The gradual recovery of the global economy from both the pandemic and the Russian invasion of Ukraine remains on track. China’s reopened economy is rebounding strongly. Supply chain disruptions are easing, while war-induced disruptions in energy and food markets are easing. At the same time, the massive and synchronized tightening of monetary policy by most central banks should begin to bear fruit, with inflation moving back towards its targets.
We forecast in our most recent World Economic Outlook that growth will bottom out at 2.8 percent this year and rise slightly to 3 percent next year – 0.1 percentage point below our January projections. Global inflation will fall, albeit more slowly than initially expected, from 8.7 percent last year to 7 percent this year and 4.9 percent in 2024.
This year’s economic slowdown is concentrated in advanced economies, notably the euro area and the United Kingdom, where growth is expected to fall to 0.8 percent and -0.3 percent this year, before rebounding to respectively 1.4 and 1 percent. In contrast, despite a 0.5 percentage point downward revision, many emerging markets and emerging economies are picking up, with year-end growth accelerating from 2.8 percent in 2022 to 4.5 percent in 2023.
Risks
However, recent banking instability reminds us that the situation remains fragile. Once again, downside risks are predominant and the fog surrounding the global economic outlook has thickened.
First, inflation is much more stubborn than expected even a few months ago. Although global inflation has fallen, this mainly reflects the sharp reversal in energy and food prices. But core inflation, excluding energy and food, has yet to peak in many countries. We expect year-end core inflation to slow to 5.1 percent this year, a significant 0.6 percentage point upward revision from our January update, and well above target.
In addition, activity is showing signs of resilience as labor markets remain very strong in most advanced economies. At this point in the tightening cycle, we expect more signs of declining output and employment. Instead, our output and inflation estimates for the last two quarters have been revised upwards, pointing to stronger-than-expected aggregate demand. This could lead to monetary policy tightening further or staying tighter for longer than currently expected.
Should we be concerned about the risk of an uncontrolled wage-price spiral? On this point I remain unconvinced. Nominal wage increases lag behind price increases, implying a fall in real wages. Somewhat paradoxically, this is happening while demand for labor is very strong, companies are posting lots of vacancies and while labor supply remains weak – many workers have not fully re-entered the labor market after the pandemic. This suggests that real wages should increase, and I expect they will. But operating margins have soared in recent years – this is the downside of sharply higher prices but only modestly higher wages – and should, on average, be able to absorb much of the rising labor costs. Provided that inflation expectations remain well anchored, this process should not get out of hand. However, it may take longer than expected.
It was never going to be an easy ride
More worrying are the side effects that the sharp tightening of monetary policy over the past year is beginning to have on the financial sector, as we have repeatedly warned. Perhaps the surprise is that it took so long.
After a long period of subdued inflation and low interest rates, the financial sector had become too complacent about the mismatch between maturity and liquidity. The rapid tightening of monetary policy last year caused significant losses on long-term fixed income assets and increased borrowing costs.
The stability of any financial system depends on its ability to absorb losses without draining taxpayers’ money. The short-lived instability in the UK gold market last fall and the recent banking turbulence in the United States underline that significant vulnerabilities exist in both banks and non-bank financial intermediaries. In both cases, the financial and monetary authorities have acted swiftly and firmly and so far prevented further instability.
Our World Economic Outlook explores a scenario in which banks, faced with rising borrowing costs and the need to act more prudently, continue to scale back lending. This will lead to an additional production reduction of 0.3 percent this year.
Still, the financial system could be tested even more. Nervous investors often look for the next weakest link, as with Crédit Suisse, a globally systemic but ailing European bank. Financial institutions with excessive leverage, credit risk or interest rate risk, too dependent on short-term financing or located in jurisdictions with limited fiscal space could become the next target. So are countries with weaker perceived fundamentals.
A sharp tightening of global financial conditions – a so-called ‘risk-off’ event – could have a dramatic impact on credit conditions and government finances, especially in emerging markets and emerging economies. It would lead to a large outflow of capital, a sudden rise in risk premiums, a rapid appreciation of the dollar in a rush to safety, and a large drop in global activity amid lower confidence, less household spending and less investment.
In such a severe downturn scenario, global growth could slow to 1 percent this year, implying that per capita income is close to stagnation. We estimate the probability of such an outcome to be about 15 percent.
So we are entering a difficult phase in which economic growth remains weak by historical standards, financial risks have increased, but inflation has not yet definitively turned the corner.
Policy
More than ever, policy makers need a steady hand and clear communication.
With financial instability under control, monetary policy should remain focused on reducing inflation, but be prepared to adapt quickly to financial developments. A silver lining is that the banking turmoil will help slow overall activity as banks restrict lending. In itself, this should partially reduce the need for further monetary tightening to achieve the same policy stance. But any expectation that central banks will give up the inflation battle prematurely would have the opposite effect: lowering interest rates, supporting activity beyond what is warranted and ultimately complicating the task of monetary authorities.
Fiscal policy can also play an active role. By cooling economic activity, a tighter fiscal policy would support monetary policy, allowing real interest rates to return more quickly to natural lows. Well-designed fiscal consolidation will also help rebuild much-needed buffers and strengthen financial stability. While fiscal policy is becoming less expansionary this year in many countries, more can be done to regain fiscal space.
Regulators and supervisors must also act now to ensure that remaining financial vulnerabilities do not turn into full-blown crisis by strengthening oversight and actively managing market tensions. For emerging markets and developing economies, this also means ensuring good access to the global financial backstop, including IMF precautionary arrangements, access to the US Federal Reserve Foreign and International Monetary Authorities’ repo facility, or, where relevant, to swap lines of the central bank. Exchange rates should be subject to adjustment as far as possible, unless this increases risks to financial stability or threatens price stability, in line with our integrated policy framework.
Our most recent forecasts also point to an overall slowdown in medium-term growth forecasts. Five-year-ahead growth forecasts fell steadily from 4.6 percent in 2011 to 3 percent in 2023. Part of this decline reflects the slowdown in previously fast-growing economies such as China or Korea. This is predictable: growth slows as countries converge. But some of the more recent slowdowns may also reflect more ominous forces: the scars of the pandemic, a slower pace of structural reform, as well as the growing and increasingly real threat of geoeconomic fragmentation leading to more trade tensions, less direct investment and a slower pace of innovation and adoption of technology across fragmented ‘blocks’. A fragmented world is unlikely to make progress for all, or to successfully address global challenges such as climate change or pandemic preparedness. We must avoid that road at all costs.
—This blog is based on Chapter 1 of the April 2023 World Economic Outlook: “A Rocky Recovery.”
