlook: Back to School, Back to Reality
Investors, economists, and policymakers alike are grappling with the most complex economic backdrop in a generation, and the result has been at least a few sudden reversals in sentiment. After spending much of the summer in rally mode, markets received a cold splash of reality from Chair Powell’s forceful Jackson Hole speech (Chart 1). However, we didn’t really need the Fed to tell us that the inflation battle is going to be protracted, nor that it will carry real risks for the growth outlook. The good news is that some of the underlying drivers of the outsized inflation of the past year are beginning to fade—oil prices, supply chain snarls, soaring demand for goods—reducing the risks of an outright recession. Nevertheless, on balance we remain on the high end of consensus on our outlook for inflation and a bit below consensus on global growth for 2023.
The single biggest risk to the outlook is the current confidence-crushing level of inflation and the associated ramping up of interest rates almost everywhere. While advanced world central banks have been travelling at slightly different speeds, they are all moving rapidly in the same direction—save Japan (Chart 2). If the Bank of Canada meets market expectations at next week’s decision with a 75 bp hike, it will re-take the leadership as the most aggressive hiker among the G10, with the highest overnight rate (3.25%) and the biggest cumulative move this year (300 bps). If anything, the developing world has been more pro-active, unleashing earlier and even more aggressive rate hikes over the past year in major emerging economies such as Brazil and Mexico. While we may be nearing the end of the tightening cycle in the developing world—and China is tip-toeing in the opposite direction—there is likely a bit more than 100 bps of rate moves still to go on average in the advanced economies, with lingering upside risk.
This near-universal policy tightening has started to weigh on growth, with interest-sensitive housing the first casualty, followed by consumer spending, which will likely slow further over the coming year. We now look for global growth to step down a bit further in 2023 to 2.5% from 2.7% this year, and just over 6% in the 2021 snap-back (Chart 3). For perspective, we regard growth of around 3.25% as a typical year for the global economy (i.e., close to potential growth). Below-potential growth for both this year and next is clearly a disappointing performance, especially in light of the re-opening of the travel and entertainment sectors through these two years. And, combining the four years of the pandemic episode—from the deep dive in 2020, to the next three years of recovery—reveals average global growth of just 2% (based on our forecast through 2023), or well below potential. In other words, even by the end of next year, the global economy will be well short of returning to its underlying pre-COVID trend, indicating that the pandemic did indeed make a lasting mark.
Looking at the G7 economies separately, we can see how they have fared since the pandemic began and through the first two years of the recovery. Table 1 shows the wide variation in how deeply these economies fell amid the initial shutdowns in the first half of 2020 (Japan was least hard hit, the U.K. was walloped the most). Then, there was also a great deal of separation in both the first year of recovery, when economies bounced big-time (to mid-2021) and the second full year, when growth cooled considerably closer to “normal” growth rates (to mid-2022). When regarding these figures, keep in mind that during typical circumstances, a gap of more than a percentage point between G7 economies would be seen as a big deal.
The final column in Table 1 may be the most telling, and the most helpful in judging which economies have fared the best (the U.S.), and those that may have the most room to ultimately rebound (Germany). Combining the full 10 quarters to-date since the start of the pandemic, only Germany has not surpassed its pre-COVID peak, but all of these major economies have fallen well short of potential growth. To pick but one example, Canada’s net 1.7% growth over the 10 quarters (or 0.7% annualized) is roughly 3 ppts below what would have been expected under normal conditions.
Yet even as economies have not fully recouped the lost growth of the past few years, the job market recovery is beyond complete. In the U.S., there are still nearly two vacant jobs for every unemployed person (and almost precisely one for one in Canada), well beyond any reasonable measure of full employment. The overall demand for workers has risen by roughly 4.5 million from pre-pandemic levels, when measured by net payroll increases and higher job vacancies, while the supply of workers has edged up by less than 200,000, when measured by the labour force. This mismatch of more than 4 million between the supply and demand for workers is constraining output, and driving wages higher (Chart 4). While the U.S. is at the extreme on the labour market imbalance, other major economies are moving in that direction, notably Canada, Britain and Germany.
The persistence of wage pressures is a fundamental reason why we remain above consensus on the global inflation outlook. While headline inflation is likely to recede notably over the next year, we look for it to remain above 3% in North America by the end of 2023, or still above the high end of the target range (Chart 5). It’s a similar story for core inflation, which is likely to remain stubbornly high amid rising wage costs and sticky service prices.
Ultimately, the speed with which inflation comes down—assuming it does come down!—will determine whether the global economy can avoid a recession. Our forecast implies a “hardish” landing for the North American economy, but just steering clear of an outright downturn. Frankly, that view requires a little bit of luck on the inflation side, namely from more moderate energy costs and an improved supply chain. For most of the past 18 months, it has been almost all bad luck for inflation, an all-too-familiar reality for policymakers. Barring such a turn in fortunes, the risk is that central banks will need to push on the brakes even harder than markets currently anticipate, ramping up the downside risks for growth—a risk Chair Powell directly addressed at Jackson Hole.