IMF Says Global Economic Recovery Endures but Its Not an Easy Ride

The International Monetary Fund (IMF) on Tuesday said that the global economy’s gradual recovery from both the pandemic and Russia’s invasion of Ukraine remained on track and China’s reopened economy was rebounding strongly.

Supply chain disruptions were unwinding, while dislocations to energy and food markets caused by the war were receding. Simultaneously, the massive and synchronized tightening of monetary policy by most central banks should start to bear fruit, with inflation moving back towards targets.

In its latest forecast in the latest World Economic Outlook, IMF said that growth will bottom out at 2.8% this year before rising modestly to 3% next year, which is 0.1 percentage points below IMF’s January projections. Global inflation will fall, though more slowly than initially anticipated, from 8.7% last year to 7% this year and 4.9% in 2024.

This year’s economic slowdown is concentrated in advanced economies, especially the euro area and the UK, where growth is expected to fall to 0.8% and -0.3% this year before rebounding to 1.4% and 1% respectively.

By contrast, despite a 0.5 percentage point downward revision, many emerging market and developing economies are picking up, with year-end-to-year-end growth accelerating to 4.5% in 2023 from 2.8% in 2022.

Risks

Recent banking instability reminds us, however, that the situation remains fragile. Once again, downside risks dominate and the fog around the world economic outlook has thickened, the IMF said in its ongoing Spring meetings held in Washington now.

“First, inflation is much stickier than anticipated, even a few months ago. While global inflation has declined, that reflects mostly the sharp reversal in energy and food prices. But core inflation, which excludes energy and food, has not yet peaked in many countries. We expect year-end to year-end core inflation will slow to 5.1% this year, a sizeable upward revision of 0.6 percentage points from our January update, and well above target,” IMF’s Chief Economist Pierre-Olivier Gourinchas said.

He said that moreover, activity shows signs of resilience as labour markets remain strong in most advanced economies. At this point in the tightening cycle, we would expect to see more signs of output and employment softening.

“Instead, our output and inflation estimates have been revised upwards for the last two quarters, suggesting stronger-than-expected aggregate demand. This may call for monetary policy to tighten further or to stay tighter for longer than currently anticipated,” he explained.

Not an Easy Ride

More worrisome are the side effects that the sharp monetary policy tightening of the last year is starting to have on the financial sector, as we have repeatedly warned might happen. The surprise is that it took so long, he said.

Following a prolonged period of muted inflation and low interest rates, the financial sector had become too complacent about maturity and liquidity mismatches. Last year’s rapid tightening of monetary policy triggered sizable losses on long-term fixed-income assets and raised funding costs.

The stability of any financial system hinges on its ability to absorb losses without recourse to taxpayers’ money. The brief instability in the UK’s gilt market last fall and the recent banking turbulence in the US underscore that significant vulnerabilities exist both among banks and nonbank financial intermediaries. In both cases, financial and monetary authorities took quick and strong action and, so far, have prevented further instability, he noted.

The IMF’s World Economic Outlook explore a scenario where banks, faced with rising funding costs and the need to act more prudently, cut down lending further. This leads to an additional 0.3% reduction in output this year.

“Yet, the financial system may well be assessed even more. Nervous investors often look for the next weakest link, as they did with Crédit Suisse, a globally systemic but ailing European bank. Financial institutions with excess leverage, credit risk or interest rate exposure, too much dependence on short-term funding, or located in jurisdictions with limited fiscal space could become the next target. So could countries with weaker perceived fundamentals,” he said.

A sharp tightening of global financial conditions—a so-called ‘risk-off’ event—could have a dramatic impact on credit conditions and public finances, especially in emerging market and developing economies. It would precipitate large capital outflows, a sudden increase in risk premia, a dollar appreciation in a rush to safety, and major declines in global activity amid lower confidence, household spending and investment.

“In such a severe downside scenario, global growth could slow to 1% this year, implying near stagnant income per capita. We estimate the probability of such an outcome at about 15%,” he added.