Soft landing of the economy in 2023?
By Andrea Siviero, Investment Strategist, Ethenea
While a repeat of the stagflation of the 1970s seems unlikely, the current environment presents several risks that we should not underestimate. We see a relatively narrow path for a soft landing for the 2023 economy.
The current environment of slowing growth and persistent high inflation poses great risks to global growth and represents a significant challenge for policymakers. Persistent high inflation may lead to tighter financial conditions and weaker growth momentum by constraining production and denting consumer confidence. However, an excessively aggressive monetary policy tightening could derail the economic recovery, while having little effect on containing cost-push inflationary pressures.
In 2020, the extraordinary Covid-19 shock unexpectedly hit inflation and growth, and they collapsed simultaneously and abruptly. The unprecedented policy response averted a global depression and led to a very unusual and swift global recovery, driven by a jump in aggregate demand. The strong rebound in aggregate demand could not be matched by a supply impaired by restrictions and lockdowns, and the global economy is going through a delicate adjustment period.
The resulting imbalance between global demand and supply caused surprisingly resilient inflationary pressures. However, economic growth is robust, unemployment rates are close to or below their pre-pandemic levels, and we see little threat of an impending recession. After the strong global economic rebound of 2021, the IMF is forecasting healthy above-trend growth of 4.4% for 2022.
Last November, the Fed started to withdraw its extraordinarily accommodative policy and turned decisively more hawkish in December, which pointed to an accelerated normalisation pace in 2022. While some economists believe the Fed has waited too long to react, the Fed made it clear that it will use all available policy tools to avoid inflationary pressures becoming entrenched. The recent behaviour of inflation expectations (as measured by the 10-year US Treasury inflation breakeven) is reassuring for the Fed’s credibility as an inflation fighter.
Very uncertain short-term inflationary environment
The stagflation of the 1970s resulted from a unique combination of policy missteps and a historic change of the international monetary system, accompanied by two severe oil shocks. The recent inflationary pressures are primarily the result of the unprecedented global policy stimulus enacted to respond to the Covid-19 pandemic. The strong pick-up in economic activity, rising energy prices, and the unusual pandemic-related mismatches between demand and supply are likely to fade gradually once the global economy rebalances and the pandemic-related disturbances are absorbed.
Recent surveys point to input shortages and supply chain disruptions peaking and gradually levelling out as progress is made in tackling the pandemic and higher prices spur investments in production capacity.
We see tighter labour markets in some countries, but there is no clear evidence that the inflationary pressures are generating second-round effects and feeding into widespread salary increases. The labour market should gradually rebalance with the improvement in the health situation, and labour shortages could even force companies to speed up the automation process.
The short-term inflationary environment is very uncertain but there are few signs of a repeat of the Great Inflation of the 1970s. Inflation is more persistent than expected a few months ago but the current situation does not point to a change in the long-term inflation dynamics. The normalisation process of central banks has begun and will contribute to curbing inflation by taming aggregate demand, while a gradual clearing of supply shortages and bottlenecks should help to reduce cost-push inflationary pressures.
Considerable challenges at the horizon
While a repeat of the stagflation of the 1970s seems unlikely, the current environment presents several risks that we should not underestimate.
Inflation risks are skewed to the upside and could materialise if supply-demand mismatches last longer than expected. The longer supply disruptions persist, the greater the risk that cost-push inflation will translate into second-round effects and more structural inflationary pressures constraining economic growth.
Rapidly rising inflation expectations and the risk of a wage-price spiral could lead central banks in advanced economies to overly aggressive monetary tightening, which could cause heightened market volatility and push their economies back into recession.
We see a relatively narrow path for a soft landing for the 2023 economy. It will need a combination of moderating economic expansion, inflation progressively returning to target, and gradual monetary policy adjustment. Central banks will need to remain flexible, policy action will need to be data dependent, proportionate, and well communicated to avoid falling back into the lacklustre pre-pandemic growth.
