We are now a year on from the first central banks shifting into tightening mode and raising policy rates to bring inflation back under control. This central bank tightening trend broadened and accelerated in spring 2022 in response to the exogenous shock to commodity prices when Russia invaded Ukraine. So, as we reach its first anniversary, it’s worth assessing how successful the monetary tightening has been and where the risks of a policy mistake are most acute. 

USA

The problem in the USA is that, unlike Europe, the inflation has largely been driven more by domestic excess demand than by the (still evident) exogenous shock of energy price increases. I would argue that the economic damage sustained during the 2020 pandemic recession was more than offset by the fiscal stimulus packages implemented in 2021, putting the Fed in the position of now having to correct that shift in current and expected inflation.

We, along with many other forecasters, expect the Fed Funds rate to peak in the mid-4s, resulting in a relatively short shallow recession in the first half of 2023 designed explicitly to deflate the economy. And on some indicators, it looks as though we are heading in that direction. Credit conditions have tightened rapidly – something we in the real estate sector have seen with a vengeance over the past couple of months – with a commensurately deflationary impact on asset prices and liquidity. 

Meanwhile, in the poker-hot labour market, job openings may still be surprising on the upside, but the quit rate looks as though it’s peaking as some of the very generous pay packages are taken off the table. We’ve also seen house price inflation decelerate – though not (yet?) outright falls in for-sale house prices. And, while leasing activity in the for-rent sector remains robust, the rental rate increase has also slowed. 

So maybe we are in for a soft landing that helpfully deflates, but doesn’t push the US into a prolonged and severe recession.

My concern is that – candidly – I’ll be proved wrong both on the timing and the magnitude of the US recession.  

It already feels as though prices – while responding – are not responding as fast as the Fed would like and that a terminal rate in the mid-4s (as markets are currently pricing in) may not be enough to trigger a deflationary recession as quickly as the Fed would like. The labour market remains robust, wage inflation remains high, consumers keep spending (even if on credit cards) and despite record-low CEO confidence, and dark mutterings about cost containment, we’re not yet seeing the mass lay-offs that some were expecting this autumn.

As a result, we’re starting to see some commentators talk about rates peaking in the low-5s, with a commensurately greater impact on credit-sensitive sectors, not least housing and real estate more broadly. This would take longer to come through though, given what we now realise are longer lags between rate hikes and real economic response, and would likely to delay the onset of the US recession into the middle, rather than the start, of next year.  

As I said, it’s not yet the base case, but it is a clear risk if we don’t start to see more responsiveness in US inflation indicators in the run up to Christmas. 

Europe

Unfortunately, central bank policy can’t bring down energy or food prices, so in order to bring general price inflation down, central banks have had to deflate the rest of the economy. Interest rates have risen highest and fastest in the smaller European countries, particularly in Central and Eastern Europe, and while the European Central Bank started later it has now put in 200 basis points of tightening.

The super-normal inflation in Europe was, in contrast to the USA, primarily driven by the exogenous shock of the Russian invasion of Ukraine and consequent sanctions on using cheap Russian energy. Of equal importance was the shock to food and fertiliser supply. Perhaps surprisingly, the wheat harvest was actually brought in and was of good yield, but the problem is getting it out to consumers when Russia is blockading the Black Sea. On top of that, we also saw extreme heat in Western Europe disrupt harvests in Spain and France this summer. 

With survey evidence in the consumer, financial and manufacturing sectors all signalling that the region is already slipping into recession, the ECB has signalled that while it may not have quite reached its terminal rate, it will slow the pace at which it gets to that point. This suggests that the worst of the bond yield adjustment is probably behind us and that by this time next year we could be seeing rates start to come down.

China

Meanwhile in China, we’re actually flirting with a DEFLATION problem. What started as a deliberately engineered ‘growth’ recession to deflate the leveraged residential development sector has spread into something wider and more problematic. The root cause is China’s ongoing commitment to a zero-Covid policy. The problem for Chinese policymakers is that Covid-19 is mutating into an ever-more contagious but less lethal disease – the typical path of any virus to becoming, basically – flu. This is fine if your host population either has high natural antibodies because everyone’s already had it a number of times (think London) or where the population has all had multiple rounds of efficacious vaccinations (London again). But China is in the invidious position of having very low natural antibodies because of harsh lockdown policies and very low vaccination rates, particularly among the vulnerable. So policymakers cannot afford to let the ever-more contagious disease break out, because it will have a severe toll on its population. Consequently, we shouldn’t be surprised that President Xi restated his commitment to the zero-Covid policy at the Party Congress in October.

This is having a devastating impact on the Chinese economy, where production is being interrupted by localised and asynchronous shutdowns, consumer confidence is at a historic low and consumer spending is focused on loading up on non-perishable food in case another lockdown is imposed. 

It’s also having an ongoing disruptive impact on the wider global economy, with supply chains continuing to be disrupted, particularly in the electronics industry. The result is a situation where China’s greatest domestic risk is deflation, but because of supply-chain issues it is exporting inflation.

Conclusion: an unusually differentiated outlook

There are periods in the economic cycle where a shock hits the global economy with equal force and the policy response is synchronised. This means that big macro bets make less sense that picking local markets and strategies. The immediate period after the collapse of Lehman Brothers was just such a time.

But today we find ourselves with markedly different inflation dynamics and policy responses by country. As a result, the timing of the near-term cyclical correction and the balance of risks is highly differentiated. In Europe, the recession risk is proximate, but this time next year we could be in recovery. The US economy looks healthier ex-ante, but could need harsher rate rises to bring inflation under control for just that reason, resulting in a delayed correction. And in China, we are in the opposite situation where the risk is of what started as a ‘growth’ recession becoming a more widespread ‘traditional’ recession with the concomitant inflationary impact.