William De Vijlder

Based on the PMI data and the European Commission business surveys, it seems that in the Eurozone, industry is clearly slowing down, demand is softening and labour market bottlenecks have eased somewhat. In combination with input prices that are down, this should lead to an easing of output price inflation. In services, the picture is different. Hiring difficulties remain a big constraint on activity, momentum in terms of activity and orders has improved. Input price and output price inflation has eased only slightly. Such a dichotomy complicates the task of the ECB: ongoing strength in services would imply that past rate hikes didn’t yet have a significant impact and would justify more tightening, but this would only make things worse for the industrial sector. Eventually, such a negative dynamic should spill over to services.

How much and how quickly inflation will decline in the Eurozone is of key importance for the ECB, households, firms and financial markets. There is concern that disinflation might be slower than expected until now. The latest ECB survey of professional forecasters shows an increase in the number of participants expecting inflation to remain elevated. Inflation persistence can have different sources: a succession of shocks, staggered price adjustment by firms, price and wage increases that try to compensate for the past increase in costs and the loss of purchasing power, evolving inflation expectations. Going forward, the tightness of the labour market, the strength of wage developments and the momentum in service price inflation are key factors to monitor.

After last year’s significant depreciation versus the dollar, the euro has found a new strength. Key factors are the reversal in the current account balance, which after moving into negative territory last year is back into surplus, and, since the autumn of 2022, the narrowing of the 1-year interest rate differential with the US. This reflects the view that the Federal Reserve is approaching the end of its tightening cycle whereas the ECB still has more work to do. We expect that this factor will continue to drive the exchange rate in the coming months. Moreover, there is also a higher likelihood that the Federal Reserve will cut rates before the ECB does. International investors have large unhedged dollar positions, so in case of further dollar depreciation, this may force them to reduce their exposure to the dollar by selling dollar assets, which would exert more downward pressure on the dollar. Finally, the euro is still well below its long-term fair value versus the dollar.   

The preliminary inflation numbers for February had the effect of a cold shower due to the acceleration of core inflation. To assess the observed price developments since the start of last year, monthly inflation has been calculated for the more than 400 HICP components.  The frequency distribution for average monthly inflation between October 2022 and January 2023 has hardly shifted compared to that for the first quarter of 2022 but the nature of inflation has shifted. Annual energy price inflation has dropped but food price inflation continues to accelerate. As the different shocks reverberate, inflation becomes sticky. Going forward, wage developments should also play a key role. The latest inflation data have caused a jump in the expected terminal rate, which implies a bigger headwind to activity. When inflation surprises to the upside, the likelihood that growth ends up surprising to the downside increases.

In the US, it seems that the expansion phase of the business cycle, the period of elevated inflation, the monetary tightening cycle and the ‘risk-on’ mindset in markets are all far from over. Ongoing relatively strong growth increases the risk that inflation would stop declining. Market commentators have started referring to such an outcome as the ‘no landing’ scenario. However, judging by the latest data, a ‘delayed landing’ seems the more likely one. Markets now expect a higher terminal rate whereby the policy easing would come later as well. The higher the terminal rate, the bigger the likelihood that the landing would be bumpy after all.

In the US, the ratio between the job openings rate and the unemployment rate remains very elevated. It is one sign amongst many of a very tight labour market. As growth slows down, this ratio should decline. Historically, this has been accompanied by slower wage growth. It can be argued that this time, this process may take more time due to labour hoarding, which should limit the increase in layoffs and hence the unemployment rate, and the high level of the vacancy rate, which should underpin the creation of new jobs. This means that there is a genuine risk of disinflation to be slow.

In the US, financial conditions have eased in recent months and weighed on the effectiveness of the Fed’s policy tightening. Jerome Powell recently gave the impression of not being too concerned, so markets rallied, and financial conditions eased further despite the hawkish message from the FOMC. In the Eurozone, another rate hike by the ECB and the commitment to raise rates again in March caused a huge drop in bond yields because markets expect we’re getting closer to the terminal rate. It reflects a concern of not being invested in the right asset class when the guidance of central banks will change: based on past experience, one would expect that bond and equity markets would rally when central banks signal that the tightening cycle is (almost) over. However, as we have seen with the surprisingly strong US labour market report, such positioning comes with the risk of being wrongfooted by the data. What follows is huge volatility.  

On an annualised basis, US GDP increased 2.9% in the fourth quarter compared to the third. This healthy increase implies only a mild quarterly slowdown. The result was also better than the consensus expectation. However, a detailed analysis shows causes for concern. About half of the increase in GDP reflects inventory rebuilding, although this comes after a negative contribution in the previous two quarters. Personal consumption expenditures have also contributed approximately half of the GDP increase, but investments in structures had a negligible impact and residential investments continue to act as a drag, suffering from high mortgage rates. Moreover, in the final quarter of 2022, GDP only grew 1.0% versus the same quarter of 2021. Despite the apparent resilience in the fourth quarter, the undercurrents are clearly negative, and they should be reinforced by the delayed effects of past rate hikes and the upcoming policy rate increases. Were it not for the strength of the labour market, the talk about recession risk would be even more intense.

