Our Previous Narrative, Disrupted

Tension is brewing for our macroeconomic outlook. The financial market turbulence in March ignited by the collapse of Silicon Valley Bank (SVB) in the U.S. threatened to disrupt our story of a protracted landing with higher policy rates for longer on both sides of the Atlantic. The market turmoil led to a forceful and apparently successful policy response that now highlights the competing forces of financial fragility vs. resilience of the real economy.

Momentum for the real sector remained surprisingly resilient through the first quarter of 2023. This was particularly true in the services sector where continued spending boosted by tight labor markets, strong wage growth, and savings buffers propelled growth. The goods sector performed less well, reflecting both some softening of demand following a COVID-19-related boom and higher sensitivity to the sharp increase in interest rates.

Overall, growth across the advanced economies continued to defy predictions of a sharp slowdown or outright recession. China's fast rebound added an extra boost.

Chart 1

As a result of the stronger-for-longer macro activity story, core inflation has remained sticky (see chart 1) although overall inflation has peaked. This reflects the composition of recent growth, which has been concentrated in the services sector where labor markets have been tighter. The implication is that financial conditions, which are driven mainly by policy rates, will need to remain tighter for longer. Also of note, eurozone core inflation has not yet begun to decline and now exceeds the rate in the U.S. Accordingly, we have begun to hear a more relatively hawkish tone from the European Central Bank (ECB) relative to the U.S. Federal Reserve.

The financial turbulence that erupted in early March was triggered by losses from the realization of interest rate risk in the "held to maturity" securities portfolio at SVB. The U.S. regional bank needed to liquidate these assets to finance steep deposit withdrawals from its tech-heavy deposit base. Contagion ensued on concerns about the prevalence of unrealized losses across the U.S. banking sector. Equity prices declined sharply, as did yields on U.S. Treasuries, and volatility spiked. Deposits shifted quickly to banks with perceived stronger balance sheets. The combined effect was a sharp tightening of financial conditions and a sharp rise in financial stress (see chart 2).

Chart 2

Forceful policy responses on both sides of the Atlantic calmed markets, at least for the time being. Markets have stabilized somewhat, volatility has eased, and expectations around future steep policy rate cuts have been pared back. Despite the market turbulence, and against the expectations of a significant part of the market, central banks have continued to hike rates. The ECB lifted its policy rate by 50 basis points (bps) on March 17, the Fed lifted its policy rate by 25 bps on March 22, and the Bank of England raised its rate by 25 bps on March 23. All cited the need to continue to rein in inflation.

Monetary Policy Considerations: Instruments Sufficient For Targets

As shown by the central banks' moves in the second half of March, we think they will continue to raise rates in response to the macro outlook despite the recent market turmoil. Baseline forecast inflation--and inflation expectations--remain above target for most central banks this year and next. This implies that financial conditions need to tighten further, which in turn calls for higher policy rates (unless the market itself does the tightening; for example, through tougher lending standards).

We reiterate our earlier view that, given the inflation forecast miss in 2021, central banks will tend to err on the side of caution and lean toward higher rates and tighter conditions to bring inflation back to target. Falling behind the curve again would not be good for credibility.

Importantly, the recent market turmoil does not present a conflict for central banks, as some commentators have asserted. The argument comes down to the number of instruments and the number of targets. Central banks can use (and already have used) their balance sheets to enhance stability in the financial sector, such as guaranteeing large deposits or offering to lend against bank security portfolios at par.

At the same time, the central bank can use its short-term policy rate to fight inflation. We think central banks will be more mindful of the impact of policy rate moves on financial fragility, but that does not imply that they are hamstrung.

Updated Baseline Forecasts Are Little Changed…

We've updated our baseline numbers (see table 1). First off, 2022 ended on a stronger note than we envisaged, so those GDP growth numbers have moved higher. As foreshadowed above, we have kept our 2023-2025 baseline broadly unchanged from our previous forecasts. Higher growth in 2023 and slightly lower numbers in 2024 for the advanced economies reflect the ongoing strength in services and labor markets. The momentum pushed the downturn into the latter part of 2023 and spilling over into 2024. Also, inflation is correspondingly higher on average, given the growth and stickiness noted above.

We now see both the U.S. and eurozone growing by small but positive amounts this year, up from zero previously. The former should grow by 0.7% and the latter by 0.3%. Within the eurozone, we still see Germany as the weakest performer with flat output. The U.K. is weaker still, where we continue to anticipate that output will contract this year by 0.5%. We've marked up China's growth by 70 bps to 5.5% and kept India's forecast unchanged at 6.0%. South Africa is the outlier in the emerging markets this year, where we have lowered our forecast to 0.8% from 1.5%. Overall, global growth should tick up by 40 bps to 2.7% in 2023.

Next year we see fractionally slower growth almost across the board. This is because part of the slowdown that was originally forecast for 2023 has been pushed forward. Our global growth forecast is unchanged next year at 3.1% as lower growth in the advanced economies is offset mainly by China.

United States

Current conditions indicate a still-resilient economy, despite challenges from the SVB fallout. Our U.S. GDP growth forecast is 0.7% for 2023 and 1.4% for 2024. This assumes regulators' measures successfully stabilize the financial markets following the recent bank failures. The job market remains tight, with February wage gains at 4.6% year over year. Inflation remains elevated, with core personal consumption expenditure (PCE) running at more than twice the Fed's 2% target. We expect it to remain above target until sometime in 2024.

With a high degree of uncertainty, the fed funds rate may now peak at 5.00%-5.25% by May 2023, in our view. This lower peak stems from the Fed's belief that the recent turbulence will result in tightening credit, curtailing aggregate demand, and slowing inflation, doing some of the work of higher policy rates.

