Chief Economist Eric Lascelles shares his outlook for inflation and explores the likelihood of recession throughout the developed world.
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Has inflation peaked?
It's hard to say with precision whether inflation has permanently peaked, but we think it's more likely than not at this point in time. And that's really good news if it holds in the sense that spiking inflation has been the greatest concern for financial markets and from an economic standpoint over the last year. And so solving that would be a big deal.
We do think it's likely turning downward for a few reasons, and so some of it is just observational. We can say that in the month of July, inflation was running a whole lot less hot than it was previously. And so we've had a bit of a turn that we can observe. But maybe more importantly, we can also say that of the four big theoretical drivers of inflation that help to explain why inflation has been so high over the last year, all four of those have turned as well.
And so, for instance, monetary stimulus has turned into monetary restraint. Fiscal stimulus has also turned into a subtle form of fiscal restraint. Supply chains are getting significantly better, and we can see that as the amount it costs to ship goods and the time ships are waiting in port, and other variables, improve. And the commodity shock has, for the most part, become somewhat less intense.
We can maybe speak with the least confidence about where commodities go from here. They do tend to be volatile. We've seen all sorts of external shocks, and of course, natural gas isn't particularly cooperating. But even there, to the extent the global economy continues to soften, that would be an excuse for commodity prices to come down. So it's likely that commodity prices, and inflation in turn, can come down from here, but it's unlikely to be a smooth or rapid process.
There is a lot of breadth to inflation that's going to take some time to work through. Wage pressures are intense, even if they're starting to come back down. And so we think ultimately inflation should become less high. Central banks certainly are on our side on that front and will, if anything, err on the side of too much tightening.
And then long term, I would admit that perhaps inflation ends up being a little higher than we were used to before the pandemic, simply because we see some deglobalization happening. We see some inflation coming from climate change. And we also see the balance of power shifting a little toward workers and away from businesses. And so a little more inflation than normal over the long run, but nothing like what we have right now.
What is the risk of recession?
The risk of recession remains quite high. We think there's about a 70% chance of recession in a U.S. or Canadian context. And quite frankly, the odds are even higher if we're talking about the European Union and the UK. Now that's not a certainty. Soft landing remains possible. It may be a 20 to 30% chance, but it would take a bit of good luck to achieve at this juncture.
So recession is more likely and you can approach that from a few angles. One would simply be that there are enough economic headwinds in the world to slow growth enough to induce a recession. And so we can observe, for instance, that interest rates are rising quite a lot. Energy costs have become more expensive. Food costs have surged. Financial conditions have tightened.
There's a war in Ukraine with swirling consequences. Even China is struggling to grow, and it's historically a big driver of growth. So the economy should slow quite a bit, potentially into recession. You can then turn and look at a variety of recession signals that we track and the majority of those do now predict recession. Even those not saying recession are seemingly converging on that conclusion.
An example of that, by the way, would be the fact that yield curves are now increasingly inverted. That's been a historical recession signal. If there is a recession, we don't expect it to be especially deep. We don't think it should be especially long. Recessions are inherently temporary. You do subsequently get a recovery, and it's also worth remembering that, particularly in this case, there is some value in a recession.
It should help to enduringly tame inflation. It should help to get the economy back to a more sustainable footing. It most certainly is not in a sustainable place right now, and it should help to fix housing excesses, which is, I think, an important societal goal on top of the economic implications. And so recession likely – not the greatest outcome in the world, but some value to it as well.
What is the outlook for emerging markets?
Emerging market economies are buffeted by the same set of global forces as developed world nations, in the sense that higher interest rates are doing damage. Higher inflation isn't great. Weakening global demand isn't helpful and so on. So, similar set of factors. But arguably emerging market countries are more negatively affected by a few of those variables than are developed countries.
And so, for instance, rising interest rates are proving even more problematic for emerging market countries. Not only is the risk-free rate going up, but emerging markets borrow with a credit spread on top and that's widened as well. So their borrowing costs have gone up by more. And we do see some amount of debt distress in some emerging market countries as a result.
To the extent food prices are going up, that is more consequential for emerging market countries because a bigger share of their spending basket is on food. They are generally poorer countries. And so that's more painful for emerging markets as well. And then lastly, the U.S. dollar has been very strong and a lot of emerging market debt is priced in U.S. dollars.
And so as that U.S. dollar goes up, essentially emerging markets owe more money. And so, as a result, there are quite material emerging market growth challenges. Their growth has also slowed quite significantly. Because their speed limit tends to be higher doesn't mean that they're going to shrink outright. You can't quite call it a recession, but it is a material growth slowdown for them.
Briefly on China, well, China is the world's perhaps most important country from an economic growth standpoint. It is still suffering from some pretty serious headwinds here. And so it has some domestic housing market excesses that are still being tackled, has some longstanding demographic challenges as well. As the global economy weakens, it's not great for China's export-led economy. As COVID ebbs and flows, China's zero tolerance policy is proving quite costly. And there's been more flowing than ebbing recently, at least in the Chinese context, which has been bad for growth. And so we’re expecting quite meager growth for China in 2022, and only a little bit better in 2023. The country simply isn’t up to the growth rates it once managed to achieve.
On India – well, structurally, we’re optimistic on India. India has solved many of the longstanding problems it’s suffered from previously. It’s improved its infrastructure quite a bit; it’s improved its banking system somewhat. It has been growing quickly, notwithstanding the pandemic, in recent years and we think it can return to being quite an important driver for global growth in the coming decades. And so, more of an optimistic take there, though perhaps a more challenging year-end for most countries first.
Where are we in the business cycle?
The idea behind the business cycle is that there are certain repeating patterns in the economy – as it recovers from a recession, as it expands, as it then eventually tumbles into the next recession. And so it’s a useful concept and can help us predict the future. And the current business cycle has been racing forward at an unprecedented rate over the last two and a half years. In fact, at the current pace, it looks like it could wrap up the cycle after a total of three years from the start of the pandemic. And just to make a point of contrast, the prior couple of business cycles lasted the better part of a decade. So the cycle has been moving very quickly. We’re already getting end of cycle readings now, just two and a half years into this cycle. Examples of end of cycle indications are, for instance, that inventory levels have begun to surge again; that consumer confidence has fallen quite sharply; wage growth, which has been fast, is starting to hook a little bit lower. All of that is again, consistent with end of cycle. And as the name would suggest, end of cycle normally happens just before a recession. And so this business cycle work that we’re doing really adds credibility to the view that a recession is more likely than not. At a minimum, a period of significantly subdued economic activity seems to be coming based on our reading of the business cycle.