The global economy entered 2022 in a weaker position characterised by the spread of the Omicron variant, by the re-imposition of mobility restrictions, by supply disruptions, and inflationary fears. The experience of handling the second wave of COVID-19 infections, which were by far the worst, gave rise to optimism that the tide could be turned in our favour.
This optimism of a strong recovery was notwithstanding the lingering downside risks. However, things changed pretty quickly by March. Russia’s invasion of Ukraine, the resultant Western sanctions, and the consequent spike and pervasiveness of global inflation have darkened the economic outlook.
By the end of 2021, we were discussing about mass-vaccination drives and getting back to the pre-pandemic path of ‘economic growth’. Now, it is more about battling rising inflation by hiking policy rates, and then minimising the stagnation or recessionary fears by going back to an accommodative policy.
Large economies such as the United States, the European Union, China, Japan, India, which account for 70 percent of world GDP, are in different stages of the business cycle. The US is overheating with retail inflation accelerating to a four-decade-high of 8.5 percent in March, and nominal wage growth at 5.6 percent. The US Fed is preparing to battle inflation from its current level of 0.25 percent to 2-2.25 percent by end of 2022.
Lael Brainard, one of the members of the Board of Governors of Federal Reserve, strongly emphasised the need of shrinking the US Fed balance sheet too. Evidence from the US economy (1960s, 1973-74, 1980, and 1990-91) have shown out of control inflation preceding a recession, and the current scenario is no different. Deutsche Bank economists have also projected a 70 percent probability of recession based upon the recent inversion in the 2-year-10-year yield curve. Thus, if US economic prospects, the US Fed will have to re-start their rate cut cycle.
At the same time, if the US Fed starts raising interest rates at a brisk pace, there can be repercussions for some developing economies in terms of foreign capital outflows. Widening current account deficits amidst elevated prices coupled with slowing or negative capital flows will pressure domestic currencies. Risks could be downsized for economies having foreign exchange buffers, like India. But a ‘sudden stop’ event cannot be eliminated otherwise.
The EU is facing concerns around inflation rather than overheating. Western sanctions on Russia have threatened the continent’s energy supply. The Economist highlights that gas prices for next winter are five times higher than the US, and spending on household energy is almost twice as high as a share of GDP. Inflation in the EU rose from 5.9 percent in February to 7.5 percent in March, well above its 2 percent inflation target. The European Central Bank has still not responded, but a policy hike is imminent. Amidst the economic consequence of the war, the ECB has cut its GDP forecast from 4.2 percent to 3.7 percent in 2022, while the council of economic advisors in Germany have slashed their projections from 4.6 percent to 1.8 percent.
China is facing a different set of challenges. They do not have the ‘retail inflation’ which the world is facing. China’s retail inflation came in at 1.5 percent in March. However, its producer price inflation has surged to 8.3 percent. The problem is that COVID-19 is back! The country has started reporting daily cases above 20,000 since the start of April. In order to eliminate COVID-19, many big cities in China have announced lockdowns. The COVID-19 Stringency Index for China has jumped from 64 by March-end to 75 in the next two weeks.
Lockdowns will disrupt supply chains and global trade could be hampered as China is one of the leading trade partners. The World Trade Organization, in its recent forecast, expects growth in merchandise trade volume to be 3 percent in 2022 as against its previous forecast of 4.7 percent. Japan’s economy is crawling back to its phase of secular stagnation (period of sluggish growth, low interest rates, and absence of inflation) following anomalies in the last two years.
Is India an outlier to all this? It’s actually been a mixed bag. The RBI has slashed the real GDP forecast for 2022-23 from 7.5 percent to 7.2 percent, while sharply raising its inflation forecast to 5.7 percent. The March retail inflation print came in at 6.95 percent, and the increase was broad-based. High frequency indicators have exhibited signs of recovery, but is still far from being robust. Decline in unemployment rate, elevated business expectations, and consumer confidence (as per RBI’s survey), robust GST collections are few positives.
The direct impact of the Russia-Ukraine war on India’s growth would be limited. However the indirect consequence via rising inflation sapping consumer confidence, prospective normalisation plans of domestic and global central banks, and lagging investment sentiments could have a more pronounced impact. Though exports are doing well, the consumption and investment story continues to lag.
The first quarter of 2022 has been dynamic, and with heightened uncertainty, events can swing in both directions quickly for the remainder of the year. Fortunately, but very unlikely, if geopolitical tensions de-escalate and inflation reverts to the central bank target quickly, policy action will be limited than envisaged. But the prominent scenario of elevated inflation, quantitative tightening, interest rate hikes, capital outflows, recessionary concerns, re-emergence of accommodative policy, and fiscal support projects a roller-coaster ride for the next 18 months. Time to fasten your seat belts!
Sushant Hede is an independent economist.
Views are personal and do not represent the stand of this publication.
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