Economic resilience to be tested

Sanisha Packirisamy

In the aftermath of unprecedented and overlapping social and economic crises, global markets and economies have demonstrated a surprising resilience, bouncing back more vigorously and swiftly than initially expected.

Clear signs of progress are emerging as the world begins to recover from the dual challenges of the COVID-19 health crisis and Russia's incursion into Ukraine. Supply chain disruptions have notably normalised back to pre-pandemic levels, global inflation pressures are showing signs of easing and labour markets are displaying unexpected strength. Economic activity and corporate earnings have proven remarkably robust, even in the face of higher interest rates and rising living expenses.

This unexpected resilience has led market participants to question the dynamics behind the economy and labour markets, especially given the sharpest pace of interest rate tightening witnessed in over four decades. Renowned economist Milton Friedman's theory on long and variable lags offers some insight, highlighting the traditional 12 to 18-month delay in the time it takes for changes in monetary policy to influence aggregate demand. Despite initial assumptions that this lag would shorten due to the contraction in central bank balance sheets, this has not been the case.

Additionally, substantial savings accumulated during the pandemic have played a crucial role in sustaining the economy despite tighter monetary policy. Outside the United States (US), households continue to possess surplus savings, providing ongoing support to economic recoveries. Furthermore, significant fiscal support has differentiated the impact on growth during this tightening cycle. The payment of interest on bank reserves since 2008, amounting to close to US$3 trillion, has provided a substantial channel of fiscal support to the private sector during a period of rising interest rates.

While the integrity of systemically-important bank balance sheets and wholesale funding markets has improved, historical precedent indicates a delay in the reaction function of risky asset markets. Hence, there is a notable chance that the prevailing complacency in global equity markets could face challenges.

Relatively healthy economic conditions have given rise to the concept of a Goldilocks scenario, characterising investing conditions that are neither too hot nor too cold. A few months ago, the market was preparing for more interest rate hikes and a well-anticipated recession, potentially prompting the start of a US Federal Reserve easing cycle in the latter half of the year. However, robust economic data releases shifted this narrative, towards a scenario of no further hikes and no recession at all.

Yet, recent announcements from major oil-producing nations like Saudi Arabia and Russia regarding extended oil supply cuts have rekindled concerns about lurking inflation. An unsettling combination of rising oil prices, expectations of persistently elevated interest rates in the US and Europe and sluggish Chinese economic activity is stirring fears in financial markets. Moreover, the narrow-based global equity market advance raises questions about the sustainability of ongoing equity market upside.

Global fixed income markets have exhibited volatility for a considerable period, reflecting the gradual loss of momentum in global activity. Given the long and variable lags associated with monetary policy, the effects of the already implemented interest rate hikes are just beginning to be felt. The reduction in central bank balance sheets through quantitative easing, which previously inflated asset prices, is additionally expected to exert downward pressure on asset prices as these balance sheets shrink.

The increase in global interest rates signifies a shift of monetary policy into restrictive territory, resulting in higher interest payments for households and firms. Consumers are increasingly seeking credit to supplement their income and support their rising living expenses. In the US, pandemic-related excess savings have dwindled, except for the top 20% of income earners, according to Bloomberg, who are sustaining the economy.

Growth expectations for the US have softened, with reduced savings and slower gains in the labour market expected to lead to a decrease in consumer contributions to growth next year. Across the Atlantic, Europe anticipates weak growth due to past inflation and interest rate impacts on economic activity. Meanwhile, the Chinese recovery, critical for commodities, has lost steam post the pandemic reopening, affecting the global growth outlook as well.

Subdued inflationary pressures in China have raised concerns about the country's economic prospects, drawing comparisons to Japan's deflationary spiral in the past. However, various factors suggest that China may avoid a similar scenario, such as its diversification of economic focus, a more robust global export share and a state-owned financial system that facilitates lending into the economy.

The emergence of geoeconomic fragmentation, where the global economy is segmented into competing blocs, poses a significant threat to emerging and developing economies highly reliant on a globally integrated economy. To mitigate these adverse effects, fostering multilateral cooperation is imperative.

In conclusion, while the current economic scenario has been termed a 'Goldilocks' environment, uncertainties regarding the impact of tighter monetary policy and persistent inflation concerns loom. Continued vigilance and international cooperative efforts are crucial to navigate these challenges, ensuring long-term prosperity across both advanced and emerging-market economies. Prioritising efforts to rebuild fiscal space, better alignment of fiscal and monetary policies and revitalising structural policy initiatives are essential steps toward enhancing growth opportunities and promoting inclusive growth for the future.