Advanced economies replicating the same monetary policy mistakes are facing monster inflation. Now with additional external pressures driving inflation even higher, policy is tightening as the economy deteriorates. That’s the opposite of what usually happens, warns global forecasting firm Oxford Economics. Typically as the economy slows, rate cuts help to craft a soft landing. This time’s different, they warn. The firm has trimmed its growth forecast, with risks slanted further to the downside.
Central Banks Are Getting Serious About Fighting Inflation, and That Requires Slowing Growth
Global forecasting firm Oxford Economics warns economic growth will have to be cut. That’s the bad news. The good news is central banks are seriously focused on cutting inflation. High inflation can produce a recession anyway, as non-productive price increases erode consumption.
Going into an inflationary recession would be much worse than a minor recession. When these happen, unemployment rises along with the cost of living. If central banks can mitigate high inflation, they can deal with a traditional one. Inflationary recessions are the worst kind. Ask your grandparents.
“Central banks have changed the way they react to economic conditions, largely focusing on current inflation and its impact on expectations at the expense of future growth,” wrote Innes McFee, Chief Global Economist at Oxford Economics.
Rising rates and inflation are a double whammy for growth. Since inflation erodes consumption, more discretionary producers see lost revenue. At the same time, higher rates will increase the cost of capital and reduce leverage. It’s a rare combination and a little trimmed growth is probably a best case scenario.
The solution seen is higher rates at the expense of growth. “Their fear now is that high inflation could influence expectations, and in turn wages, ingraining inflation. This shift is the reason for downgrades to our H2 2022 and 2023 advanced economy growth forecasts amid upgrades to our policy rate forecasts,” he adds.
The Wealth Effect Is About To Reverse With Losses
A wealth effect is the behavioral observation that people spend more when they feel rich. If they made a bunch of money from their stocks or home, even if only on paper, they’re more comfortable spending. If and when that reverses, a reverse wealth effect can appear. This is when consumers stop spending out of fear of losing money, and we see the savings rate shoot up.
As lofty valuations correct, a reverse wealth effect is expected in the coming months. McFee’s firm expects global equities to fall by 25% and home prices to drop by 5%. Remember, that’s global home price growth. The firm expects more bubbly countries to see much larger corrections.
In Canada, they’ve recently forecast a price drop of 24% by 2024 and stalling beyond. Larger inefficiencies require larger corrections, so they’ve warned a correction may not happen. But in the case of Canada, they’re risking a financial crisis if they extend home prices further.
The reverse wealth effect and inflation will trim global GDP significantly. McFee’s model estimates GDP will contract between 0.3 and 0.6 points, from the reverse wealth effect. Not the biggest drop, but certainly not an increase. Although that might be an optimistic view, the firm hints.
Expect Downward Revisions To Global Growth Forecasts
As central banks prioritize fighting inflation they’re acting more unpredictably. Making a 0.75 point rate hike might be the right thing to do, but it was hard to forecast. Consequently, the firm can’t forecast on the path policymakers should be taking, but the path they’ve laid out in front of the public. McFee expects downward revisions to grow as central banks aggressively tackle inflation.
“Overall, our forecasts have been adapting to this new reality and we expect to make more upward revisions to policy rates and downward revisions to growth in the July forecast round,” he says.
There’s good and bad news when reaching peak growth for the economic cycle. Lower interest rates — after some turbulence, of course. “… with the economy in a mature phase of the cycle, a recession and lower rates cannot be far off.”
It’s probably safe to say the next recession won’t involve such a large stimulus. Even central banks are beginning to understand the issue with quantitative ease (QE). That and plunging the public into a binge-purge business cycle every two years instead of every decade is a less than desirable outcome.