Global Outlook 2023 - Five key questions for 2023

In this Global Outlook, we explore five key questions informing our calls and assumptions for 2023. The full Global Monthly including regional updates on the Eurozone, Netherlands, UK, US and China you can find in the PDF.

Global 2022 has been a year of massive shocks to the economic system, starting with the war in Ukraine and the subsequent energy crisis, the broadening and surprising persistence of inflation, and now the most aggressive rate hike campaign by central banks in decades. Shocks by their nature are impossible to predict, and we do not attempt to do so for 2023, only to say that we have learned to be prepared for anything. What has become clear is that 2023 will be a year of recessions: if not driven by the energy crisis directly, then by the enormous pressure on households and business from high inflation and the jump in interest rates. While the coming recession is unlikely to lead to the kind of rise in unemployment we have seen in more recent downturns – given the position of extreme tightness in labour markets that we are coming from – a recession can nonetheless take on a life of its own once it takes hold, and the fact that central banks are continuing to tighten policy even as we enter a downturn could amplify the risk that it ends up being worse than we currently expect. At the same time, we should also acknowledge that the economy has in some respects exhibited surprising resilience in the face of the energy crisis – a key theme that we tackle in this Global Outlook.

Given the complex but deeply intertwined drivers of the outlook over the coming year, we once again look to our specialists in this Global Outlook to give their views on a range of topics, in the form of five key questions and answers. Starting with Europe’s energy crisis, we then look at how the nature of the coming recession is likely to differ to previous downturns. Inflation naturally will remain a key theme, and so we also devote special attention to why we expect a significant decline next year. Finally, in our last two questions, we tackle the complex issue of monetary policy lags, and explain why we hold an out of consensus view for significant rate cuts in late 2023 by the Fed, ECB and Bank of England.

Wherever economic developments take us in 2023, we wish our readers a restful holiday period, and a happy new year!

Outlook 2023: Recession, declining inflation, and eventually rate cuts

The energy crisis is expected to remain the dominant theme in 2023, provided no new black swans along the lines of the Russia-Ukraine war enter the picture. We expect European industry to scrape through without major output losses next year, but the European economy will still be hit by the collapse in real incomes from high inflation, and the jump in interest rates. The silver lining is that inflation is expected to come down significantly, enabling rate cuts by central banks by the end of the year, setting the stage for a modest recovery in 2024.

In the below Q&A, we explore five questions informing our key judgment calls and assumptions for 2023.

1. What do falls in gas demand mean for the energy transition and for industry next winter

?Russian gas deliveries via pipelines to the EU have dropped sharply, causing major increases and volatility in gas prices, and sparking fears over potential energy shortages. At the time of writing, however, EU gas storage is well filled at about 90% of maximum capacity – far better than perhaps even the most optimistic assumptions earlier this year. A combination of still-flowing Russian pipelines during summer, relatively low LNG demand from China, and unseasonably mild temperatures which delayed the start of the European heating season, have helped. At the same time, gas demand has seen massive reductions, while industrial output has been remarkably resilient. Will Europe still face the same benign scenario this time next year?

Gas savings: Better than expected…Europe could still run into trouble refilling its inventories next year, according to a recent set of OECD scenarios, which assume a complete cut-off of Russian pipeline gas (currently, gas still flows through the pipeline via Ukraine). Even with a consumption reduction of 10%, storage levels could fall dangerously low, for instance if the winter is an especially cold one, and/or if LNG supplies are constrained. Thus far, however, gas consumption falls have been much bigger than expected, with around a 20% fall in consumption in the second half of 2022 compared with the 2019-21 average. In the right graph below we distinguish between the change in gas consumption by Local Distribution Zones (LDZ) and non-LDZ, where the former includes residential and commercial customers and the latter industry and Gas-to-Power. We have seen significant falls for both categories.

