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Short and mild recession …
Persistent elevated inflation has been increasingly weighing on household real incomes, leading to a cost-of-living crisis and demand destruction. High energy prices also disrupt growth in energy-intensive industrial sectors, e.g. metals, ammonia, chemicals or glass producers. Central bank interest rate hikes have tightened financial conditions and adversely affected private investment. That coupled with heightened uncertainty all weigh on consumer and business sentiment, resulting in economic slowdown, with many economies poised to contract. We anticipate the euro area GDP to shrink by 0.7% over the 2022 Q4 - 2023 Q1 period, and the US GPD to fall by 0.8% in 2023 H1. The recession, however, should be short and shallow, largely due to:
- The resilience of labour markets. Employment continues to grow and unemployment is at (or near) an all-time low. Many firms will hoard workers to avoid subsequent difficulties hiring employees, as already experienced by many businesses during the post-pandemic recovery. Economic slowdown will likely lead to wage growth deceleration, but without a significant surge in layoffs and with only a limited increase in unemployment.
- A significant decline in commodity prices. Prices of metals, agriculturals and energy commodities have dropped back below pre-war levels on recession fears, easing geopolitical tensions and slowdown in China. Of particular importance is the recent drop in natural gas prices and significantly reduced risk of energy rationing in Europe this winter.
- Government responses – European governments have stepped in to limit the effects of high energy prices on consumers and, to a lesser extent, businesses by introducing energy price caps and/or increasing transfers to households.
… followed by a shallow recovery
Most recent inflation data have shifted the balance of risks to the downside for inflation and to the upside for economic growth, increasing the likelihood of a soft landing scenario. However, a mild recession will likely be followed by a shallow recovery, since elevated energy prices will continue to weigh on growth.
Short and mild recession …
Persistent elevated inflation has been increasingly weighing on household real incomes, leading to a cost-of-living crisis and demand destruction. High energy prices also disrupt growth in energy-intensive industrial sectors, e.g. metals, ammonia, chemicals or glass producers. Central bank interest rate hikes have tightened financial conditions and adversely affected private investment. That coupled with heightened uncertainty all weigh on consumer and business sentiment, resulting in economic slowdown, with many economies poised to contract. We anticipate the euro area GDP to shrink by 0.7% over the 2022 Q4 - 2023 Q1 period, and the US GPD to fall by 0.8% in 2023 H1. The recession, however, should be short and shallow, largely due to:
- The resilience of labour markets. Employment continues to grow and unemployment is at (or near) an all-time low. Many firms will hoard workers to avoid subsequent difficulties hiring employees, as already experienced by many businesses during the post-pandemic recovery. Economic slowdown will likely lead to wage growth deceleration, but without a significant surge in layoffs and with only a limited increase in unemployment.
- A significant decline in commodity prices. Prices of metals, agriculturals and energy commodities have dropped back below pre-war levels on recession fears, easing geopolitical tensions and slowdown in China. Of particular importance is the recent drop in natural gas prices and significantly reduced risk of energy rationing in Europe this winter.
- Government responses – European governments have stepped in to limit the effects of high energy prices on consumers and, to a lesser extent, businesses by introducing energy price caps and/or increasing transfers to households.
… followed by a shallow recovery
Most recent inflation data have shifted the balance of risks to the downside for inflation and to the upside for economic growth, increasing the likelihood of a soft landing scenario. However, a mild recession will likely be followed by a shallow recovery, since elevated energy prices will continue to weigh on growth.
In our baseline scenario, we forecast global GDP growth to decelerate from 3.0% in 2022 to 1.4% this year, to recover to 3.0% in 2025. In the US, from 2023 H2 onwards, a gradual recovery is expected. GDP growth will decline from 2.1% in 2022 to 0.3% in 2023, to increase to 1.8% in 2024. In the euro area, GDP growth should decrease from 3.3% in 2022 to 0.0% this year, to recover to 2.0% in 2024. However, in our downside scenario (with higher energy prices) the euro area economy might shrink this year by 0.9% and grow by a meagre 1.4% in 2024. Economies most vulnerable to a renewed increase in energy prices include: Czechia, Romania, Croatia, Hungary, Italy and Germany.
