Global economy struggles amid inflation, pandemic aftershocks and war

7 min

A pair of central bank decisions next week will shape the outlook for a wobbly global economy that the World Bank warns in a downbeat new assessment is battling stubbornly high inflation amid the pandemic’s aftermath and the war in Ukraine.

The gloomy forecast arrives days after one threat to global growth was eliminated when President Biden signed legislation Friday to raise the U.S. debt ceiling and avert a potentially catastrophic government default.

But other risks remain: China’s reopening after the end of its “zero covid” policy is starting to flag, while the German economy has shrunk for two consecutive quarters, meeting one definition of a recession. Even in the United States, where growth remains resilient, most analysts anticipate that activity will ebb in the coming months.

The World Bank is scheduled to release a report Tuesday warning that the global economy is slowing dramatically as higher interest rates take a toll on both advanced and developing economies. Overall, global growth is projected to slump to an anemic 2.1 percent annual rate this year, down from 3.1 percent in 2022, and will remain “frail” through next year, according to the bank’s latest forecast.

Investors now are focused on how much more work the Federal Reserve and European Central Bank must do to stem inflation, which has declined from last year’s highs but remains elevated.

Fed officials have signaled they may pause at next week’s meeting after lifting their benchmark lending rate over the past 14 months at the fastest pace in four decades. European policymakers are expected to increase the euro zone’s key rate by a quarter percentage point when they meet next week.

“The risks for both of them are high, and they always were in this inflationary environment. There is a chance they overdo it,” said Kathy Bostjancic, chief economist for Nationwide.

If U.S. defaults on debts, this company has two months of payroll saved up

If central bankers raise rates too much, the United States or Europe could be driven into recession. But if they fail to raise them enough, inflation will keep eroding living standards.

Striking the right balance is difficult. In the United States, Fed officials warn that the full effects of the rate increases already enacted have not yet been felt. As the Fed considers whether more increases are needed, it must also take into account other forces that are expected to slow the economy, such as tighter lending conditions in the wake of recent bank turmoil and government spending cuts under the debt ceiling deal.

In Europe, meanwhile, annual inflation dipped in May to 6.1 percent from 7 percent in April. Energy costs are falling, after a spike last year at the outset of Russia’s invasion of Ukraine. But food, alcohol and tobacco prices are soaring at a double-digit annual pace, according to the European statistical agency.

“How quickly will inflation come down? How much higher do rates have to go up? We’re obviously focused on that,” said Neil Shearing, chief economist for Capital Economics in London.

Higher interest rates represent a challenge that ripples from big economies to small ones, according to the World Bank.

When the Fed raises borrowing costs, it slows the U.S. economy by making it more expensive for consumers and businesses to obtain loans. That reduces demand for goods produced overseas, hurting growth there. Higher U.S. interest rates also encourage investment in the United States rather than elsewhere. The inflow of capital pushes up the value of the dollar, which makes it more expensive for foreign governments and businesses to repay their dollar-denominated loans.

Spillovers from Fed policy could lead to a financial crisis in the most vulnerable developing nations, which borrowed heavily over the past three years to deal with the pandemic’s health and economic consequences, the bank warned. The danger of renewed weakness in the banking industry could further constrict credit, aggravating those effects.

“The global economy remains in a precarious state,” the bank’s latest assessment concluded.

China’s performance, after ending its stringent zero-covid stance in December, has been mixed. The Chinese economy grew by 4.5 percent in the first quarter but appears to be hitting a soft patch.

China’s official purchasing managers index for May showed the manufacturing sector falling into contraction. The index for services also declined from April’s level but remained in expansion territory. Youth unemployment tops 20 percent, and the heavily indebted property sector remains a worry.

“The post-zero-covid recovery is peaking, and growth is going to slow over the second half of the year,” Shearing said.

After JPMorgan’s purchase of First Republic, tougher banking regulations loom

Apple told investors last month that its China revenue fell by more than 5 percent for the six months ending April 1. Auto parts maker BorgWarner, which sells 70 percent of its made-in-China output to Chinese auto companies, said its production there has been weaker than anticipated.

So far, the U.S. economy has defied repeated recession forecasts. The Federal Reserve Bank of Atlanta’s real-time forecast says output is growing at a 2 percent annual rate, an acceleration from the first quarter’s 1.3 percent.

The labor market, likewise, remains robust. In May, employers created 339,000 jobs, while government statisticians revised higher the April and March figures by a combined 93,000 jobs, according to the Bureau of Labor Statistics.

In Europe, meanwhile, inflation is higher and growth lower, and countries face twin-barreled strategic challenges. They must replace Russian energy with more reliable supplies while “de-risking” the trade relationship with China, said Carsten Brzeski, global head of macro for ING Research in Frankfurt.

“It’s very easy to see these transitions in the next one to two years will weigh on growth, putting pressure on European industry’s business model and household wealth,” he said. “It’s not like a financial-crisis-style recession. But it’s anemic growth for a couple of years.”

Both the Fed and its European counterpart are determined to quash inflation, which means interest rates will continue going up until it is clear that prices are under control.

The strong U.S. job market makes it likely that the Fed’s expected pause in June will be temporary. Since March of last year, the central bank has lifted rates from near zero to a range of 5 percent to 5.25 percent. Several Fed governors favor taking stock of the effects of tighter credit before resuming rate hikes as soon as the Fed’s end-of-July meeting.

“History shows that monetary policy works with long and variable lags, and that a year is not a long enough period for demand to feel the full effect of higher interest rates,” Philip Jefferson, a member of the Fed Board of governors, said in a recent speech.

Biden seeks expanded domestic production and more robust supply chains

But some economists disagree. Jason Furman of Harvard University said consumer credit markets reacted quickly to the Fed’s change of policy, meaning there is little reason to expect lagging impacts.

The average 30-year fixed-rate mortgage cost increased from 3.8 percent as the Fed began raising rates to 6.8 percent at the end of September. But there has been little change since then, even as the Fed raised rates five more times, Furman noted.

“The full monetary tightening happened 12 months ago and worked its way through the system,” said Furman, who was President Barack Obama’s top economic adviser.

Indeed, overall financial conditions grew tighter even before the Fed’s first rate hike, as investors reacted to public comments by Fed Chair Jerome H. Powell suggesting an imminent move, according to an index maintained by the Federal Reserve Bank of Chicago, which tracks 105 financial-market and banking-sector data points.

One wild card is the potential for lingering fallout from the regional bank turmoil of recent months. In May, the nation’s banks reported tighter standards and weaker demand for commercial and industrial loans, according to the Fed’s most recent senior loan officer survey.

A second unknown is the impact of the Treasury Department’s efforts to refill its general account, which was nearly exhausted during the debt ceiling showdown. To replenish government coffers, Treasury will auction an unusually large amount of short-term debt in the coming months. Those sales of government securities will effectively drain funds from the banking sector, further chilling credit availability.