…with a little help from Lady Luck

The upside surprise in gas savings is partly attributable to the mild autumn and better than expected access to LNG. Lower LNG demand from China was also an important contributor, partly due to recurrent lockdowns, but also due to increased domestic production and pipeline imports from Russia. Both of these factors cannot be counted on for next winter. A significant relaxation of Zero-Covid, with a sharp rebound in consumption, could mean that China’s imports of oil and gas return to pre-Covid levels (or even beyond). Our base case assumes only a gradual exit from Zero-Covid, given issues with ICU capacity and vaccinating/boosting the elderly. Such a gradual exit could nonetheless reduce the number of gas flex contracts resold to European parties. Additionally, part of the current LNG supply is provided by Russia. This could also be at risk if Russia decides to cut these supplies as well.

With that said, Lady Luck has not always been on Europe’s side. For instance, France has suffered major nuclear reactor outages, leaving a shortfall in power supply that has had to be made up for with gas. As reactors are expected to be back online next year, this could prove to be a counterweighing factor to a China reopening or colder winter.

Could industry turn out to be more resilient?

Yet another positive surprise has been from industrial output, which has held up despite significantly lower gas use. Industry gas savings (non-LDZ in upper right chart) have been as high as 30%, while output increased or held steady throughout the eurozone. If these developments are maintained, industry could potentially avoid supply disruptions this winter and next, and the high price of gas could prove to be a push towards renewable energy substitution. While we indeed see some early indications of energy efficiency improvements and switching to renewables, there are also indications that industry could face some trouble ahead.

Sectoral output versus gas usage data for the Netherlands shows that even for the energy intensive sectors such as oil, chemicals and metals, output has so far not declined much. This is in line with survey results from the German Ifo institute on whether firms have been able to save gas without production loss. To some extent, it appears that fuel switching from gas to oil and even coal explains part of the resilience. The only slight increase in European oil consumption (1.4% y/y in September) conceals a bigger switch from gas to oil because car fuel consumption fell. In addition, Germany generated 82.6bn kWh of electricity from coal during the first six months of the year, which is 17% higher than the same period last year. While data on the European energy mix shows a steady increase in renewables, electricity consumption has not increased compared to last year. In fact, we see a small decline as of August (-0.9% y/y).

Further falls in gas consumption are likely to lead to production cuts

Despite the progress so far, German businesses have become much less optimistic about their ability to further reduce gas consumption without a production loss. The majority of energy intensive sectors expect production cutbacks in the next six months if faced with a need to further cut gas consumption (on top of existing cuts to consumption). With that said, one has to wonder whether firms would have responded to the survey the same way if asked this question six months ago; in other words, they may be underestimating the potential for savings. An additional factor, however, comes from the demand side. Despite significant government support for households via energy price caps, households will still face a significant real income hit that is likely to hit demand. By the winter of 2023, some output losses are then inevitable, unless external demand makes up for weaker domestic demand (not our expectation given recession conditions globally).

Could household gas savings prevent industry stoppages?

If household gas savings are the result of either switching to renewables and insulation or behavioural changes that have become routine, the pressure on industry to cut consumption is reduced. While the savings on the part of households so far have indeed been impressive, data from the last few weeks show that as the weather gets colder household savings in Germany have fallen back to 12% compared to the 2019-21 average for this time of the year. Moreover, price caps (particularly those without usage limits) lower the incentive to continue saving gas at the same rate we have seen over the past 9 months, as we explained in our Global Monthly of September.

Sustainability push for the longer term

The energy crisis has not enabled a sudden switch to fossil fuel-free alternative energy sources, but it has made households and firms acutely aware of their energy use and savings potential. In the short run, there has unfortunately been some switch to dirtier alternatives, but the crisis has set in motion a number of medium to longer term shifts that will accelerate the transition.

As the return period of private investments in renewables has about halved since the war (due to higher energy prices), insulation, solar panel and heat pump subsidy applications have increased quite dramatically, as well as spending on imported solar panels to Europe. In addition, governments have upped their ambitions for wind energy substantially.

Besides increasing investment in renewable energy, equally important has been the decision to avoid fossil fuel lock-ins via LNG regassification terminal investments by choosing floating terminals rather than building permanent infrastructure. However, for economies with tight labour markets (e.g. Germany, the Netherlands, the US and the UK), the lack of available workforce in professions that are crucial for the energy transition is a major hurdle for speeding the transition. As major investment decisions made today will only pay off in perhaps 10-15 years, potential for fossil fuel use reductions this – and next – winter, will therefore depend mainly on behavioural changes and short-term investments, such as better insulating the existing housing stock. Also for residential real estate companies, we judge that investments in energy efficiency improvements will still pay off, despite higher financing costs from rising interest rates.

