One year since the inception of our Stagflation Shock scenario, the global economy continues to face elevated inflation and falling growth. Both are slowing, but they are slowing—slowly. And the descent has not been smooth.
China’s property sector crackdown cooled a key engine of growth, the Ukraine war threatened Europe’s recovery from the pandemic, and most recently, banking sector turmoil shocked U.S. markets. But recession forecasts continue to be postponed, even as an extremely aggressive global rate hiking cycle keeps investors on edge for what may break next.
Despite the turbulence, there are several atypical factors keeping the economy on course. Both U.S. and euro area households are supported by savings buffers built up during lockdowns. Labor markets, while starting to cool, remain strong, supporting nominal wage growth and spending. Companies were able to take advantage of low interest rates and successfully pass on higher prices to consumers. Also, order book backlogs remain a driver of industrial production. China’s current re-opening provides promise to its domestic economy and hope for international tourism destinations. Moreover, while PMIs have been cooling, the declines are overstated by easing supply chain delivery times which are a drag on headline indices.
The U.S. economy should slow substantially in the second half of the year, driven by the depletion of savings buffers, the tightening of credit conditions, the cooling of consumption, and firms’ margin pressures. Inflation will trend down, but the path will be bumpy, requiring additional Fed rate hikes this spring. Firms will respond to slower growth and higher funding costs by some increase in layoffs. Yet, a shortage of workers exacerbated by an ageing population points to a limited rise in unemployment. Many firms did not find enough workers to meet demand in the last three years. Any recession—this year or next—should be short and shallow.
In the euro area, growth and inflation have proved more robust than expected. A solid banking sector allowed the region to avoid severe contagion from stress across the Atlantic. Base effects should now help cool inflation, aided by a few more ECB rate hikes. Risks skew toward more, rather than fewer, hikes if the downward trend in inflation proves more elusive than expected.
In China, lockdowns plagued the economy for much longer than the rest of the world. Delayed re-opening will make it the only major economy to experience faster growth this year than last. However, the rebound will mostly rely on domestic consumption. The rest of the world will benefit from less uncertainty and more tourism.
We have upgraded our Stagflation Haze scenario from 60% to 70% as slowing growth and above-target inflation continue to define the outlook. The recent tightening in U.S. financial conditions has led us to downgrade our Boiling Over scenario, in which growth and inflation continue to come in hot and force central banks to deliver many more rate hikes, with odds down from 30% to 10%. Similar reasons have led us to boost the odds of our Steeper Slide scenario from 10% to 20%, in which the economy is not strong enough to withstand the aggressive tightening and slips into a more traditional recession this year.
While fears of a recession have been elevated over the past year, economies have shown resilience thus far. The path ahead is surely lower, but unless another exogenous event blows the global economy off course, the journey to lower inflation, via elevated policy rates and slowing growth, will still take time