November 28 , 2023
By Patrick Er
While a disinflationary trend has emerged and continues to play out, economic growth has proven to be resilient, especially in the US, despite economic headwinds including significantly tight monetary policy since mid‑2022. Our analysis for Issue 03 of the Fixed Income Strategic Forum 2023 suggests that the current policy mix of easier fiscal policy and tighter monetary policy may revert to an overall tighter stance in 2024, mainly due to a gradual diminishing of the fiscal policy impulse while the monetary policy stance remains tight. Households and businesses whose incomes are slowing significantly are likely to bear this burden, at a time when their balance sheets are expected to weaken. This should prolong the disinflationary trend but reinstate the slowing growth outlook closer to our yearlong base-case call for a mild cyclical recession.
Introduction
A year ago, as the global supply recovery from the COVID-19 pandemic settled into a slow but strengthening trend going into 2023, we believed demand would take centre stage in determining economic outcomes. Our basecase outlook through 2023 was underpinned by diminishing fiscal policy support and significant monetary policy tightening, which would drive demand deceleration, culminating in a cyclical recession (like in 2001) and the decline of inflation toward central bank targets. However, global economies, especially the US, have proved resilient. This has driven global bond yields higher despite the expected emergence of disinflation. In this note, we present our analysis from Issue 03 of the Strategic Forum 2023 on these current macro trends (illustrated using US data) and, more importantly, how their projected trajectories will affect the growth and inflation outlook into 2024.
Prelude: How did we get here?
As 2023 unfolded, with the supply recovery broadening and strengthening and demand slowing (Figures 1a and 1b), inflation trended lower, as expected. When demand exceeds supply, inflation rises; but when supply exceeds demand, inflation falls. Only the magnitudes are uncertain. But the current interplay between the paths of supply and demand does not offer a similar definitive outcome on growth: it could slow into either stagnation or recession. More analysis on the intensity of demand deceleration is needed, which will be discussed in the sections that follow.
Figure 1a: The path of demand and supply since the COVID-19 pandemic
Figure 1b: Growth and inflation since the COVID-19 pandemic
Sources: Macrobond, Macquarie.
At the time of Issue 02 of the Strategic Forum in May, a significant event that could intensify demand deceleration and thereby pose a negative growth risk had emerged in the US. This was due to the need to extend the debt ceiling. Historically, significant spending reductions have followed fractious negotiations to a debt ceiling resolution, hence the heightened concerns of a severe growth outcome (i.e. the much-feared “hard landing” after mid-2023). Fast-forward to Issue 03 and market nerves have been much less frayed thanks to one of the more benign resolutions to the debt ceiling issue. Fears of a severe hit to demand did not materialise. In Figure 2, we can see that private spending began to move higher with the suspension of the debt ceiling in June 2023.
Figure 2: Private consumption spending reaccelerates after debt ceiling resolution
Sources: Macrobond, Macquarie.
To summarise, growth has been higher than anticipated, although inflation has declined in line with our expectations thanks to the significant supply recovery. In the next section, we offer an explanation of the perception of “resilience,” which we use to form the basis for assessing the outlook for growth and inflation at the end of this note.
The role of “policy mix” and its changing impact on the broader economy
Since 2022, the policy mix – the combination of fiscal and monetary policy – has changed materially. This has significantly impacted demand and, hence, macroeconomic outcomes. The policy mix progressively tightened going into 2022, reversing the extreme easing of 2020-2021, then changed again as 2023 unfolded. We make a few salient observations:
1. Monetary policy
Historically, interest rate hikes alone have not led to recessions. This is because rate changes create winners (savers) and losers (borrowers). That said, higher interest rates in the current tightening cycle – which began at the end of 1Q22 – have worked as expected on rate-sensitive sectors such as residential investment, which contracted significantly (Figure 3a). Gross domestic product (GDP) growth tends to react within a year after residential investment responds, but in 2023 this has not repeated (Figure 3b, which shows better-than-expected GDP growth in 1H23).
Figure 3a: The effect of interest rates on residential investment
Figure 3b: Residential capex leads GDP by no more than 1 year
Sources: Macrobond.
