“The Middle East war adds to an already uncertain geopolitical situation, with several ongoing conflicts and great human suffering. Its proximity to oil-producing countries is a risk factor, but our main scenario is that the economic consequences of the war will be limited. Uncertainty about global cooperation, trade and climate change will affect the behaviour and future plans of countries and businesses. Everyone is adapting to the new world. Although abrupt fluctuations in trade flows are unusual, we are now seeing, for example, that US imports from Mexico have surpassed those from China,” says Jens Magnusson, Chief Economist at SEB.
Global growth of 3 per cent for 3 years
The latest statistics support our view that a deep economic downturn can be avoided. China’s outlook has improved somewhat, and emerging market (EM) economies are holding up relatively well. The slowdown in the 38 mainly affluent OECD countries is clear, but uneven. American growth has again surprised on the upside but is expected to decelerate around the turn of the year. In the euro area, growth rates are already around zero. The next few quarters will be weak, but both the United States and the euro area will avoid a recession. Overall, GDP growth in the OECD countries will decelerate from 1.6 per cent this year to 1.2 per cent next year, followed by a recovery to 2 per cent in 2025. Global GDP will increase by a moderate 3 per cent per year during 2023-2025. The changes in our forecast compared to the August issue of Nordic Outlook are minor.
Complicated monetary policy balancing act
Although growth will remain below normal for a while longer, the impact of the rapid interest rate hikes and inflation shock has so far been surprisingly limited. Strong labour markets, remaining household savings buffers and well-filled company order books after the COVID-19 pandemic have contributed to a gentle slowdown. But looking ahead, we expect these forces to fade. Rising long-term bond yields have recently contributed to further tightening of financial conditions during this late stage in the central bank hiking cycle.
“There is thus reason to fear that the impact on the real economy and the financial system may be greater now than at the start of the tightening cycle. This suggests that central banks will refrain from new rate hikes, even though underlying inflation remains a bit above target, and will instead increase their preparedness for monetary easing in 2024,” says Daniel Bergvall, Head of Economic Forecasting at SEB.
Can differences in inflation dynamics change the order of central bank rate cuts?
A continued decline in the inflation rate towards 2 per cent is crucial for our forecast. The drivers of inflation have clearly lost momentum, especially energy and other goods as manufacturing activity has weakened. Meanwhile the service sector has held up better. Once demand falls more generally and labour markets cool, wage pressures will subside. This will help core inflation to reach its target late in 2025. Because of higher costs than during the decades before the pandemic, core inflation will not fall back below 2 per cent. The biggest upside risk is that the upturn in service prices will not subside, along with the risk of compensation demands aimed at restoring real wages. This autumn, the euro area has also seen surprisingly low inflation figures for service prices, but uncertainty ahead of next spring’s wage and salary negotiations makes us cautious about extrapolating these trends.
“If the downside risks to the euro area were to materialise at the same time as US growth continues to surprise on the upside, we may see a situation in which the European Central Bank cuts interest rates earlier than the Fed, which would be the opposite of the order most observers have predicted so far. This is not our main scenario, but the probability has swung in that direction and so has market pricing,” says Jens Magnusson.
High public sector debt and inflation risks will hold back interest rate downturn
Our main scenario is that the Fed will lead with a key rate cut in May 2024 and that the ECB will follow suit at its June policy meeting, while somewhat more persistent inflation problems may lead to a further rate hike by Norges Bank and the Bank of England. At the end of 2025, the Fed’s key rate will stand at 3.00 per cent and the ECB’s deposit rate at 2.50 per cent. Key interest rate cuts will be a driver of lower US bond yields in 2024 and 2025, while the downside potential in the euro area is limited, given already depressed levels. Worryingly high levels of public sector debt − especially in the US − as well as reduced central bank asset purchases and increased inflation risk premiums suggest that in the future, investors will demand a larger premium to invest in fixed income instruments with longer maturities. Because of already large budget deficits and more nervous fixed income markets, fiscal policies will be largely neutral during the next couple of years, despite the slowdown in growth.