Originally published at Project-Syndicate | March 9th, 2023
Despite signs that inflation in most major economies has peaked and is trending back down, recent data releases have renewed fears that central banks will have to tighten monetary policy still further. In the face of maddeningly mixed signals, much will depend on a few key factors.
LONDON – In January, I expressed optimism that a recession across the Western world (and beyond) was becoming less likely, and high-frequency indicators since then have indeed supported a benign outlook. This is especially true in the United States and China, now that it has reopened, but it also applies to continental Europe, the United Kingdom (to a more modest degree), and many developing and emerging economies.
Yet despite recent positive signs, several new sources of uncertainty have presented themselves. First, the evidence for a sustained downward trend in inflation has weakened both in the US and Europe, leading central bankers to warn that they may need to resume rapid monetary-policy tightening. US Federal Reserve Chair Jerome Powell has just told Congress that, after having reduced the size of its last interest-rate increase from 50 basis points to 25, the Fed may need to return to larger hikes. Given US monetary policy’s central importance in the global economy, such changes are no small matter.
Financial markets have duly swooned, with short-term interest-rate expectations moving sharply upward. Markets now expect the Fed to raise rates above 5%, and some observers even anticipate a rise toward 6%. Either way, investors will have to navigate many more hurdles for many years to come, including in equities.
The next big signal will come on March 10, when the US Bureau of Labor Statistics releases employment data for February. Market participants will be scrutinizing the BLS report for evidence of increased tightness in the labor market, which would imply more potential inflationary momentum. And not long after the jobs report, we will get the next monthly update on consumer prices. If these point to continued inflation “stickiness,” a more widespread freak-out in financial markets cannot be excluded.
Both forthcoming reports could renew fears of the hard landing (a recession with a sharp increase in unemployment) that everyone was discussing in the second half of 2022. Evidence of continued inflation would heighten pressure on the Fed to over-tighten in the name of demonstrating its credibility on price stability. And wherever the Fed goes, many other central banks will follow.
I do not envy today’s central bankers or professional forecasters. Their jobs are becoming increasingly tricky. After all, other leading indicators for inflation remain rather encouraging. Despite China’s reopening, many global commodity prices have not rebounded significantly, and some have even continued to soften. Leading commodity-price indices are down almost 20% year on year, and some crucial ones, like European natural gas, have fallen even further.
These indicators should not be overlooked, considering that commodity prices helped drive up inflation in the first place. Moreover, monetarists would point out that the growth rate of the US money supply has slowed. In an earlier era, this data point alone would suffice to keep the Fed from raising rates any further. And, to top it all off, several housing-market indicators – such as a broad-based decline in home prices – have also begun to suggest that the economy is cooling off.
Given these more encouraging signs, if the next monthly employment and consumer-price reports are more positive than expected, the Fed and financial markets will heave a sigh of relief. A soft landing – or a “no landing” – will remain a distinct possibility.
Of course, a host of other issues could still muddy the waters. For starters, Russia’s war in Ukraine remains a source of deep global uncertainty. At this point, no one has any idea when or how the fighting will end, let alone what economic consequences it will have, especially on commodity prices.
The second source of uncertainty is China’s economic recovery. Chinese policymakers recently announced a goal of around 5% real (inflation-adjusted) GDP growth this year, which is lower than many forecasters would project given the strength of the post-COVID rebounds seen elsewhere. Moreover, it remains to be seen if China’s recovery will proceed with little hindrance from other structural challenges, especially those emanating from its property market. China watchers will have plenty of issues to follow and ponder heading into the rest of the year.
And, finally, there is Japan, where Haruhiko Kuroda is stepping down as the governor of the Bank of Japan after ten years in the job. Will the changing of the guard lead the BOJ to depart faster from the ultra-loose monetary and bond-market policies over which Kuroda presided? Given the long duration of the BOJ’s quantitative easing and its effects on financial markets at home and abroad, any new shifts away will undoubtedly have far-reaching consequences.
Jim O’Neill: A former chairman of Goldman Sachs Asset Management and a former UK treasury minister, is a member of the Pan-European Commission on Health and Sustainable Development.