Whatever happened to the recession that never was?
The pitfalls of forecasting.
One of the hazards of making forecasts is that time can hold us to account. At the start of 2023, many forecasters were confidently predicting that we would see a recession over the year ahead. There were discussions over whether it would be a hard landing or a soft landing, never quite considering the possibility that there would be no landing at all. As we now know, the economy pottered along with no significant downturn. There was no real growth either. It simply flatlined. It would be interesting to review this. Why was it that a recession was forecast? Why didn’t that forecast prove accurate? And what does that mean for 2024?
We have previously written about why economic forecasts are invariably wrong (see here). Normally, the inaccuracies are questions of degree. It is unusual for the inaccuracies to be questions of direction. That suggests that something interesting is happening, that ought to command our attention. A useful starting point might be with the factors that suggested a recession might occur. Over 2022, the interest rate cycle had turned and the central banks across the developed world were tightening monetary policy. Interest rates had started to rise and liquidity was being sucked out of the economy through quantitative tightening.
At that point, the pace of inflation was greater than the pace of wage increases, leading to falling real wages and diminishing purchasing power. The pace of price increases was being driven by increases in the cost of energy and food. The war in Ukraine had disrupted global energy and global food markets, sanctions on Russia had caused a disruption to global financial markets, and the response of China to the pandemic was still evident in snarled global supply chains. There was an issue about the extent to which demand could be sustained through what was called at the time a ‘cost of living crisis’. Prices were rising quite fast and many households felt the squeeze in living standards.
With this as a backdrop, it is not difficult to see where the view emerged that we were heading into a recession. Only that didn’t happen over 2023. Why was that? To start with, we need to account for the extraordinary efforts of government to put a cap on increases to household bills. It is estimated that the energy price guarantee cost the UK government just under £40 billion in 2023. This tended to be borrowed money, and highlights the degree to which the UK has enjoyed a fiscal expansion over the course of the year. This feature is not confined to the UK. The US enjoyed a fiscal expansion of $369 billion, again all from borrowed money. This is comparable to the energy support schemes costing €390 billion in the EU. These are large sums of money that were spent on supporting the economy in general and household budgets in particular.
In addition to the fiscal loosening, the monetary tightening undertaken by the central banks was not fully evident in 2023. In normal times, we would expect the transmission mechanism for monetary tightening to take effect within 18 months to two years from the policy change. That would time the impact on demand from mid-2023 onwards. However, there is evidence to suggest that the transmission mechanism has lengthened in recent years. Changes in the household borrowing markets tend to delay the passage of interest rate rises, and the corporate sector came out of the pandemic with relatively high levels of liquidity. Both of these factors suggest that, at the start of 2024, the transmission of the recent monetary tightening is yet to be felt fully.
If we have yet to feel the full effects of the monetary tightening, what of the other factors impacting 2023? How much has changed and how much remains the same? Two key factors have changed that will have an impact in 2024. First, we have gone past the disruption phase caused by the war in Ukraine. Food prices are settling down again and the energy markets are quite sluggish. This is the result of a downturn in economic activity in China which, in recent years, has been the driver of global economic growth. Second, governments in Europe and North America are starting to feel the debt constraint that limits much further fiscal expansion. Global bond markets are now more sensitive to fiscal expansions and there are questions over the degree to which additional borrowing can be accommodated. These will act as a natural brake upon economic activity.
The case for reduced activity is not, however, the only factor to take into account. Across the developed world, there is enough evidence to suggest that inflation has peaked. Whilst we may be some way from calling it defeated (i.e. falling back to the central bank targets), we can say that it is less of a factor than it was a year ago. On top of that, most developed economies are facing acute labour shortages. This is having the effect of forcing up wages to a rate faster than inflation, meaning that real wages are rising again. Part of this additional spending power will be absorbed by additional tax revenues, but we can also expect consumer spending to be a little more robust in the year ahead. Given the structure of western economies, this is likely to be made evident in the service sector — principally the hospitality and entertainment sector — rather than in the manufacturing sector in 2024.
This leaves us with a rather mixed bag of prospects. On the one hand, we can expect to see the increasing effects of monetary tightening on household budgets. This is likely to be coupled with a degree of fiscal containment as the focus of government shifts to tax raising rather than expanding expenditures. The external account will be the place to see how this is turning out, as foreign savings are needed to support the fiscal deficit. If these factors can be contained, then 2024 has the prospect of being a relatively good year. Real wages are rising, inflation is falling, and that creates the space in which interest rate reductions could occur.
Of course, it could be objected that we have given a response that is typical of economists. We have been asked what 2024 has in store and we have replied that it could be a bad year, where the promised recession eventually arrives. Or it could be a good year, in that it is unlikely to be that bad after all. As we said earlier, all economic forecasts are invariably wrong, this one included. However, we have given some pointers over what to look out for. As these uncertainties unravel, we will have a clearer picture of the road ahead.
© Stephen Aguilar-Millan 2024
