According to the International Monetary Fund (IMF), the outlook continues to be uncertain in view of the financial sector turmoil, high inflation, ongoing effects of Russia’s invasion of Ukraine, and three years of COVID which have now become sort of perennial issues with little hope about their settling down to the normal levels in any conceivable short term.
The IMF has forecasted the growth rate to fall from 3.4 percent in 2022 to 2.8 percent in 2023. The growth rate for advanced economies is expected to take a steeper dive from 2.7 percent in 2022 to 1.3 percent in the year 2023. Taking a more plausible view, the IMF projects that if the financial sector stress intensifies further, the global growth rate may even fall to about 2.5 percent with advanced economy growth falling below 1 percent in the year 2023.
It is not easy to ride on a rocky road
The IMF report opines that apparently, the global economy looked poised for a gradual recovery from the powerful blows of the pandemic and of Russia’s war on Ukraine due to several factors:
- reopening of the Chinese economy
- unwinding of the supply-chain disruptions particularly in the energy and food markets
- massive and simultaneous tightening of monetary policy by most central banks forcing inflation rate to recede back toward its targets in several economies.
- Powerful growth performance by the emerging market and developing economies in many cases, with growth rates of the fourth quarter on year-to-year basis jumping from 2.8 percent in 2022 to 4.5 percent this year.
- Concentration of slowdown in select advanced economies, especially the euro area and the United Kingdom, where growth in the same period was expected to fall to 0.7 percent and –0.4 percent, respectively, this year.
However, what is not so apparently seen are factors indicating that turbulence is building and that has made the road to recovery bit rocky. They include:
- recent bout of banking instability and
- Inflation being much stickier than anticipated.
Even as the global headline inflation in the baseline is estimated to fall from 8.7 percent in 2022 to 7.0 percent in 2023 on account of lower commodity prices yet the underlying (core) inflation may decline even more slowly as it is getting much stickier than anticipated even a few months ago. Moreover, it is quite unlikely that inflation rate may return to its target anytime sooner than the year 2025 in most cases. Besides, global supply-chain disruptions and rising geopolitical tensions have evoked a rethinking about the risks and potential benefits and costs of geo-economic fragmentation for most policy makers.
Is there a possibility of uncontrolled wage-price spiral?
Despite a massive tightening cycle across countries there are no strong signs of output and employment softening seen. Rather there is an upward revision of output and inflation estimates in the last six months in many countries which indicates that demand may be stronger-than-expected. Besides there is resilience seen in the labor market which simply means that we may expect monetary policy to tighten further or to stay tighter for longer.
However, it is suggested that there is little possibility of uncontrolled wage-price spiral to occur. The nominal wage inflation continues to lag far behind price inflation which is rather indicative of a steep and unprecedented decline in real wages. Yet, on account of the tightness in the labor markets, this is unlikely to continue, and real wages may recover. Also, since corporate margins have surged in recent years, may be on account of steeply higher prices coupled with modestly higher wages, it is quite likely that they may as well be able to absorb rising labor costs on average. Yet, so long as inflation expectations remain well anchored, that process is not expected to move out of control.
Side effects of monetary tightening on financial sector may be worrisome
There has been sharp policy tightening policy stance taken by many countries in the last 12 months which has had serious side effects for the financial sector, as was also apprehended by the IMF earlier. The reason is that the policy interest rates were raised in quick succession after a prolonged period of subdued inflation and extremely low interest rates, and this triggered into sizable losses on long-term fixed-income assets.
These side effects were reflected through instances of financial instability in the gilt market in the United Kingdom earlier and the collapse of a few regional banks quite recently in the United States which have only highlighted that significant vulnerabilities exist not only among banks but also in the non-banking financial institutions.
However, in both cases the concerned authorities took quick and strong action and have been able to contain the spread of the crisis so far. Yet the financial system may still be facing dominant downside risks. Investors apprehend there may be few more weaker links such as Credit Suisse, which may test the strength of the financial system in the times to come.
Thus, there is a need to monitor the health of the financial institutions having excess leverage, credit risk or interest rate exposure, or having too much dependence on short-term funding, or located in jurisdictions with limited fiscal space. The credit conditions and public finances in the emerging market and developing economies may be adversely affected in case of a further tightening of global financial conditions leading to things like:
- large capital outflows,
- sudden increase in risk premia,
- dollar appreciation, and
- major declines in global activity amid lower confidence, household spending, and investment.
According to the IMF, if such downside risks persist, there is 15 percent probability that the global GDP per capita could even come close to falling.
Monetary Policy focus may continue to be on containing inflation
The WEC report of the IMF visualizes a perilous phase which may be characterized by less than normal economic growth rates, heightened financial risks amid no certainty that inflation will be back to its targeted levels. Hence the IMF recommends that there is an unprecedented need for steady moves with clear communication by the policy makers as they resort to taking appropriate measures based on the state of the respective financial systems.
It is important that if the financial system remains resilient, the focus of the monetary policy should continue to be on curbing inflation and the IMF even suggests that the such effort may as well be corroborated by the respective fiscal policies across nations. Besides, amid recent instances of the banking turmoil and rising cost of funding, the banks may curtail lending which may as well slow aggregate economic activity and if this happens the monetary policy may not require further tightening measures.
But in a scenario where there are signs of systemic financial crisis seen, the monetary policy needs to be geared to safeguard both the financial system and economic activity. There would also be the need for better liaison among the financial regulators and financial institutions so that there are no extraneous factors such as volatility in the exchange rates that may increase the financial stability risks any further.
What would you choose: A fragile or fragmented world?
Something fragile can still be handled with due care. But a fragmented world may not achieve progress across all countries or help us protect the environment or calamities like the pandemic. Hence, IMF now talks about the importance of a natural rate of interest across leading advanced and emerging economies to serve as a reference level to define the monetary policy stance as well as a benchmark for the sustainability of public debt.
It also suggests that the currencies should be allowed to adjust to changing fundamentals, barring exceptional situations such as crisis or imminent crisis like circumstances.
Further they recommend measures to address structural factors supply bottlenecks which may hurt the medium-term growth. Therefore, there is a need to take necessary steps to promote multilateral cooperation for creating a more resilient world economy through boosting access to the global financial safety net, mitigating the costs of climate change, and reducing the adverse effects of geo-economic fragmentation.
Disclaimer: This article is based on the own understanding of the author about the views, data and opinions contained in the WEO report, April 2023 published by the IMF. Hope it will provide a rich understanding of some of the major issues raised in the said WEO report. For detailed analysis and use for business or policy decisions, readers are advised to refer to the full report subject to the assumptions contained therein.