Oliver Mangan: Risk of overkill from the tough-talking US Fed
The Eurozone is set to grow at a minimum of 2.3% this year.
The OECD in its recent update on the global economy refrained from publishing new forecasts. It observed that the magnitude of the economic impact of the conflict in Ukraine is highly uncertain, and will depend in part on the duration of the war and the policy responses. The OECD noted, though, that the war will result in a substantial near-term drag on global growth and significantly stronger inflationary pressures.
Its analysis showed that if the moves in commodity prices and financial markets seen since the outbreak of the war proved sustained, it could reduce global growth by over 1 percentage point in the first year and push up global inflation by 2.5 percentage points. The impact on growth, though, could be tempered somewhat by a greater than expected rundown of elevated private sector savings or a loosening of fiscal policy.
The latter is already underway. There will be increased government spending on supporting refugees in Europe and to offset some of the effects of higher energy costs on households. Increased spending is also likely on military defence and alternative energy sources.
The ECB looked at a severe downside scenario which included disruptions to European gas supplies and greater second-round inflation effects. It saw the Eurozone economy growing by 2.3% this year in this scenario. This would be consistent with the economy largely stagnating in the final three quarters of the year. Hence, the ECB is cautious about tightening monetary policy, indicating that any rate increases will be very gradual.
The Bank of England is also very cognisant of the downside risks to growth in the UK economy and recently downplayed the need for a considerable tightening of policy. The US Fed, though, does not seem to have the same concerns, with some Fed officials even contemplating hiking rates in 50bps steps. The Fed projection is for rates to rise to 2.875% and it believes the robust US economy will be strong enough to withstand it.
Markets are not as convinced, with two key US financial indicators beginning to send recession warning signals. Two year US Treasury bond yields have risen above 10-year yields, which in the past has often been a harbinger of a recession on the way. Meantime, the markets are taking the Fed at its word and pricing in that rates will be hiked to circa 3% by summer 2023. However, they think this may prove an overkill for the economy and expect the Fed will be forced to start cutting rates soon after, in early 2024.
It may not even get that far. Tough-talking from the Fed is easy for now, with the economy still in strong shape and the unemployment rate at 3.6%. The scale of the inflation shock that is underway, though, may slow the US economy much more than the Fed expects, thereby curtailing its rate hiking intentions.
- Oliver Mangan is Chief Economist with AIB
