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Tough Love - Global Economics Quarterly

Central banks around the world now have a serious fight on their hands. Inflation in most places has been far too high for far too long. Worse still, it continues to rise.

The major central banks have ratcheted up their response, with the US Federal Reserve hiking by 75 basis points (bp) at its June meeting, and the European Central Bank giving a clear signal it could soon be lifting rates in steps of at least 50bp. These moves have come too late in the view of many, but unexpectedly abruptly for financial markets. Prices for equities and bonds have tumbled as markets assess how much interest rates may have to rise and how much growth could slow.

While central banks say they are ready to do whatever it takes to rein in inflation, mostly they are still forecasting a fairly benign outlook for GDP and employment: a “Goldilocks” scenario with relatively little impact on economic growth. Given the array of uncertainties facing the global economy, this seems somewhat optimistic to us.

The impact of the war in Ukraine continues to worsen. Commodity prices for energy, metals and food are close to record highs. And the pandemic is causing ongoing disruption – not only in places such as mainland China, which maintains its “zero-COVID-19” policy, but also in developed markets such as Australia, where levels of work absenteeism have hit a new high.

Our forecasts are not as rosy as those of central banks. We have cut our projection for global growth for 2022 to 3.0 per cent (from 3.5 per cent), and for 2023 to 2.6 per cent (from 2.9 per cent). While we are not forecasting a full-blown recession globally or in the US in 2022-23, our outlook certainly paints a picture of a partial recession: for some economies, companies, and households.

We have also raised our inflation forecast for this year to 8.3 per cent (from 6.5 per cent), and for the next to 5.6 per cent (from 4.2 per cent). If high inflation persists, income inequality concerns could grow, with potential social and political consequences further down the line. Already strikes are becoming more prevalent in some countries, including the UK and Korea. Surging food prices are also triggering street protests in some low-income countries.

It is little wonder then that central banks, with the key exceptions of the Bank of Japan and the People’s Bank of China, are making it clear that they cannot cease tightening until inflation comes down. They want to avoid a re-run of the 1970s and early 1980s, when the Federal Reserve ended a tightening cycle too soon, and then had to resort to a much longer run of higher interest rates to get inflation back under control.

Reining in inflation means unemployment will most likely rise over the next year or so, as central bankers increasingly acknowledge. This is politically challenging. Policymakers will have to hold their nerve even in the face of political pressure: today’s inflation backdrop calls for a period of tough love.

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