Global Markets Brace for Recession in 2023 as Inflation and Rate Hikes Bite

The world economy is facing the risk of a global recession in 2023 as inflation pressures and simultaneous interest rate hikes by central banks threaten to derail the recovery from the Covid-19 pandemic, according to analysts and experts.

One of the main drivers of the looming recession is the surge in inflation, which has reached levels not seen since the 1980s in some countries. Inflation is the general increase in the prices of goods and services over time, which erodes the purchasing power of money and reduces the real income of consumers and businesses.

The causes of the current inflation spike are manifold, but some of the main factors are:

• The unprecedented fiscal and monetary stimulus that governments and central banks have injected into the economy to combat the Covid-19 crisis, which has boosted aggregate demand and created excess liquidity in the financial system.
• The supply chain disruptions and bottlenecks that have resulted from the pandemic, which have hampered the production and distribution of goods and services, creating shortages and pushing up costs.
• The rebound in commodity prices, especially oil and gas, which have soared due to strong demand and supply constraints, adding to the input costs of many industries and sectors.
• The base effects of comparing the current prices with the depressed levels of a year ago, when the pandemic hit the global economy hard and caused deflationary pressures.

According to the latest data from the International Monetary Fund (IMF), global inflation is expected to average 5.9% in 2023, up from 3.6% in 2022 and 2.8% in 2021. Some of the countries with the highest inflation rates in 2023 are:

• Argentina: 48.4%
• Turkey: 36.9%
• Venezuela: 28.8%
• Brazil: 10.2%
• Russia: 9.8%
• India: 9.1%
• Mexico: 8.7%
• United States: 8.2%
• United Kingdom: 7.8%
• China: 6.2%

Central Banks Tighten Monetary Policy to Fight Inflation

In response to the rising inflation, central banks around the world have started to tighten their monetary policy by raising their benchmark interest rates, which are the rates at which they lend money to commercial banks and influence the cost of borrowing in the economy. Higher interest rates are meant to cool down the economy by making borrowing more expensive and saving more attractive, thus reducing the demand for goods and services and easing the inflationary pressures.

However, the timing and pace of the rate hikes vary across different countries, depending on their inflation outlook, economic growth, and financial stability. Some of the central banks that have already raised their rates or signaled their intention to do so in the near future are:

• The Bank of England (BoE), which increased its base rate from 0.1% to 0.25% on December 16, 2023, the first rate hike since 2018, and indicated that further increases are likely in 2023 to bring inflation back to its 2% target.
• The Federal Reserve (Fed), which announced on December 15, 2023, that it will start to reduce its monthly bond purchases by $30 billion from January 2023, a process known as tapering, and projected three rate hikes in 2023, starting from the second quarter, to bring its federal funds rate from the current range of 0-0.25% to 1.25-1.5% by the end of the year.
• The European Central Bank (ECB), which confirmed on December 16, 2023, that it will end its pandemic emergency purchase program (PEPP), which has bought €2.4 trillion worth of bonds since March 2020, by March 2023, and hinted that it may start to raise its deposit rate, which is currently at -0.5%, from the second half of 2023.
• The People’s Bank of China (PBOC), which raised its medium-term lending facility (MLF) rate, which is a key reference rate for bank lending, by 5 basis points to 2.85% on December 15, 2023, the first increase since 2017, and signaled that it may raise its benchmark loan prime rate (LPR), which is currently at 3.85%, in the coming months.
• The Reserve Bank of India (RBI), which hiked its repo rate, which is the rate at which it lends money to commercial banks, by 25 basis points to 4.25% on December 8, 2023, the first increase since 2018, and indicated that further hikes are possible in 2023 to contain inflation within its 2-6% range.
• The Central Bank of Brazil (BCB), which has been the most aggressive in tightening its monetary policy, raising its Selic rate by 150 basis points to 11.25% on December 15, 2023, the ninth consecutive hike since March 2020, and signaling that it may raise it further to 12.5% in January 2023.

Global Recession Looms as Rate Hikes Bite

The simultaneous tightening of monetary policy by central banks around the world poses a serious threat to the global economic recovery, which is already losing momentum due to the emergence of new variants of the Covid-19 virus, such as Omicron, and the reintroduction of lockdowns and travel restrictions in some countries.

According to a comprehensive new study by the World Bank, the world may be edging toward a global recession in 2023 and a string of financial crises in emerging market and developing economies that would do them lasting harm. The study defines a global recession as a contraction in global output per capita, which has happened only four times since 1960: in 1975, 1982, 1991, and 2009.

The study warns that the combination of high inflation and high interest rates could trigger a vicious cycle of lower growth, higher debt, and financial instability, especially in countries that have high external debt, low foreign exchange reserves, and weak fiscal and monetary institutions. Some of the potential channels through which the rate hikes could cause a global recession are:

• The crowding out effect, which occurs when higher interest rates reduce the availability of credit for private investment and consumption, thus lowering the aggregate demand and output in the economy.
• The exchange rate effect, which occurs when higher interest rates appreciate the domestic currency, making exports more expensive and imports cheaper, thus worsening the trade balance and output in the economy.
• The balance sheet effect, which occurs when higher interest rates increase the debt servicing costs and default risks of borrowers, especially those with foreign currency debt, thus impairing their solvency and liquidity and triggering a financial crisis in the economy.
• The confidence effect, which occurs when higher interest rates reduce the expectations and sentiments of consumers, businesses, and investors, thus lowering their spending and investment decisions and output in the economy.

The study estimates that if all the major central banks raise their policy rates by 100 basis points in 2023, the global output per capita would contract by 0.8% in 2023 and 0.6% in 2024, compared to a baseline scenario of no rate hikes. The impact would be more severe for emerging market and developing economies, which would see their output per capita shrink by 1.4% in 2023 and 1.1% in 2024, compared to a baseline scenario of no rate hikes.

The study also cautions that the actual impact of the rate hikes could be much worse than the simulations suggest, as they do not account for the nonlinear and unpredictable effects of financial contagion, capital flight, and currency crises that could spread across countries and regions.

How to Avoid a Global Recession in 2023

The study suggests that the best way to avoid a global recession in 2023 is to adopt a coordinated and gradual approach to monetary policy normalization, taking into account the different economic conditions and inflation outlooks of each country and region. The study recommends that central banks should:

• Communicate clearly and transparently their policy intentions and actions, and explain the rationale and evidence behind their decisions, to avoid surprising and confusing the markets and the public.
• Monitor closely the inflation dynamics and the inflation expectations of the agents in the economy, and adjust their policy stance accordingly, to avoid overreacting or underreacting to temporary or transitory shocks.
• Balance the trade-offs between fighting inflation and supporting growth, and consider the spillovers and feedback effects of their policy actions on other countries and regions, to avoid creating unnecessary volatility and instability in the global economy.
• Coordinate and cooperate with other central banks and international institutions, and share information and analysis, to enhance the effectiveness and credibility of their policy actions and to mitigate the risks of policy divergence and divergence.

The study also emphasizes the need for complementary fiscal and structural policies to support the monetary policy and to address the root causes of the inflation and growth challenges. The study advises that governments should:

• Implement credible and sustainable fiscal consolidation plans, and prioritize spending on health, education, social protection, and infrastructure, to reduce the fiscal deficits and debt levels and to boost the potential growth and productivity of the economy.
• Enhance the flexibility and resilience of the supply chains and the labor markets, and promote innovation and competition, to reduce the supply bottlenecks and cost pressures and to increase the efficiency and diversity of the economy.
• Strengthen the financial regulation and supervision, and improve the governance and transparency of the financial institutions, to reduce the financial vulnerabilities