Large scale output losses are a tail risk

Whether all of this will be enough to avoid disruptions next winter ultimately also depends on how cold the weather will be and if potential problems in securing LNG will arise. However, with gas savings being higher than expected, and without showing clear signs of aggregate output losses, Europe is showing resilience, with an increasing likelihood that gas inventories will be refilled ahead of next winter. On balance, we judge that despite the challenges, European industry will continue to scrape through the energy crisis, with large-scale output losses now looking to be a tail risk scenario rather than a reasonable base case. (Sandra Phlippen, Aggie van Huisseling, Jeannine van Reeken, Casper Burgering, Arjen van Dijkhuizen, Hans van Cleef)

2. How will this recession differ from previous ones?

The unfolding recession contrasts with prior downturns in three main areas: 1) supply shocks are back as root cause, 2) financial resilience and tight labour markets mean a better starting point for consumers going into the recession, and 3) governments are more active in cushioning the blow (though their room for manoeuvre is more constrained than during the pandemic). The bottom line is that in many respects this recession is likely to be different than previous downturns, with less of a rise in unemployment, and less risk in the banking sector than before. On the downside, high inflation means that central banks cannot provide the same support to economies as they would normally entering a downturn. Coming from a period of very strong post-pandemic growth, Europe is on the brink of a recession. Contrary to most of the recent downturns, which were demand driven, this recession is driven by an energy supply shock resulting from the Russia-Ukraine war. Surging energy prices have led to record inflation in the eurozone. For households, this means higher energy bills and real income declines, whereas for businesses the supply shock is putting pressure on margins and constraining production.

Though this downturn is not being driven by the demand side of the economy, domestic demand still plays a big role in the dynamics of the recession. Frontloaded goods consumption during the pandemic and catch-up growth in services consumption after lockdowns meant that the energy supply shock hit the economy when supply and demand was already out of balance. This unbalanced starting point combined with the energy supply shock resulted in soaring inflation rates, which led to aggressive central bank policy tightening in order to bring demand back into balance with constrained supply.

The good news is that structural and cyclical aspects provide a better starting position going into the economic downturn than during previous recessions. In particular, the financial resilience of both businesses and households has much improved. Banks are far better capitalised and more capable of weathering a storm than during the 2008 global financial crisis or the eurozone sovereign debt crisis, which has reduced systemic risks to the wider economy stemming from the banking sector. The strong cyclical upswing moving out of the pandemic has contributed to a solid starting position as well. Strong catch-up growth has resulted in tight labour markets, and the pandemic had left households with significant excess savings, both of which have cushioned the real income shock. Although we expect a modest rise in unemployment, and excess savings to decline, these two factors mean the downturn is unlikely to be as deep as during most recent recessions.

The final crucial difference with previous recessions is the degree and speed of government support measures aimed at protecting households and companies against the impact of soaring energy bills. Governments have been much more pro-active in supporting domestic demand than for instance during the eurozone sovereign debt crisis, although the full compensation for income losses that we saw during the pandemic is unlikely this time. Given the inflationary environment and the impact on government finances from higher interest rates, we expect governments to be more prudent and target most support at the poorest households only.

The bad news is that high inflation means that central banks cannot ease monetary policy moving into the downturn, as they have in the past. In contrast, central bank are expected to continue to tighten policy for the time being. Indeed, should governments go too far in attempting to ease the pain of the recession, this could backfire and require even higher interest rates to offset this stimulus (as we saw with the UK’s mini budget debacle in September). (Jan-Paul van de Kerke, Aline Schuiling, Bill Diviney)

3. Why will inflation come down, even with energy prices staying high?

Inflation rates across advanced economies have all moved in the same direction in 2022: higher. Still, there have been wide differences between countries, which we describe in the Box on the next page. Looking ahead at 2023, while the factors driving inflation and where it ends up will still vary, we think that the global tendency for inflation in 2023 will be the same again across advanced economies: lower.

