As we move into 2023, the global economy continues to face a confluence of challenges. Inflation has dogged markets this year, with Inflation at a 40-year high and the fastest central bank interest rate hiking cycle since 1980.
2022 has emerged as one of the biggest threats to global prosperity. When prices rise unexpectedly, money doesn’t go as far as it used and, and the basic functioning of an economy can break down.
The forces driving inflation
First, is the Stimulus factor. Stimulus undoubtedly helped many in some very big, tangible ways. Namely, it reduced poverty, beyond merely keeping people afloat during the early days of the pandemic.
Once we look at the stimulus plan, reality shows that the multiplier effect of government spending is virtually non-existent and has long-term negative implications for the health of the economy. Stimulus plans have bloated government size, which in turn requires more dollars from the real economy to finance its activity.
Higher government spending simply cannot be financed with much larger economic growth because the nature of current spending is precisely to deliver no real economic return. The government is not investing; it is financing mandatory spending with resources of the productive sector.
Supercharged by COVID-19 stimulus payments, prices began to leap in 2021 as countries emerged from lockdowns. Consumer demand jumped because of pent-up demand; economic activity propelled forward.
According to the International Monetary Fund (IMF), “If the money supply grows too big relative to the size of an economy, the unit value of the currency diminishes; in other words, its purchasing power falls and prices rise.”
That describes the quantity theory of money, which is among the oldest and most primary economic concepts, but it’s not the only game in town. The stimulus had big economic benefits, but it also fuelled inflation.
Second, unprecedented series of shocks on both the demand and supply sides of the economy. This has restricted aggregate supply while also directing demand towards sectors with capacity constraints.
The world faced pandemic-induced lockdowns, supply chain disruptions, energy production cuts, and Russia’s invasion of Ukraine, all while demand has been shifting back and forth across sectors at speed. Recently, the reopening of the economy has led to a rapid release of pent-up demand, supported by high levels of excess savings.
Since the start of the pandemic, the volatility of durable goods consumption has been almost ten times higher than during the preceding two decades, and almost 30 times higher for services.
As a result, demand and supply factors are currently contributing more or less equally to core inflation, with demand being more important for services and supply more important for industrial goods. The result has been a large and persistent inflationary shock.
Third, we are seeing a faster and stronger pass-through of these shocks in prices.
The pass-through of producer prices to industrial goods inflation has been taking place much faster. When inflation is high everywhere and supply is constrained, firms can more easily pass on cost increases to customers without losing market share to their competitors.
The fourth factor aggravating to this situation is the persistence of the shocks due to structural changes in the economy.
The shocks triggered by the pandemic and the war have created a new global map of economic relationships. The cut in gas supplies caused by the Russian invasion is a major structural change which could have ramifications for several years. European countries are now paying a premium to attract uncontracted LNG to replace Russian gas. Substitution effects will probably also increase prices for other sources of energy.
Defeating Inflation – Central bank’s most immediate challenge
Persistently high inflation has tested central bank credibility, forcing them to tighten the monetary policy in bigger increments and more swiftly than expected, thus ending the phase of low or even negative interest rates
The most urgent concern for central banks is the trajectory of inflation while avoiding recession. In an almost synchronised manner, central banks from all around the world have raised their key interest rates in a bid to stem inflation and limit currency depreciation. Central banks got all of us used to jumbo-size rate hikes and, the policy rate is almost back at levels last seen prior to other financial crises.
While not all actions of central banks have achieved a soft landing yet, encouraging November’s consumer price index (CPI) report shows inflations may have peaked.
Against this background of gradually declining but structurally higher inflation, the key question is what central banks will do if core inflation doesn’t return fully to target over the next 12 to 18 months. One option would be to keep policy rates high or higher for longer. The other option could be to become more flexible once inflation falls much lower. But it does suggest a return to consistently below-neutral interest rates is less likely in the medium-term.
King $
For decades, the US dollar has been said to be ‘crushing for a bruising’. The dollar has risen rapidly against practically everything else, thus dynamic enhances the “safe-haven” status of the dollar and the desire of companies to settle deals in dollars.
For many countries, the weakening of their currency relative to the US dollar has made the inflation fight harder. The dollar’s appreciation also is reverberating through balance sheets around the world. Approximately half of all cross-border loans and international debt securities are denominated in dollars. A stronger dollar only compounds the pressure, especially on emerging markets and many low-income countries that are already at a high risk of debt distress.
Several countries are resorting to foreign exchange interventions to limit currency depreciation. Total foreign reserves held by emerging markets and developing economies fell by more than 6 per cent during the year 2022.
A key factor to watch is where the dollar goes from here. The USD should be supported by its interest rate advantage for most of 2023. As a result, it is expected the USD to stay strong, particularly versus emerging market currencies such as the Yuan.
Conclusion
We are entering a year with the widest range of possible outcomes and forecasts in years. Timing the bottom of the inflation cycle is extremely challenging and there are potential blind spots such as the start of a new COVID outbreak, recession, or a further escalation of the Russia/Ukraine war.
Will 2023 be any better? Yes! eventually. Inflation appears to have peaked, which will eventually enable central banks to slow the pace of rate hikes and ultimately shift into a holding pattern.
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Mayank Srivastava
Director
DOTO Global Ltd, Mauritius