Higher rates, when prolonged, tend to be followed by financial stress, which prompts tighter lending standards, as occurred in the wake of the US regional banking crisis in 1Q23. Historically, rate hikes and tighter credit conditions have resulted in a recession, every time. But this time around, tighter lending standards have coincided with lower demand for loans; tighter lending standards are less impactful if “borrowers are not borrowing” (Figure 4). So, credit conditions have indeed tightened through 2023 but not as much as when compared to conditions preceding prior recessions. However, this alone seems insufficient to explain the modest negative impact of one of the most intense rate-hiking cycles since the late 1970s/early 1980s. Given that the transmission of monetary policy seems to have worked as expected, the following section presents a rationale for its lack of a broader impact.
Figure 4: Tighter lending standards versus less appetite for loans
Sources: US Federal Reserve. “Banks tightening lending standards” is based on the Senior Loan Officer Opinion Survey (SLOOS) on Bank Lending Practices.
2. Fiscal policy
Fiscal policy, unlike rate hikes, directly impacts economic activity, especially if spending is engaged. Coupled with easier monetary policy, fiscal spending worked through 2020-2021 to stave off the worst-case scenario from pandemic lockdowns. The subsequent ending of pandemic support programs resulted in a fiscal drag that contributed greatly to the technical recession of 1H22, even before the impact of rate hikes was felt (Figure 5).
Figure 5: Fiscal impact contributes to technical recession
Sources: Macrobond, Macquarie.
First, the US federal government eased off, albeit slightly, the fiscal brakes in 2H22. Then, major adjustments were made to transfer programs in January 2023, such as raising cost-of-living payments to Social Security, effectively boosting beneficiaries’ nominal incomes by almost 9%; these are cohorts who tend to spend almost 100% of their incomes. Finally, defence spending increased, partly related to the Russia-Ukraine war. This launched the US federal government’s spending growth higher through 1H23. With the debt ceiling ultimately proving to be no more than a speed bump, fiscal policy expanded into 3Q23, by more than most equivalent countries (Figure 6).
Figure 6: Relative country budget balances: US “exceptionalism”
Sources: Macrobond, Macquarie.
The pickup in fiscal spending also “crowded in” private spending. An example is the fiscal-related industrial policies that enabled an easing of bottlenecks in key input sectors such as semiconductors, thus adding to overall economic activity, including boosting the ongoing supply recovery.
In summary, the policy mix that left 1H22 in relatively tight mode – with steep rate hikes and an effective fiscal drag – changed in 2023 to one in which tighter monetary policy was accompanied by a somewhat neutral to expansive fiscal policy. Rarely has the US economy experienced a policy mix of tight monetary policy and easy fiscal policy under such late-cycle economic conditions (Figure 7).
Figure 7: Policy mix in fiat money era
Sources: Macrobond, Macquarie.
3. Prevailing conditions of the private sector
While the changing policy mix was the key factor behind the “resilient economy” narrative, we should recognise that prevailing conditions did matter, particularly in the US. The balance sheet positions of households and businesses were generally in better shape when policy tightening emerged, largely due to the repairs implemented after the global financial crisis. Thus, current debt burdens (Figure 8), reflecting the private sector’s lack of desire to borrow as alluded to above, are not at levels that significantly impede spending. Although for some countries (e.g. Australia), serious concerns remain.
Figure 8: Contained debt burden enables private balance sheet cushion
Sources: Macrobond.
Moreover, the normalising of labour markets in the immediate post-pandemic recovery period (Figure 9) meant improving job prospects and nominal wage income growth. This enabled some offset to the cost-of-living pressures due to the lingering effects of pandemic-related supply shocks and steadied household balance sheets when the policy mix tightened into 2022.
Figure 9: Labour demand versus labour supply
Sources: Macrobond, Macquarie.
The net result of this section’s analysis points to a change in the policy mix due to the fiscal easing in 2023 as the driver behind the “slowing of the slowdown” and the shift in consensus toward a “soft landing” outlook. Of course, this is with support from a better set of prevailing conditions. We therefore believe the outlook for the policy mix holds the key to the likely economic trajectory going forward.
