As policymakers battle against the impact of the conflict in Ukraine, soaring prices, and a slowing global economy, can they engineer a soft landing, or is a recession coming?
The war in Ukraine compounds renewed COVID-19 restrictions in China, surging price pressures, and tightening financial conditions to create an almost perfect storm. The accumulation of these dark clouds has encouraged economists to downgrade their global growth forecast and raise inflation projections.
We still expect robust growth of 3.3% this year, which would be a significant downgrade from the 4.4% estimate we proffered at the start of the year. We now forecast global inflation to average 5.9% this year, before easing back to 3% in 2023.
The conflict in Ukraine
Russia’s invasion of Ukraine has reverberated throughout the global economy and financial markets. Persistently higher commodity prices and the potential rationing of energy have hit inflation forecasts, manufacturing output, and household consumption levels. European officials are considering a phased import ban on Russian oil.
The implementation of an energy embargo would put further downside pressure on our 2.4% European growth forecast for this year, and could even lead the euro area into a recession. The European Central Bank (ECB) estimates that a 10% rationing of gas on the corporate sector would knock 0.7 percentage points (pp) off gross domestic product (GDP) in the bloc.
China’s battle against Omicron
The arrival of the highly infectious Omicron variant in China, reduced efficacy of local vaccines, and inferior vaccination rates among its elderly population have reinvigorated the government’s determination to enforce its near zero-tolerance approach to coronavirus. Its approach, known as “dynamic clearing”, aims to eliminate cases through targeted testing, contact tracing, and enforced quarantine periods. If these measures fail to stop transmission, then the authorities aim to impose rapid and aggressive citywide lockdowns.
Analysts estimate that up to 370 million people are currently affected by partial or total lockdowns. China’s financial hub and largest city, Shanghai, has confined its 25 million residents to their homes since 28 March.
While officials appear committed to zero cases, they have begun experiments to mitigate the impact of these restrictions on industrial production by introducing the “closed-loop system”. This process results in workers being put into “bubbles” that isolate them from the wider population by keeping them in company-run accommodation when not at the factory.
Economic impact of the lockdowns
While China’s strict lockdowns have saved lives (officially there have only been 5,000 deaths from COVID-19 on the mainland), they have come at an economic cost. Consumer spending has slumped and unemployment in the world’s second largest economy is also rising. Retail sales contracted by 3.5% in March, the first decline since July 2020, and their lowest level since the start of the pandemic. China’s unemployment rate rose to 5.8% last month, up from 5.5% in February and its highest since May 2020.
The disruption to production is expected to further exacerbate global supply-chain pressures. China’s quarterly production of semiconductors shrunk for the first time since early 2019, and there have been major production halts at some of the nation’s largest car manufacturing plants.
Given containment measures are expected to be in place for a prolonged period of time, we have cut our China GDP growth to 4.3% for this year, which is significantly below the official 5.5% target level.
The upward pressure on inflation has been broader and longer-lasting than envisaged at the start of the year. Food and energy prices have surged, supply-chain disruption has taken longer to resolve than expected at the start of the year, and tighter labour markets have been pushing up wages. Recent data shows that services inflation, particularly in hospitality, has seen a sharper increase as economies reopen.
Europe, the US, and the UK have registered multi-decade highs for year-on-year inflation prints over the past couple of months. While forecasts suggest that price pressures may peak in a few months, headline inflation is still expected to remain above central bank target levels through 2023 in many leading economies.
Central banks eye more aggressive rate hikes
In order to curb inflationary pressures, central bankers have been forced to embark upon a more aggressive policy tightening path, even if it comes at the cost of activity.
As expected, the US Federal Reserve (Fed) raised rates by 50 basis points (bp) at the May meeting, its biggest increase in more than two decades. The central bank also announced that the balance sheet reduction would start in June. The half point increase pushes the fed funds target range up to 0.75-1%. Fed chair Jerome Powell dismissed speculation that the committee has been considering hikes of 75bp. He also helped market participants who were looking for clues as to the rate to future hikes by saying that 50bp hikes are likely the committees’ baseline for the next couple of meetings.
We have adjusted our policy forecasts to reflect this and now anticipate half-of-one-percent increases in June and July, followed by 25bp increments at each meeting through January 2023. This would put the terminal rate for the cycle at 2.75-3%.
The ECB has indicated that its net asset purchases under the Asset Purchase Programme (APP) will be concluded by the third quarter. This could lead to a rate hike in the second half of the year, the timing of which will likely be determined by incoming data. Evidence of a wage-price spiral and/or a dis-anchoring of inflation expectations may force the Governing Council into raising rates as early as September. That said, the risk of this is low and a hike in 2023 still looks more likely, given the vast level of uncertainty.
In the UK, the Bank of England offered a gloomy assessment of economic conditions after forecasting inflation would hit double digits in October and warned that UK economy faces a prolonged period of stagflation. Despite the faltering growth profile, the Monetary Policy Committee (MPC) still felt compelled to hike rates by a further 25bp to 1%, which is the highest since 2009.
Given that the central bank is now far more concerned about the level and persistence of inflation, the second-round effects on wages, and rising inflation expectations, we expect further policy increases in the coming months. We forecast 25bp hikes at both the June and August meetings, putting the bank rate at 1.5% in the summer.
Global economy: targeting a soft landing
Despite the reduction in the global growth profile, our projections still suggest trend growth for this year and next. We expect Europe to wean itself off its reliance on Russian energy eventually, and that commodity prices should stabilise in the not too distant future. Supply chains ought to improve as businesses overcome logistical constraints and capacity levels normalise.
While it may feel very disconcerting to be bombarded by a seemingly endless barrage of negative headlines, it’s important to remember that policymakers still have plenty of options.
If, as expected, inflation moderates into year-end, we can expect some of the intensity over the hiking narrative to ease as officials try to orchestrate a softer economic landing. Meanwhile, growth prospects should continue to be underpinned by solid labour markets, excess consumer saving, and the recovering service sector.