A persistent decline in real incomes, tightening of financial conditions and fiscal policy following the failed mini-budget as well as the lingering effects of Brexit will place the UK among the weakest performing economies this year, with GDP expected to shrink by 1%.
2023 will be the year of disinflation
Disinflation has already started in most countries, while in others inflation rates are approaching their peak. Large drops in commodity prices recorded over the last months will support deceleration in inflation. Lower input prices for many commodities, easing supply bottlenecks and declining shipping costs should lead to outright price falls in some durable goods. The slowing consumer spending, reinforced by the lagged impact of the previous and forthcoming interest rate hikes will also alleviate the demand-driven inflationary pressures.
In our baseline scenario, inflation will remain elevated on average in 2023, but will be falling relatively quickly over the course of the year. However, some CEE countries, especially Hungary, will continue to see double-digit inflation figures in 2023. In 2024, inflation in the US and euro area will be close to the 2% target.
Inflation uncertainty is much higher in Europe than in the US as in Europe inflation is driven predominantly by volatile and shock-prone food and energy prices. By contrast, in the US, inflation is generated mostly by demand factors, while food and energy account for a much smaller share of the consumer basket and their prices have increased less than in Europe. Shelter and core goods inflation is bound to decline in the US on the back of the lagged impact of Fed tightening, slowing housing market, easing supply bottlenecks and dwindling demand for durable goods. The disinflation path in the US is thus less uncertain.
Monetary policy: still more rate hikes to come, albeit at smaller rate increases
Given declining inflation, major central banks have already scaled down rate hikes and the Fed will likely do that again during the next meeting. Despite this, we anticipate that central banks will maintain a relatively hawkish rhetoric, at least until they see further declines in inflation and underlying price pressures.
We expect that the Fed will only raise rates twice more by 25 bps to pause the tightening cycle at 4.75-5.00% in March. The markets currently price in some rate cuts in 2023 H2, which may not materialize, if tight labour market conditions persist and interest rates need to be kept at an elevated level for an extended period of time to bring core inflation back to the target.
Since the ECB’s rhetoric has recently turned very hawkish, in our projection we assumed that the ECB would continue with aggressive tightening and reach a terminal deposit rate of 3.25% by May 2023, though given recent inflation data, there is a downside risk to this forecast. In our view, the hawkish shift in the ECB’s monetary policy stance is not fully justified, given that underlying price pressures in the euro area remain relatively weak and inflation should fall relatively quickly as supply shocks continue to fade. This increases the risk of excessive tightening and an abrupt policy reversal, which may happen as soon as in 2023 Q4.
In the UK, inflation will be higher than in the euro area or the US and will come back to the 2% target only in 2025. Monetary policy is more uncertain than elsewhere, as the Bank of England is faced with an unusual prospect of a recession, high inflation and tight labour market. We expect the BoE rate to peak at 4.25% in 2023 H1; first rate cut may come as soon as in December, however.
Key risk factors
Despite the recent improvement in the balance of risks for 2023, global economic outlook remains highly uncertain, with several key risk factors:
Weather conditions will have a critical impact on the demand for natural gas and the risk of energy rationing and energy prices in Europe. In particular, weather conditions will affect the level of natural gas reserves in Europe after the 2022-23 winter, which will impact the ability of European governments to replenish gas storage facilities (in the absence of Russian flows in 2023) ahead of the 2023-24 winter
The pace of disinflation and tightness of monetary policy. Persistent elevated inflation would (a) squeeze household budgets for longer and weigh on private consumption and (b) increase the risk of excessive monetary policy tightening by major central banks that may prefer to err on the side of overtightening
Geopolitical tensions (the war in Ukraine), including their impact on commodity prices
Lingering impact of COVID-19, especially in China. China reopening will further ease supply bottlenecks and support global growth, but at the same time – through an increased demand of China for energy commodities, not least natural gas – would add to price pressure
Summary
We should also not forget that energy crisis and many other disturbances, including those driven by changes in the geopolitical landscape, are not transitory shocks. We should thus get used to an extended period of uncertainty and volatility.