To begin with, inflation rates are measured by comparing the current price (or price index) of a good or service to the price one year ago. So, even if the level of the price (or price index) stays very high, yet stable, the inflation rate will drop to zero a year later. Therefore, even if energy prices were to remain at their current high levels, the inflation will rate will fall sharply during the course of next year. The same is expected to happen with food price inflation. In fact, food commodity prices have fallen sharply in the last few months (see graph below), meaning that global food price inflation could actually turn negative during the second half of 2023.

With regards to core inflation (excluding food and energy), a number of factors will probably also contribute to a global decline in 2023. To begin with, industrial goods price inflation and services inflation are currently still being lifted by companies passing on high energy costs to consumers. Although this process tends to be lagging and, therefore, could continue for a while, we think the impact of high energy costs on good and services inflation will diminish during the course of next year. The recessions we expect across advanced countries, with consumption contracting, should also limit companies’ options to raise prices.

Another factor weighing on goods inflation is the unwinding of imbalances between global industrial goods supply and demand, which we think is in its final phase. This is illustrated by our global supply bottlenecks index (see graph above), which fell to a two-year low in November. The ratio between indicators for output in emerging markets and demand in developed markets has been an important driver of this, but other indicators of supply bottlenecks that are included in the index also point to a further easing. The benchmark for global container tariffs has fallen back by more than 75% compared to its peak reached a year ago. The components of our index that measure delivery times for manufactured goods, electronic equipment and semiconductors have also continued to normalise. All in all, our index suggests that imbalances between global goods supply and demand have diminished, thereby mitigating price pressures.

Finally, services and housing related inflation is primarily driven by domestic factors. Wage growth and changes in house prices in individual countries tend to have a large impact here. Wage growth is expected to pick up in the coming quarters as employees seek compensation for the loss of real income in 2022. However, as we describe in the various country chapters of this Global Outlook, all main developed countries are expected to experience recessions, with deteriorating labour market conditions. This should keep a lid on wage growth. Meanwhile, aggressive interest rate hikes by all major central banks are expected to result in house price corrections in a number of countries, which should result in lower housing rent inflation, particularly in the US (something we also discuss in our Global Monthly of 26 October). (Aline Schuiling)

4. Will rate hikes affect the economy more quickly than they did in the past?

Milton Friedman once stated famously that changes in interest rates affect the economy with ‘long and variable lags’. Historically, academic research suggests that the full effect of a change in interest rates takes 18-24 months to be visible. Are there reasons to think rate rises might now affect the economy more quickly than in the past?

In some respects, the lags do appear to be shorter. A change in policy now starts with central bank officials merely telling markets what they plan to do, with market interest rates rising and falling in response. Through communication alone, central banks now exert a powerful influence on long term interest rates, long before actual changes to policy. The Fed’s communication shift in late 2021 was a prime example, when it became clear that inflation in the US was not as ‘transitory’ as most economists (us included) thought. This led to a surge in government bond yields, a rise that was so significant that it had global spillover effects – dragging European government bond yields higher, long before the ECB changed its communication to markets.

This rise in government bond yields then cascaded through the economy via higher borrowing costs for businesses and households. One of the most visible of these for households was higher mortgage rates, which began moving up in early 2022. Indeed, housing is one of the first areas of the economy to respond to shifts in monetary policy, and this is now visible in correction in house prices that is now unfolding across advanced economies. Weaker housing markets lead to lower housing investment, weighing on GDP growth. They also dampen consumer confidence as homeowners feel less wealthy. Finally – and important for the inflation outlook in the US in particular – this leads to a slower growth in rents. For this part of the economy, then, the lag appears to be relatively short – perhaps 3-6 months after the first policy rate rise (the Fed began raising rates in March; the ECB in July).

Then, there are the more indirect channels of impact. As interest rates dampen demand, they also raise recession risks. Higher recession risk makes banks more cautious with lending, further dampening demand and creating a self-reinforcing recessionary cycle. In the last major rate hike cycle in the eurozone – from 2005-08 – bank lending standards took much longer to tighten than in the current cycle. This partly reflects the impact of the energy crisis, which by itself has raised recession risks. But it arguably also reflects the greater degree of forward guidance deployed by central banks, which have sought to steer a tightening of financial conditions ahead of actual policy decisions in their attempt to get ahead of the curve in the inflation fight.

