This year should have been the year of either the hard landing or the soft landing. Instead, 2023 is set to become the year of no landing, and for many that adopted a defensive stance in financial portfolios one year ago, this has been really uncomfortable.
According to IMF projections, global growth should approach 3 per cent and that of advanced countries 1.5 per cent — with 2.1 per cent for the US and 0.7 per cent for the eurozone.
The resilience of the global economy has been remarkable and the US third-quarter earnings season should be relatively strong. Activity data has largely surprised to the upside year to date, and leading indicators, such as earning revisions by analysts, point to the likelihood of a greater-than-average proportion of earnings per share beats during the season.
The robust job growth in September is testament to the resilience of US activity.
In a way, we can say that Jerome Powell has succeeded in his challenge of being able to achieve a restrictive monetary policy to tame inflation without causing a contraction in activity, at least for the moment.
Risks for 2024 are piling up, especially with the lag effect of previous interest rate increases. The big question now is the severity of the economic downturn to come.
The robustness of the global economy and advanced countries in 2023 is the result of several seemingly temporary factors that are fading: fiscal largesse, excess of savings and cash, and the recovery in services and positive real wage growth. Above all, the impact of the central banks’ rate hikes so far is clearly yet to come.
Indeed, despite the most aggressive programme of rate increases in 40 years — 500 basis points in 13 months — the US Federal Reserve is still confronted with a booming job market and historically low unemployment.
Only time will tell
A large body of research tells us it can take, on average, 18 months (the lag is long) to two years or more for tighter monetary policy to materially affect inflation and real activity, and that time can differ unpredictably across episodes (the lag is variable). Post-Covid, there are good reasons for that lag to be longer than usual.
US economist Milton Friedman identified the “lag on monetary policy effect” in an article published in 1961, based on an analysis of money supply, inflation and the business cycles from 1870 to 1960. In his book A Program for Monetary Stability, Friedman writes: “There is much evidence that monetary changes have their effect only after a considerable lag and over a long period and that the lag is rather variable.”
Friedman used his own metaphor — the “fool in the shower” — to describe the issue of long and variable lags using the analogy of fine-tuning the knobs for the hot and cold water for a shower in older structures.
A person turning on the shower might adjust the controls trying to achieve a comfortably warm setting. Initially, the water in the pipes may be freezing cold. The person might respond by cranking up the hot water. The panicked person, after another lag, may unexpectedly find themselves scalding. The shower-taker will then turn the temperature down and the cycle repeats.
