Prepare for rising tensions between fiscal and monetary policy

THE WORLD economy is slowing and many countries risk falling into recession in 2023. In America sharply higher interest rates, the necessary result of the Federal Reserve’s fight with inflation, threaten to crash the housing market and raise unemployment. Tight money has brought about a strong dollar, which is exporting inflation to emerging markets and making their hard-currency debts harder to service. Europe is grappling with a severe energy crisis that is shutting factories and hurting consumers; the severity of its downturn depends significantly on the weather. And China is fighting with a housing-market crash and the instability brought about by its zero-covid policy, which entails sharp lockdowns at a moment’s notice.

The first half of 2023 may bring some relief. Europe has enough gas in storage to make it through a mild winter without a major crisis. Commodity prices will stay high and volatile, but merely not repeating their rapid ascent of 2022 will be enough to cause headline annual inflation to fall somewhat. The immediate pressure will come off the Fed.

Neither the inflation problem nor the energy crisis will be over, however. The Fed faces a rate of underlying inflation that is probably around 4%, in part because labour markets are so tight, with nearly two vacancies for every unemployed worker. Europe will once again need to refill its gas storage in preparation for winter, but with much less supply from Russia than flowed in 2022. If China rebounds, global growth will be higher, but that will also increase global demand for liquefied natural gas (LNG), the supply of which is unlikely to rise materially until the middle of the decade. Higher LNG prices could make the second winter of the energy crisis harder to bear than the first.

Across the rich world, central bankers will continue to be as hawkish as it takes to contain inflation. Gone is talk of promoting employment; restoring price stability is the priority. But whereas technocrats might tolerate economic slowdowns in the name of slaying inflation, for politicians the trade-off will seem more finely balanced as worries about the economic outlook mount. In Europe, governments are spending huge sums to protect their economies from high energy costs. Britain’s brief attempt to borrow more to encourage growth, now abandoned, could be repeated elsewhere. But as its ill-fated experiment showed, stimulating economies, even as central banks curtail demand by raising interest rates, is likely to backfire.

The next conflict between monetary tightening and fiscal sustainability could take place in indebted Italy. The European Central Bank (ECB) is buying Italian bonds even as it raises interest rates to fight inflation. Nonetheless, ten-year Italian debt trades at a yield 2.2 percentage points higher than the German equivalent. Even if the spread falls, in the event that the ECB has to raise rates by as much as the Fed to contain inflation, Italy’s budget will come under severe stress.

Central bankers will continue to be as hawkish as it takes to contain inflation

Remarkably, it is also possible that monetary-fiscal conflict could strike Japan. Its enormous public net debts, of around 170% of GDP, have hitherto been sustainable because of the Bank of Japan’s ongoing commitment to low interest rates amid below-target inflation. But now even Japanese inflation is rising, and the chasm between its loose monetary policy and Fed tightening is putting severe downward pressure on the yen. A turn towards monetary tightening is possible if inflation proves persistent.

The only big economy that lacks any tension between fiscal and monetary policies is China, which is not suffering from high inflation. But that is because its growth has slowed, which is no good thing. As China keeps its borders tightly controlled, loses investment to other East Asian countries with lower lockdown risk and increases government control over businesses, the disconnect between its economy and that of the rest of the world could grow. The balancing act China faces is not between growth and unemployment, or higher rates and sustainable debts, but between the present and the future. It must fix its housing crisis without creating moral hazard that stores up problems, and find a way out of its zero-covid policy, even at the short-term cost of an “exit wave” of infections.

Elsewhere in emerging markets the challenge is coping with a tightening Fed. Middle-income countries are on the whole more robust than during past episodes of rising rates. The biggest problems are found where economic policy has perennially offended, as in Argentina and Turkey. But in poorer parts of the world, especially in Africa, many countries continue to teeter on the edge of crisis, required to negotiate debt relief with China before a bail-out from the IMF is feasible. Reconciling rising interest rates with high public debts is even harder when it is someone else’s policy decisions that matter most.■

Henry Curr: Economics editor, The Economist

This article appeared in the Leaders section of the print edition of The World Ahead 2023 under the headline “Bankers v budgets”