The “policy mix” outlook
Globally, in general, there is increasing desire to reduce government deficits and debt. In the US, particularly, roadblocks to further fiscal support may emerge sooner, given the start of its new fiscal year (on 1 October 2023) when spending decisions are made. What is known for now is that cost-of-living adjustment increases will be much lower due to lower inflation (e.g. Social Security adjustments will be about 3%, almost one-third of 2023’s increase). Note that the forbearance of student loan repayments, a major pandemic support program, also ended at this time. As events continue to unfold, the risks will likely tilt to less spending given the current fractious state of Congress. Finally, in a presidential election year – like 2024 – absent a major emergency, fresh fiscal spending bills tend not to be a priority. Essentially, all these manoeuvres point to a diminished fiscal impulse from 4Q23 onward and a potential return of fiscal drag.
The monetary policy stance should remain tight – in the US, the Federal Reserve has pushed rates to 5.5%, and long bond yields have launched higher. To gauge the extent of tightness of monetary policy, we utilise our proprietary Macquarie “rule of thumb”, which measures the nominal target policy rate against the trending growth rate of consumer spending (Figure 10) – movements above 2.5% are historically coincident with the onset of recession. In 2023, this “rule” has moved toward the 2.5% threshold, implying that US monetary policy is indeed “overtightened” and is likely to remain so for a significant period.
Figure 10: Rule of thumb pointing to overtightening
Sources: Macrobond, Macquarie.
We believe that this tighter policy mix will likely have negative consequences on the broader economy going forward. Moreover, the prevailing conditions will no longer be as supportive, with the cushion from private balance sheets likely to weaken as income growth declines. The latter is premised on labour demand having peaked and poised to decelerate just as labour supply is rising. This implies lower wages growth, which leads to slower household spending. Businesses, as recipients of spending, should then post slower revenue growth after a lag, and hence a weakening profit outlook as high input costs are prolonged (i.e. low inflation, not deflation).
To summarise, the supportive policy mix stance in 2023 is about to shift tighter from 4Q23 and will be loaded on households and businesses whose incomes are poised to grow much more slowly. We will now discuss how the expected policy mix could impact the paths for growth and inflation.
Impact on growth and inflation
The outlook for inflation will be driven by a combination of structural and cyclical forces. Structurally, if the ongoing aggregate supply recovery meets a reignited demand deceleration, then inflation should continue to decline. Cyclically, the outcome hinges crucially on how the two forces of exogenous external energy prices interact with the expected easing of major domestic price pressures, such as rental inflation in the US. We expect the latter to dominate.
Thus, our base case is for inflation to trend back toward central bank targets, especially in the US; but going forward, it could be volatile due to the impact of cyclical forces. There is also less certainty on the question of inflation sustainability at or below target in the medium-to-longer term. For that to happen, demand deceleration needs to intensify further toward outright demand destruction.
The outlook for economic growth remains hazier, as the expected paths for demand and supply tend to paint a less definitive picture on spending and output. We do continue to expect lower growth to emerge. But while major indicators of growth currently suggest that a base-case recession similar to a cyclical 2001-style recession is most likely – especially in the US and possibly worse in the EU and UK – a stagnation scenario cannot be ruled out. The likelihood of recession will increase if the expected fiscal drag causes an intensifying of demand deceleration. With that in mind, we are watching the indicators in Figures 11a and 11b in assessing the growth outlook. (Please refer to Table 1 in the Appendix for a more complete list of indicators to watch.)
Figure 11a: Conference Board Leading Economic Index (LEI) and recessions
Figure 11b: ISM Manufacturing Purchasing Managers’ Index (PMI) and recessions
Sources: Macrobond.
Financial crisis?
