- Growth and inflation are both expected to slow, but not severely
- Challenge to manage recession risks and sticky inflation simultaneously was flagged
- China’s role in global financial architecture was widely discussed
- Tightening financial condition was seen as the key driver of a potential recession
- US debt ceiling related uncertainty could be another source of market instability later this year
Commentary: Notes from Washington DC
The recently concluded IMF meetings were characterised by a somewhat cautious view on the post-pandemic recovery. Ongoing tightening of financial market conditions was expected the slow the growth momentum in the US, although the IMF still projected over 1.5% growth in the world’s largest economy. Emerging market economies, led by China, were expected to grow by around 4%, leaving the outturn broadly unchanged from 2022.
The meetings featured a great deal of conversation on the fraying of a rules-based system of global trade and commerce, the escalating headwinds from climate change, tools and ideas to deal with global warming, mechanisms for debt restructuring of some developing economies, the role of China in the international financial architecture, and support for war-torn Ukraine. In the following sections, we summarise the views gathered from discussions with policy makers, IMF staff, and financial market participants.
Inflation
Consensus expectation is that inflation is heading down substantially this year. Cyclical factors pulling down inflation include a favourable base effect, energy and electronics supply side normalisation, ample food stocks, and tightening monetary/financial conditions slowing down demand.
Even as inflation comes down, price level is too high in most parts of the world, with grave cost-of-living implications. First, nominal wages may have risen, but in most cases they have not yet caught up with prices. This means that some degree of wage inertia even as growth slows is likely, posing challenges to monetary policy. Second, with wage levels lagging price levels, reports of declining inflation will not show up in commensurate improvement in affordability and consumer sentiment. Third, businesses that have not fully passed on input costs may find margins shrinking going forward as pricing power weakens along with slowing growth.
The hope for policy makers is a soft landing, with the rise in real rates and decline in credit impulse eroding labor market tightness on both the jobs and wages front, accompanied by adjustment to asset prices and corporate profitability. Growth would slow, but no more than a mild recession would transpire, with modest duration and manageable output loss.
Medium term upside risks to inflation comes from green transition, aging, and deglobalisation. But market-based indicators of inflation expectations don’t reflect such concerns, which is interpreted as undiminished credibility of key central banks. There are concerns that such expectations could get ratcheted up if the disinflation trend fades by Q4 despite a growth slowdown. This could be a source of instability in financial markets.
Multilateral organisations like the IMF and World Bank continue to express worries about widespread food and energy insecurity persisting despite likely disinflation this year. Adverse weather conditions and escalation of war in Ukraine could compound this matter.
Financial conditions
Financial conditions have tightened considerably since 2H22, and most meeting participants marked this as the key likely driver of a major slowdown in 2H23. Especially in the US, bank credit impulse has turned negative with the medium-sized banking crisis. This could amount to as much as 75bps in effective tightening. Such tightening taking place while debt levels and financial system fragility are considerable could pave the way for further setbacks in the financial sectors.
Fiscal policy
After rising sharply in 2020 and 2021, public sector debt/GDP ratios came down last year, thanks to inflation. Nonetheless, debt service ratios have begun to rise with higher interest rates. This could lead to sovereign ratings downgrades, which may force some governments, both in EM and DM, to pursue austerity measures.
A major potential spoiler for the markets and the global economy could be the US debt ceiling. If the Republicans in Congress take a strong position on spending cuts as a precondition to the ceiling being lifted, and the US treasury resorts to unconventional solutions to keep the federal government running, that could lead to legal challenges going all the way to the Supreme Court. Such developments could transpire in 4Q, with adverse implication for US debt rating, rates, and the USD.
China and sovereign finance
As deliberated extensively in last year’s annual meetings, China’s increasing role in global finance remains a focus. The key discussion point was China’s creditor status to numerous developing countries. As multilateral organisations work on debt restructuring in a number of cases, China’s cooperation in uniform treatment of all creditors was called for repeatedly. China’s response was largely constructive, with assurances that it would participate in coordinated relief efforts for crisis-stricken countries.
Overall, the Chinese officials in the Spring Meetings were highly engaged, reflecting a cohesive and assertive leadership. It is clear that multilateral organisations are struggling with their old structures, with China’s share substantially lower than warranted by its economic footprint. How US and European governments embrace the necessary reforms to raise the representation and voice of large EM economies, particularly China and India, would be absolutely critical to sustain a unified stance on generational challenges like climate change and income inequality.
Ukraine
The economic and financial support for Ukraine has been exceptional. Recently announced support packages for the country have stretched the scope of multilateral modalities. The IMF’s recently announced program for Ukraine, for instance, included assurance from its largest shareholders that the lending would be secure. Post-Ukraine, the nature of support for war-torn economies would be far more expansive than it has been in the past.
Overall, the meetings, despite taking place a month after a series of stress events in global finance, were characterised by a somewhat constructive tone. A slowdown is forthcoming, but between strong household balancesheets in the West and post-pandemic recovery underway in China, the effect of tight monetary policy was not expected to cause widespread distress this year.
Taimur Baig
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