Rate cuts are a distant prospect

While they are the subject of much speculation, interest rate cuts across many economies remain a distant prospect. Services inflation is too strong, household balance sheets too resilient and the level of demand too robust for substantial rate cuts before mid-2024 at the earliest.

The main surprise has been in greater China. ANZ Research has cut its 2023 mainland China gross domestic product forecast from 5.4 per cent to 4.9 per cent and halved our 2023 consumer price index forecast from 2.2 per cent to 1.2 per cent.

The key driver of the surprise has been the housing sector’s unresponsiveness to the economy’s re-opening, reflecting generalised household caution as evidenced by sharply rising bank deposits. More fundamentally, however, it’s hard to ignore China’s demographic challenges.

Demography is rarely considered in cyclical macro dynamics, perhaps because it is often slow moving. But sometimes moves pick up pace, and sometimes it has most impact when the environment is most receptive.

China has had an unusually sharp fall in birth rates over the last four years, and anecdotal evidence suggests that has been sustained even through the post COVID-19 reopening. It’s possible China’s debt challenges and demographics are conspiring to sharply lower China’s growth potential.

China has taken some easing steps to help stabilise the economy through interest-rate reductions. But the uncomfortable reality is it doesn’t have much policy room. The International Monetary Fund suggests China’s public sector’s augmented funding needs are at 16.7 per cent of GDP this year, with debt at 120.5 per cent of GDP.

Local government finances appear increasingly fragile, suggesting they will be calling on more central government support. Interest rate cuts are also constrained by the renminbi having already depreciated against the United States dollar and concerns about reinvigorating an already overvalued property sector.

Spillover

It is difficult to identify any broad spillover from China’s sub-par performance to the rest of the world. The consensus has continued to be surprised by the hikes in advanced economies.

In ANZ Research’s view, the global economy is close to the end of the tightening cycle, but not quite there yet. ANZ Research expects one more 25 basis point rise in the US, European Union and New Zealand, two more in Australia and three in the United Kingdom.

ANZ Research is hopeful, but not necessarily expectant, we will soon see an accumulation of the evidence required to become confident interest rates have peaked.

Not yet fully appreciated is the likelihood of rates staying at peak levels for an extended period. If central banks are successful in landing their economies without too many bumps, the central expectation should be that many of the rate hikes we have seen will prove to be long lasting.

ANZ Research does not expect the US, Euro Area or UK to start easing until the second quarter 2024, and Australia and New Zealand until the third quarter of 2024. In Asia, only Korea is expected to ease in 2024 at all.

Active

The prospect, or not, of recessions in the economies raising interest rates remains an active discussion. ANZ Research thinks it is important to keep in mind the difference between a technical recession and one that causes deep and lasting economic damage. Recessions in this cycle so far have been very mild.

New Zealand GDP was reported at -0.1 per cent for the first quarter, after -0.7 per cent in the fourth. The European Union is also in recession, but unemployment in both economies has been quite well behaved.

Unemployment has risen by less than half a percentage point in New Zealand and fallen to a cyclical low in the EU. This fits with ANZ Research’s expectations. Australia has some protection against recession from its 2 per cent population growth.

Demand

For the most part private balance sheets entered this tightening cycle in solid shape. The economic upswing has also been so rapid there hasn’t been time for credit bubbles or excess leverage to accumulate in a broad-based manner.

This suggests proportionately weaker demand, rather than a quick tightening of credit, is the factor that will ultimately shift monetary policy this cycle.

The mild economic response following the collapse of Silicon Valley Bank provides some evidence of this. While it was labelled by some as a credit crunch, it has been more a credit crimp. US bank lending standards tightened sharply to a point that would normally be associated with sharply falling employment. But, so far, the impact on data trends in the United States has been extremely mild.

In addition to these factors, conservative investor positioning limits the ability of markets to act as an amplifier of rate hikes. Expectations of recession have been rising the past year, and this has translated into many market participants taking more defensive positions. The challenge is that the data have not weakened enough to corroborate this bearish view.

This is not to say the risk cycle is likely to strengthen. Central banks are tightening, which means liquidity is likely to progressively tighten and risk spreads widen. For a more durable risk rally the weak point in US growth will likely need to be in sight and the Fed anticipated to be soon shifting towards an active easing stance. For that, US inflation will need to be much closer to the Fed’s 2.0 per cent target than ANZ Research’s forecasts for 2023.

Much of Asia is in a more neutral cyclical position than has been discussed to this point. The region is not as soft as China, but also doesn’t face the inflation challenges of the developed economies. This is likely to keep Asian asset markets on the sidelines and the popular commentary focussed elsewhere.

Richard Yetsenga is Chief Economist at ANZ

This is an edited version of a piece which originally appeared in the ANZ Research Quarterly, published June 20, 2023