2022 was a year of rising inflation and slowing economic growth; it was a year in which the conventional wisdom of central banks, sell-side research, and consensual forecasts turned out to be mostly wrong about key economic, policy and market views. In particular, consensus forecasts got the inflation outlook wrong: the rise in inflation proved to be persistent and permanent, rather than transitory and temporary.
The consensus view was also that the rise in inflation was mostly driven by excessively loose monetary, fiscal and credit policies. But, in addition to these bad policies there was also plain bad luck, with a series of negative aggregate supply shocks taking place. These included the initial impact of Covid-19 on the supply of goods and services, and on the supply of labor and global supply chains; the impacts of the Russian invasion of Ukraine regarding energy and other commodities prices; and the impact of the continuation – until recently – of China’s Zero Covid Policy on global supply chains.
Another opinion held by the consensus was that central banks, as they were phasing out QE and credit easing and raising policy rates, would be able to achieve a “soft landing”: a fall in inflation to the 2% target without a recession or rise in the unemployment rate. That turned out to be incorrect, as now the UK and Eurozone economies are already entering into a recession, and even the Fed expects that a soft landing will be “very challenging”, and thus expects a “softish” landing and some serious “pain”.
Now the new conventional wisdom is that we will experience a “short and shallow” recession (rather than a severe one) that will trigger a sharp drop of inflation and allow central banks to ease by H2 of 2023. The consensus also argues that – consistent with such a mild recession – central banks will remain committed to achieving their 2% inflation target. We continue to have views different from the consensus in these last two debates, after having been correct in the previous debates of 2021-22.
We believe that a hard landing is more likely than a short and shallow recession. Why? First, we argue that although inflation has peaked in most advanced economies, and has started to fall, it will nevertheless remain more sticky than central banks and consensus opinion expects, and thus central banks will be forced to hike more than currently predicted, if they want to push inflation closer to target.
The argument for stickier inflation is based on several points: the war in Ukraine will continue and get uglier, rather than be resolved; the supply bottlenecks in China will remain in spite of the phase out of Zero-Covid Policy, as China will continue its stop-and-go policies towards Covid and a full phase out of the policy will lead to a spike in cases and reduce the available labor supply of healthy workers; even if stronger growth were to resume in China – not our baseline scenario – its impact on commodities demand and prices would be sharper. Commodities prices have declined in the last few months in spite of their spike during H1, mostly because of expectations of lower demand – given the expected global economic contraction – rather than because of much higher supply. Next year commodity prices – and not just in energy – are likely to spike, as many years of under-investment in new capacity will lead to a shortfall in supply, even if demand falls as well.
Secondly, geopolitical factors will continue weighing on economic activity. The war in Ukraine will continue for much longer than people expect. One cannot rule out a military strike by Israel against Iran – that is effectively now a threshold nuclear star – that would lead to a dramatic spike in energy prices. An outright confrontation (not our baseline scenario now) between US and China over Taiwan – where 50% of all computer chips and 80% of high end chips are produced – would be another massive stagflationary shock.
