Economic and financial risk insights: the inflation challenge is far from over
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We are braced for a growth slowdown globally and mild US recession later in 2023 as inflation continues to represent a significant risk to major economies. We see the inflation challenge as far from over, even if a drop in headline inflation below core in many economies soon creates an illusion of having conquered it.
Globally, the divergence between weakness in the manufacturing sector and services sector strength continues (see Figure 1). In the US, the impact of higher interest rates and tighter credit standards is becoming more apparent as labour demand and wage growth have moderated in recent months (see Figure 2). However, labour markets appear still too strong for inflation to return quickly to 2%, which could delay the US recession into early 2024.
Figure 1. US, euro area and China Purchasing Manager Indices
Figure 2. US average hourly earnings vs non-farm payroll (NFP) growth
In Europe, we expect the lagged impact of monetary policy tightening to have its peak impact next year. We have lowered our 2024 GDP forecasts for the euro area (-0.4ppt) and the UK (-0.3ppt) relative to consensus. We also slightly lower our GDP growth projection for China (-0.1ppt) to reflect recent slowing momentum, despite a stronger 1Q GDP result.
We expect headline inflation to soon fall below core inflation in several economies, mostly due to base effects. This may create an illusion of having defeated inflation, but in reality core and services inflation remain too elevated for a sustainable return of inflation to 2%.
Figure 3. CPI inflation in the US and euro area
Continued inflation strength in Australia, Canada and the UK highlight that inflation is far from defeated and policymakers should not become complacent. We revise up our 2023-24 CPI forecasts for the UK and Japan, but lower our 2023 CPI forecast for China to 1.5% (from 2.4%) given weaker domestic demand.
After "skipping" a rate hike this week, the US Federal Reserve is likely either at, or very close to, the end of its hiking cycle, whereas the ECB’s rate hike in June reaffirms our view that further tightening is still to come.
Table 1. Key SRI forecasts (in %)
Through unexpected rate hikes earlier this month, the central banks in Canada and Australia confirm a theme applicable to most developed market central banks: the bar for further rate hikes is lower than the bar for rate cuts. We revise up our terminal rate forecasts for the euro area, the UK, Australia and Switzerland by the end of 2023 and 2024. We revise down the policy rate forecast for China, due to easing financial pressure from global monetary tightening. Finally, we expect the liquidity backdrop to deteriorate, as quantitative tightening will result in declining bank reserves.