Rates Shock Puts The Economy On A Slower Path
Six short months ago the macro landscape was markedly different from today. The U.S. and eurozone economies were expected to grow at around twice their potential rates in 2022; emerging markets were closing the gaps. Inflation was elevated, but seen as largely transitory. Economies were beginning to heal from the effects of the COVID-19 pandemic and the narrative was around what type of "V" the recovery would resemble and what the new steady state would look like.
Things have changed, and not for the better. The main twist has been the about-face in the inflation narrative. With the wisdom of hindsight, central banks are now viewed as having waited too long to raise rates, putting too much weight on supply-side explanations, or putting too much weight on labor market outcomes, or both. A swath of central banks, most notably the U.S. Federal Reserve, have brought forward their rate-hike timetables.
As we inch toward potential recession, we expect the Fed's stronger action to slow hiring and raise unemployment. Under such a scenario, the "cure" for the U.S. economy and jobs market may feel worse than the disease.
Recent indicators show a resilient economy through June, despite rising prices and interest rates--but there appear to be cracks in the foundation. We continue to expect U.S. GDP growth to slow to 2.4% this year, in line with our preliminary May forecast, though 80 bps lower than our March estimate of 3.2%.
U.K. inflation stood at 9.1% in May--a multi-decade high. This level alone will depress household spending power dramatically, weaken spending, and ultimately contribute to negative GDP growth this quarter and next. Growth in the second quarter will also be lower because the government has all but stopped spending on both testing and tracing and on the vaccination roll-out at the end of March.
But there is more: To bring inflation back down to the target of 2%, the Bank of England (BoE) will continue raising its policy rate into early next year, to reach 2%, before pausing for a few quarters. While policy tightening is necessary and even beneficial for medium-term growth, it comes at a short-term cost. Higher funding costs, will exacerbate downward pressure, mainly via weaker investment, but also by reducing wealth. These effects will be compounded by already tighter market conditions in the U.K. and around the world.
With the exception of China, Asia-Pacific is breathing easier than the rest of the world. Global obstacles have altered the outlook since the Credit Conditions Committee convened three months ago. These include a longer-than-expected Russia-Ukraine conflict; higher energy and commodity prices; higher and more sticky inflation, especially in the U.S.; faster monetary policy normalization in the U.S. and Europe; and economic damage from COVID-19 lockdowns and restrictions in China.
For Asia-Pacific, the two key changes to the global outlook are the weaker growth in China due to stringent COVID restrictions and the higher projected U.S. interest rates. Considering the slower-than-expected easing of COVID restrictions and shallow recovery of domestic demand in China, we have further lowered our baseline 2022 growth forecast for the country to 3.3%.
S&P Global Ratings lowered its real GDP growth forecasts for emerging markets (EMs) to 4.2% in 2022 (was 4.8% in March), triggered by weaker China forecast. For EMs, excluding China, upside growth surprises in several EM economies in the first quarter, offset a weakening growth momentum second quarter onwards, which led to a small upward revision for 2022. Growth forecast for EM, excluding China, in 2023 is unchanged at 4.1% as many countries face protracted recoveries to pre-pandemic trends amid lingering inflation and financial conditions shock. Risks to baseline growth forecasts remain squarely on the downside.
We raised our consumer price inflation forecast across the board—annual average inflation in a median EM (in our sample of 15 countries) will be 6.8% and 4.1% this year and the next, respectively (0.9 ppt and 0.6 ppt higher, respectively, compared with March forecasts), emphasizing the sharper hit to consumers' purchasing power and subsequent lower real domestic demand the remainder of 2022 and 2023.
The eurozone economy's focus has shifted away from COVID-19 toward the inflationary environment and rising interest rates. Yet, recovery from the pandemic remains a key factor protecting the eurozone from a recession so far. We expect the growth tailwind from pent-up demand will continue to provide some momentum to activity over the summer, although it will likely fade toward the end of this year.
Even though inflation has exceeded 2% since mid-2021, households have continued to accumulate excess savings, putting aside a significant buffer at close to 7% of 2019 GDP in the eurozone (see chart 1). Even lower-income households are today reporting a greater ability to save than before the pandemic. Nonetheless, high inflation is now starting to bite into households' savings buffers. While COVID-19-related restrictions in the first quarter (Q1) of this year seem to have maintained the consumer savings rate above 2019 levels, this is likely to have changed for Q2 as restrictions were lifted (see chart 2). This is backed up by the European Commission sentiment survey, with consumers indicting their savings expectations for the next 12 months are now back to pre-pandemic levels.