The ‘low for longer’ theme which characterised interest rates for nearly a decade was upended when central banks responded to high and surging inflation with sustained interest rate hikes. Policy rates which had hovered near zero shot up quickly to 4%+. Real interest rates (i.e. after inflation) have continued to be negative but in recent months have begun to increase, although the uptick has been modest.
In its latest World Economic Outlook, the International Monetary Fund suggests that recent increases in real interest rates are likely to be temporary. The IMF refers to natural rates - the real interest rate that would keep inflation at target and the economy operating at full employment – which, until recently, had been steadily declining in the UK, US, France and Germany. Structural drivers, most notably a changing and ageing demographic and productivity slowdown, have been in play for the decline in the natural rate.
The IMF’s baseline forecast is for global headline CPI inflation to decline from 8.7% in 2022 to 7% in 2023, the projected disinflation reflecting declining fuel and commodity prices as well as the dampening effects of monetary tightening on economic activity. The IMF suggests that recent increases in real interest rates are likely to be temporary. Once inflation is brought back under control, central banks are likely to ease monetary policy and bring real interest rates back towards pre-pandemic levels.
The IMF’s outlook, titled ‘A Rocky Recovery’, is for global growth to fall from 3.4% in 2022 to 2.8% in 2023 before increasing modestly to 3% in 2024. The prospect is more sombre for advanced economies which are expected to experience a pronounced slowdown in growth from 2.7% in 2022 to 1.3% in 2023. The UK and German economies are projected to shrink this year. Further out to 2028, global growth is forecast at 3%, the lowest medium-term growth forecast published by the IMF in all World Economic Outlook reports since 1990, the heady effects of globalisation having given way to ‘geoeconomic fragmentation’ and trade disputes and barriers.
The side effects of the rapid rise in policy rates are also becoming apparent – sizeable losses on long-term fixed income assets and raised funding costs, the instability in UK gilts last September and the recent banking turbulence in the US.
The adjective ‘uncertain’ to describe economic outlooks might appear overused and unhelpful. However, disparate shocks (recent examples: the pandemic, Russia’s invasion of Ukraine, trade and supply disruptions, bank-specific risks) with a cumulative effect make determining a precise economic path increasingly difficult. The IMF puts it plainly: “With the recent increase in financial market volatility and multiple indicators pointing in different directions, the fog around the world economic outlook has thickened. Uncertainty is high, and the balance of risks has shifted firmly to the downside so long as the financial sector remains unsettled.”
A hard landing, particularly for advanced economies, has become a much larger risk. Although downside risks to growth dominate, the global economy could prove more resilient (it did in 2022) with the excess savings built up in the pandemic years boosting household consumption. It just makes central banks’ task that much harder as they balance bringing down sticky inflation, maintaining growth and, given the elevated volatility in financial markets, also safeguarding financial stability.