For details, see "Economic Outlook U.S. Q2 2023: Still Resilient, Downside Risks Rise," published on March 27.

Eurozone

Despite the eurozone's solid start to 2023, our baseline scenario remains one of growth stagnation, with an elevated risk of a mild recession down the road. We revised down our eurozone GDP forecast to 1.0% from 1.4%. We expect it will take until 2025 before GDP growth returns to potential. Headline (core) inflation will not return to target before first (third) quarter of 2025.

Sticky inflation will force the ECB to raise rates for longer than we previously expected, probably until the deposit facility rate reaches 3.50% by this summer, unless the ongoing market turmoil undermines the current outlook for growth and inflation. The near-term outlook for the eurozone economy appears complicated. Restrictive monetary policy will transmit to domestic demand, while interest rates should turn positive in real terms in 2024. At the same time, production and the labor market might lose steam.

For details, see "Economic Outlook Eurozone Q2 2023: Rate Rises Weigh On Return To Growth," published on March 27.

Asia-Pacific

We expect a largely organic recovery in China this year, led by consumption and services; our GDP growth forecast of 5.5% exceeds the country's modest target of "around 5%." Spillovers to the rest of the region--and globally--will be modest and limited mainly to tourism and some commodity prices. Other Asia-Pacific economies should slow but not stumble on weaker global growth, the receding of the benefits of domestic re-opening, and the impact of higher interest rates. Inflation is mostly manageable, with notable exceptions. But some central banks will need to raise rates to normalize interest rate gaps with the U.S. amid current account deficits.

For details, see "Economic Outlook Asia-Pacific Q2 2023: China Rebound Supports Growth," published on March 27.

Emerging markets

We expect real GDP growth to slow sharply this year in most emerging markets (EMs) as the post-pandemic rebound fades and higher interest rates bite. China and Thailand are the notable exceptions. Higher growth in China is a positive for EMs but is not enough to offset slower growth in the U.S. and Europe. Inflation is poised to decelerate through the year, easing pressure on EM central banks to continue hiking rates.

Still, we don't anticipate most central banks to ease monetary policy settings in 2023 before the Fed clearly signals its intent to also do so. The long shadow of the Russia-Ukraine conflict and even sharper tightening of global financial conditions remain key downside risks to growth for EMs.

For details, see "Economic Outlook Emerging Markets Q2 2023: Global Crosscurrents Make For A Bumpy Deceleration," published on March 27.

…But The Balance of Risks Has Moved To The Downside

While our baseline forecast has not changed much since our previous round, the risks around the baseline have shifted materially to the downside. This shift reflects the emergence of financial fragility over the past few weeks and its potential impact on our baseline. We see two main channels that are not necessarily independent.

The real sector channel relates to lower spending by households, and to a lesser extent firms. In this channel, the recent turbulence and ongoing uncertainties lead to a pullback in spending, particularly for services, which have been driving outsize performance in recent quarters. This in turn leads to lower demand, output, and employment, pulling down growth. It also will dampen both wage and inflation pressures.

The financial sector channel relates to tighter lending conditions imposed by banks, particularly smaller ones. Here, these banks may be forced to raise deposit rates to protect their balance sheets (including not having to sell assets with unrealized losses). To protect margins, this could lead to higher rates for borrowers, slow the demand for credit, and put a brake on activity and employment. As with the real sector channel, this would slow the economy as well as wage and inflation pressures.

In these scenarios, cuts in central bank policy rates may be required if inflation is forecast to fall below target at the prevailing policy rate. This is in contrast to our baseline. Market pricing of the fed funds rate at 100-150 basis points below prevailing rates over the past two weeks implied a sharp reduction in output, which was not always consistent with the consensus macro forecasts.

Returning to previously identified risks, geopolitics is still with us and continues to be a source of downside risks. Europe was able to avoid an energy (gas) squeeze this past winter due to warm weather and a surprising rise in efficiency. A repeat performance is not guaranteed next winter. More broadly, the Russia-Ukraine conflict continues, as do U.S.-China tensions, both of which are a source of tail risk.

Wash, Rinse, Repeat

Financial fragility has once again thrown a potential wrench into the macro mix. This time it emanated from the asset side of bank balance sheets, but the way it unfolded was familiar. Panic ensued in the form of fast deposit withdrawals, contagion risks were high and, fearing a systemic event, the authorities acted quickly and decisively. They extended the public sector balance sheet to ease strains on the balance sheets of private financial institutions. Markets were calmed, but questions remain about the effectiveness of supervision and the moral hazard implications of the response.

The implications of the policy response for macro appear to be beneficial, at least for now. Any spillovers to the real sector from the recent turbulence will take time to manifest but appear to be bounded. Consumer behavior and labor market strength in particular will be crucial watchpoints, given their role in producing better-than-expected outcomes in recent quarters.

All of this takes us back to the questions that dominated in early 2023: Will surprising macro resilience persist? Will policy rates need to stay higher for longer? Will the necessary landing be shallower or steeper? And, most importantly, will "lower for longer" and the associated distortions be over when this all ends?

Related Research

• Economic Outlook U.S. Q2 2023: Still Resilient, Downside Risks Rise, March 27, 2023
• Economic Outlook Eurozone Q2 2023: Rate Rises Weigh On Return To Growth, March 27, 2023
• Economic Outlook Emerging Markets Q2 2023: Global Crosscurrents Make For A Bumpy Deceleration, March 27, 2023
• Economic Outlook Asia-Pacific Q2 2023: China Rebound Supports Growth, March 27, 2023