The state of the labour market occupies a central role in the analysis of the business cycle. Historically, the percentage of months over the past 12 months with nonfarm payrolls below the 200K threshold increases in the run-up to a recession. Today, this indicator stands at 0 percent. Although there have been many false signals, a significant increase in this percentage calls for vigilance, necessitating closer monitoring of other data as well to assess the risk of recession.  An alternative approach consists of making the link between monthly payrolls and the unemployment rate. However, given the latest data on job creations, a swift increase in the unemployment rate sufficient to trigger a recession signal seems unlikely. This means that the slowdown of wage growth and, more broadly, the decline of core inflation, might take more time than expected, forcing the Federal Reserve to keep policy rates high for longer. This is not exactly what is being priced by financial markets.

Despite the ongoing good pace of job creation and slower wage increases, which through its impact on inflation could influence future Fed policy, there is enough ambiguity in the recent data to fuel the debate on whether the US will end up in recession or not. The survey of professional forecasters points towards heightened recession risk and so do the inversion of the yield curve and the downtrend of the Conference Board’s index of leading economic indicators. If this index were to decline further, one would expect, based on the past relationship, a significant weakening in the monthly payroll numbers whereby the narrative that a recession is around the corner would gather force.

The drop in gas prices, the decline in headline inflation and the improvement of survey data in December have created a feeling that for the Eurozone 2023 might be better than expected hitherto. The survey data bode well for the growth momentum at the turn of the year, which could create a favourable carry-over effect for GDP this year and some hope that lower inflation will mean fewer ECB rate hikes. However, caution is warranted. Inflation remains far too high and core inflation has moved higher in December. Moreover, survey data provide little or no information on the pace of growth beyond the first quarter of this year.

Economic developments in 2023 will to a large degree be the result of the inflation shock of 2022 and the policy reaction of central banks that followed. Three developments look highly likely: disinflation -in terms of headline inflation- should gather momentum, central bank policy rates should reach their cyclical peak and activity should suffer from the rise in interest rates that started last year, implying that the euro area and the US should spend part of the year in recession. The list of uncertainties is long -the evolution of energy prices and the extent and pace of disinflation are key ones- but there are also several factors of resilience, implying that, all in all, the recession should be shallow.

2022 was a year of profound transformation, of shifting geopolitical and economic paradigms. Looking ahead, 2023 should see a change of direction in key economic variables. Headline inflation should decline significantly, central bank rates should reach their cyclical peak and the US and the euro area should spend part of the year in recession. 2023 can be considered as a year of transition, paving the way for more disinflation, gradual rate cuts and a soft recovery in 2024.   

From an economic perspective, 2022 will go down in history as the year in which elevated inflation made a surprising comeback forcing major central banks to start an aggressive tightening cycle. It is highly likely that in twelve months’ time we will look back at 2023 as a recession year, a year of disinflation, and a year in which official interest rates reached their terminal rate and stayed there. As usual, the list of ‘known unknowns’ is long. Energy prices might increase again after their recent decline, disinflation might be slower than expected, policy rates might peak at a higher level than currently priced by markets, and the recession might be deeper and longer than anticipated. However, we should also pay attention to factors of resilience: companies hoarding labour, thereby limiting the rise in unemployment, the support from fiscal policy in many European countries, the need to invest in the context of the energy transition.

Meeting the European Union’s climate-related and digital ambitions will require a huge additional annual investment effort. In the near term, against a background of slowing growth and the prospect of a recession in 2023, this represents a potential source of resilience. In the medium term, this demand impulse may underpin or even increase inflation, in addition to other factors that could lead to greenflation. This would influence the level of official interest rates as well as long-term interest rates. The latter could also be under upward pressure due to the huge additional financing needs compared to the normal financing flows. The financing mix -banks versus capital markets- plays a key role in this respect.

Companies in the US and the euro area continue to struggle to fill vacancies. This will probably make them reluctant to lay off staff when economic conditions worsen, fearing that during the next upturn they would rapidly face new hiring difficulties. By limiting the increase in unemployment, such labour hoarding would be a source of resilience. However, this would be reflected in a decline in labour productivity, which would weigh on profits and could push companies to increase selling prices, thereby slowing the pace of disinflation.

Economic forecasting in the run-up to and during recessions is particularly challenging. An analysis of the Federal Reserve of Philadelphia’s survey of professional forecasters shows that, since 1968, forecast errors during recessions are significantly higher than during non-recession periods. Moreover, forecast errors during recessions are predominantly positive, so forecasts tend to be too optimistic, even if they concern the next quarter. At the current juncture, there is broad consensus, if not unanimity, that downside risks to growth dominate due to the multiple headwinds and uncertainties. The historical forecast record is another reason to be mindful of these risks.   

Since the start of this year, the European Commission’s industry sentiment survey has seen a significant decline, yet companies continue to report that labour remains a key factor limiting production. This is probably due to order books that remain at record high levels in terms of duration of assured production. Through their impact on the growth of employment and wages, labour market bottlenecks should provide some resilience to consumer spending when the economy is turning down. This support will probably not last however. Hiring intentions of companies have started to  decline, which should ease the bottlenecks through a slowdown of employment growth.