Our analysis of the policy mix outlook suggests a prolonged period of “overtightening” going into 2024. Such a tight policy mix environment has historically caused something to break in the financial economy. Could this repeat? Was the US regional banking crisis in 1Q23 a warning of things to come? If history is any guide, financial dislocations can emerge from places that are hard to predict. Therefore, we recommend both caution and vigilance because an unexpected financial dislocation might be contagious to the real economy (i.e. cause a more serious recession). In closing, we find it interesting to note that historically, interest rate cuts have been motivated mainly by dislocations in financial markets rather than by real economic developments (see Table 2 in the Appendix).
Conclusion
In Issue 03 of the Strategic Forum 2023, we presented evidence that a less-tight-than-anticipated policy mix – reflecting relatively expansive fiscal policy (more so after the US debt ceiling resolution) that offsets continued tight monetary policy – was (and likely still is) the critical factor underpinning the resilient economy narrative, especially in the US. In addition, the more-robust-than-usual private sector balance sheets have helped cushion the blows from potential headwinds.
Going forward, we expect the policy mix to revert to a tighter stance overall, mainly due to a gradual diminishing of the prevailing fiscal policy boost, while monetary policy should remain tight. Households and businesses whose incomes are slowing significantly will bear the burden, at a time when their balance sheet cushion is expected to diminish.
This implies that the demand deceleration trend will re-intensify. This view has underpinned our base-case call for a cyclical recession like the one in 2001 following the tech crash. The risks on either side remain: stagnation, defined as positive but near-zero growth with a harder landing, requiring a serious financial dislocation. Finally, in conjunction with the continuing supply recovery, this result keeps alive our expectation for lower inflation closer to the central bank target ranges within the next 12 months, or maybe sooner with “transitory deflation” a possibility.
Appendix
Table 1 – Suggested indicators watch list
| Indicators for: |
| Economic growth: |
| Conference Board LEI |
| ISM Manufacturing PMI |
| Composite ISM PMI - New orders Sub-Index |
| Inflation: |
| Federal Reserve Bank of York’s Global Supply Chain Pressure Index |
| US shelter rental prices |
| Global oil prices |
| Global overall commodity prices |
| Fiscal policy path: |
| US budget balance (estimated from Daily Treasury Statements) |
| Monetary policy path: |
| Job openings and quits |
| Initial jobless claims |
| Temporary employment |
Sources: Macquarie (2023).
Table 2
A summary of what coincided or triggered the first rate cut after a significant hiking cycle: rarely rate cuts after a sustained and/or significant hiking cycle were for purely unemployment or “victory over inflation” reasons.
| Rate cuts | Recession followed | Cut before recession | Reasons |
| 1981 | Yes | No | Significant rising unemployment from elevated (above-trend) levels; some banking distress but not severe yet (that would come in 1982). |
| 1984 | No | N/A | Banking distress leading to the Continental Illinois failure. At the time, it became the largest bank failure since the Great Depression. |
| 1987* | No | N/A | Black Monday. |
| 1989 | Yes | Yes | Savings and loan (S&L) crisis peaking; junk bond crisis leading to big name failures in the months ahead (e.g. Drexel less than a year later). |
| 1994 | No | N/A | Bonds selloff; prolonged Latin American debt crisis (e.g. peso crisis) impacting US banks. |
| 1998* | No | N/A | Long-Term Capital Management (LTCM), Russian default, etc. |
| 2001 | Yes | Yes | Tech crash; emerging market debt crisis (e.g. Argentina) impacting US banks. |
| 2007 | Yes | Yes | US financial crisis contagion; credit fund redemptions freeze (e.g. BNP Paribas, Bear Stearns). |
| 2019 | No | N/A | Repo/LIBOR spike/money market redemptions. |
| ? | ? | ? | ? |
Source: Macquarie (2023). *Not a sustained rate hiking cycle because financial dislocation caused an early reversal.
Authors
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A cost-of-living adjustment (COLA) is an increase in Social Security benefits to counteract inflation.
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The Senior Loan Officer Opinion Survey (SLOOS) on Bank Lending Practices is a survey conducted by the US Federal Reserve Board to gain insight into bank lending practices and conditions.
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The Federal Reserve Bank of New York’s Global Supply Chain Pressure Index integrates transportation cost data and manufacturing indicators to provide a gauge of global supply chain conditions.
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