The US Federal Reserve has made its position on inflation very clear by the language it is using and the quantum of hikes it is prepared to deliver. As a result, ANZ Research has revised its Fed forecasts, bringing almost the entire Fed tightening cycle into 2022.
This compresses the cycle enormously (relative to history), implies the rapid evolution of economic developments is likely to continue, and suggests avoiding extrapolating views and instead focussing more on inflection points.
Several of these are behind us, some are contemporaneous, and others are coming into sight.
Advanced economies (AE) are still leading the tightening cycle. Asia is participating, but the hikes (outside China, which is easing, and Japan) are modest in scale and vigour compared with the Fed, Bank of England, Reserve Bank of Australia, Reserve Bank of New Zealand and others.
For the AE central banks, ANZ Research’s forecasts now envisage the vast bulk of tightening being completed by the end of 2022, and a number of central banks raising rates well into restrictive territory.
ANZ Research expects rates in the US to rise to 4.0 per cent in the March quarter 2023, Australia to 2.60 per cent in March 2023 and then 3.10 per cent in March 2024, and New Zealand to 3.50 per cent in December 2022. Our economists have more modest tightening profiles for Europe (to 1.50 per cent in June 2023) and the UK (to 2.25 per cent in June 2023).
Prior to the pandemic, central banks generally operated in a forward-looking manner. They were often willing to tolerate inflation away from their targets, provided they assessed policy was consistent with inflation returning to target in a reasonable timeframe.
Given how far inflation is currently away from target and how surprised central banks have been by inflation developments, it is unlikely they will pause hiking for any material length of time until there are clear signs of a turn in labour market indicators, such as job vacancies. As such, central bank time horizons will likely remain quite short.
The Fed will also likely need to see some decline in market-based inflation expectations, which are currently above the Fed’s targets for inflation. Base effects suggest headline inflation should peak in 2022, which will aid the inflection in market pricing.
If market-based inflation expectations haven’t inflected already, they are likely to do so soon in the face of the Fed tightening expected over the next few months.
This setup suggests that where growth peaks haven’t been seen already, they are likely to occur quite quickly. Higher inflation itself suggests economies have less spare capacity, central banks’ rhetoric implies they want to see weaker demand with some haste, and consumer sentiment is signalling cost of living pressures are serious.
In the US, the housing market has been cooling rapidly and recent manufacturing surveys have weakened sharply. Growth in 2023 is likely to be materially weaker than 2022 for most economies.
The risk of hard landings has commensurately risen, not least because of the difficulty of calibrating policy when tightening is starting so far away from optimal and given the range of inflation shocks.
ANZ Research expects US GDP growth to slow to zero through mid-2023, suggesting a technical recession – two negative quarters of GDP growth – is entirely possible. However, we still think the risk of a deep recession is low.
While there are supply factors adding to inflation, the bulk of the world’s inflation challenges, in ANZ Research’s view, are driven by demand. The volume of global imports and industrial production, for instance, suggest global demand is well above pre-pandemic levels. Weaker demand, therefore, is ultimately necessary to control inflation.
The consensus assessment of history is almost every Fed tightening cycle in the last half century has culminated in recession. At face value this seems worrying, but there is some nuance that reduces concern.
Former Fed vice-chair Alan Blinder recently pointed out that, of the eleven Fed tightening cycles since 1965, only three resulted in hard landings with deep recessions. Three were ‘softish’ with shallow recessions, three were soft with no recessions and two were ambiguous. We would urge a more nuanced reading of history.
Several other considerations are also relevant. Firstly, as we define economic cycles from one recession to the next, timing matters. Business or investment decisions today will differ radically depending on whether a deep recession might be in 2022 or 2025, for instance.
Secondly, shallow and deep recessions are quite different. With the US, and many advanced economies, operating at such high levels of activity, two quarters of modestly negative growth may be a refreshing pause in the economic cycle.
Thirdly, advanced economy consumers seem in general to be in very good health. Fed tightening is likely to spill over into developing economies, already challenged by high energy and food prices, well before it seriously threatens a deep recession at home.
This also highlights the deeply unequal nature of the post-pandemic environment; a trend exacerbated by the impact of the climate transition. The rise in energy and food prices, in some part due to efforts to reduce carbon emissions, impact most negatively on lower income households who spend a higher proportion of their income on necessities.
This is exacerbating inequalities between economies - and contributing to strong fiscal spending in advanced economies.
While this remains a challenging backdrop for financial markets, a nuanced approach is required. As central banks are focussed primarily on inflation and not yet sensitive to growth or asset market weakness, asset markets are likely to continue to perform poorly. Systematic signals suggest challenging conditions will persist into the back half of 2022.
At the same time, ANZ Research urges against extrapolating asset-market weakness. Much adjustment has already occurred. Bitcoin is down more than 70 per cent from its high, the S&P500 down 23 per cent and Asia has seen five consecutive months of capital outflows.
Moreover, deep recessions in AEs seem unlikely over the next year or two, and elsewhere in Asia policymakers are tightening with more caution. With China easing COVID restrictions and south-east Asian economies resilient against external headwinds, sentiment towards Asian assets should start to improve. This will reduce the likelihood of further significant outflows, in ANZ Research’s view.
This story is an edited version of the ANZ Research report, “ANZ Research Quarterly: inflection points”, published June 21, 2022
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