Labour markets again likely the last domino to fall

While it is clear that some of the policy lags are shorter in this cycle, it is the effect on labour markets and overall inflation where lags arguably do still fit the ‘long and variable’ description posed by Friedman. Inflation has been largely driven by supply/demand imbalances for goods and services up until now, and this component of inflation is already beginning to ease in the US. But the risk that tight labour markets in the US and many parts of Europe entrench high inflation is what keeps central bankers awake at night. Labour markets tend to be the most ‘laggy’ part of the economy, and this tightness will not evaporate overnight. Ahead of a rise in joblessness, consumption and investment typically slow sharply or contract. We have seen this to some extent, for instance with investment in the US contracting for much of 2022. Anecdotal reports suggest firms have been reluctant to let go of workers in the face of weakening demand, i.e. there has been an element of labour hoarding due to recent difficulties recruiting workers. However, this situation cannot be sustained for very long, and we are seeing some early signs of a rise in layoffs now in the US. In both the eurozone and the US, we expect unemployment to start rising in the first half of 2023, but do not expect unemployment to peak until 2024 – which would be consistent with the academic literature suggesting a policy lag of 18-24 month for the full effects to be felt.

Central banks are cognisant of these lags in their policy deliberations, and this became a key topic of discussion among FOMC members as the Fed raised rates well into restrictive territory in November. ECB president Christine Lagarde recently suggested that policy lags may require the central bank to act even more forcefully in the near term in order to achieve the desired dampening effect on demand. We judge that this significantly raises the risk of central banks going too far in their policy tightening, which is one of the main reasons we expect central banks to begin reversing course and cutting rates in late 2023. We explore this topic in our next question. (Bill Diviney)

5. Why do we see central banks cutting rates later next year?

We think central banks are currently in the process of over-tightening monetary policy and will likely compensate for this by the end of next year by cutting rates, especially with macroeconomic conditions looking very different by then. The over-tightening of monetary policy is not an accident, but rather conscious risk management strategy.

Policymakers feel that the risks currently are asymmetric. If they raise interest rates too far, they can always re-adjust later, even though this might do more damage to economy than otherwise. This is seen as being the lesser evil. If they raise too little, and inflation becomes entrenched, they main need to step harder on the brakes later on, causing a longer and deeper recession.

The other element of the risk management approach reflects the anchoring of inflation expectations. They hope that the combination of language signalling their determination to control inflation coupled with large-front loaded rate hikes will convince households, businesses and investors that inflation will come down. This is important, as expectations of inflation are important driver of actual inflation. For instance, if businesses expect inflation to remain high, they are more likely to raise their prices to support their margins, while employees will be minded to ask for larger pay rises.

Finally, the recent period of unexpectedly high inflation has also meant that central banks do not trust their forecasts as much. As monetary policy works with significant lags (see chart on left, and as discussed in Question 4) usually central bankers set interest rates with a view to where inflation will be 12-18 months ahead. However, given the uncertainty, policymakers have put more weight on recent inflation trends, and have been minded to continue raising interest rates until they are convinced that inflation has peaked and is clearly coming down. All of this means that there is considerable monetary tightening in the pipeline, which will increasingly weigh on the economy during the course of next year.

So let’s try and imagine the circumstances that would emerge in the second half of next year. First, if our forecasts are correct, the major advanced economies would have experienced a recession. Second, unemployment would have risen and slack would have started to build. Third, inflation would have come down sharply and although still above central bank targets, there would be the prospect of a further downtrend in the months ahead.

Crucially, monetary policy would be restrictive and with inflation (expectations) coming down and real interest rates rising, the stance would become tighter even with no further rises in nominal rates (see chart on the right). Central bankers may return to a forward looking approach and will likely come to the conclusion that inflation could undershoot targets in 2024-2025 if policy were to remain restrictive. We therefore think that policy rates will be moved from above neutral levels back towards neutral levels. In that sense, our call for rate cuts is not a judgement that central bankers will push down on the accelerator, but rather that they will take their foot off the brakes. (Nick Kounis)