Six short months ago the macro landscape was markedly different from today. The U.S. and eurozone economies were expected to grow at around twice their potential rates in 2022; emerging markets were closing the gaps. Inflation was elevated, but seen as largely transitory. Economies were beginning to heal from the effects of the COVID-19 pandemic and the narrative was around what type of "V" the recovery would resemble and what the new steady state would look like.

Things have changed, and not for the better. The main twist has been the about-face in the inflation narrative. With the wisdom of hindsight, central banks are now viewed as having waited too long to raise rates, putting too much weight on supply-side explanations, or putting too much weight on labor market outcomes, or both. A swath of central banks, most notably the U.S. Federal Reserve, have brought forward their rate-hike timetables.

The Fed raised rates by 25 basis points in March, 50 basis points in May, and 75 basis points in June, bringing the federal funds rate range to 1.50%-1.75%. And there is more to come. The expectation is now for continued large hikes that would bring the policy rate close to 3.00% by year-end and eventually to around 4.00% on current Fed dot plots and market pricing.

The European Central Bank (ECB) has signaled that it will raise rates by 25 basis points (across all three policy rates) in July, followed by a rise of at least that much in September, depending on the data. With less (core) inflation pressure than the Fed, the ECB forecasts a peak rate this cycle at the estimated neutral level of around 1.50%.

Almost all other advanced economy central banks have moved (often from effectively zero) earlier and more aggressively than expected just a few months ago. The sole holdout is the Bank of Japan.

The other change has been geopolitical: Russia's invasion of Ukraine. Sticking to the economic impact, this event sent energy and food prices--which had been rising on the back of a strong recovery from COVID--even higher. This complicated the inflation picture for central banks. Combined with general uncertainty about the extent and duration of the conflict, consumer and producer confidence fell, putting additional downward pressure on growth.

Markets have adjusted sharply to the new developments. This includes both financial and nonfinancial assets. As of this writing, U.S. and European equities are down by almost 20% year to date. Housing markets are showing some signs of weakness as the cost of borrowing has risen sharply. And in the currency markets the U.S. dollar continues to strengthen against most currencies, reflecting the large cumulative rate hikes expected to come from the Fed relative to other central banks.

Despite inflation and geopolitical shocks and the market reaction, the overall global macro picture remains reasonably healthy, although signs of softening are rising. Looking at S&P Global's purchasing managers' indices (PMIs), manufacturing sentiment remains well above the neutral threshold in the U.S., Europe, and much of Asia. China, in contrast, had dipped below the neutral level amid property sector weakness and the impact of COVID lockdowns and restrictions. On nonmanufacturing (dominated by services) the PMIs have been choppier, but the same pattern holds: the U.S. and Europe remain above 50 while China has fallen sharply in recent months as consumption has plunged due to recent COVID outbreaks and the measures to contain it.

Chart 1a

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Labor markets remain a bright spot, with the unemployment rate at or near longer-term lows across many economies. Strong employment, combined with savings cushions built using COVID-related government transfers, have underpinned resilient consumption spending. This despite wealth losses--financial and nonfinancial--as a result of the ongoing market correction and in some cases reductions in real incomes owing to inflation outpacing wage gains.

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Our Revised Forecasts

GDP growth forecasts over 2022-2025 have generally been revised lower relative to our previous round in May (see table 1). The sole exception is commodity-exporting emerging markets. These markdowns occur mainly in 2022 or 2023, depending on the context. Our narrative for the main countries and groups appears below.

Table 1

U.S.

Economic momentum will likely protect the U.S. economy from recession in 2022. But the weight of extremely high prices is damaging purchasing power and, as aggressive Federal Reserve policy increases borrowing costs, it's hard to see the economy walking out of 2023 unscathed. Our U.S. GDP growth forecast is now 2.4% for 2022 and 1.6% for 2023 (compared with 2.4% and 2.0%, respectively, in May). The job market remains tight, and will remain near that rate until early 2023 when it climbs higher as successive Fed hikes take hold. With economic strains worsening as the Fed tightens the screws, we now expect the unemployment rate to top 4.3% by the end of 2023.

Given recent inflation developments, the Fed will now be much more aggressive: we see the policy rate rising from zero at the beginning of 2022 to 3% by year-end, reaching 3.50%-3.75% by mid-2023. The Fed will keep monetary policy tight until inflation decelerates and nears its target in the second quarter of 2024. Our lower GDP and inflation forecasts for 2023 and 2024 reflect this more aggressive stance.

For our latest U.S. macro report, see "Economic Outlook U.S. Q3 2022: The Summer Of Our Discontent," published June 27, 2022, on RatingsDirect.

Europe

We have lowered our GDP growth forecasts modestly for the eurozone economy. We now expect 2.6% growth this year and 1.9% next year (from 2.7% and 2.2% in our interim forecasts in May). Higher inflation drives our downward revision. We now expect consumer price inflation to reach 7% this year and 3.4% in 2023 (from 6.4% and 3% previously) on the back of higher energy and food prices resulting from geopolitical tensions. Lower international demand, particularly from China, is also expected to dampen growth. Consumers are starting to feel the squeeze on their purchasing power, especially as wage increases are not sufficient to make up for higher prices. We still expect significant pandemic-related saving buffers and pent-up demand for services to keep consumption rising, but to a lesser degree than three months ago. This is because financial market turmoil is eroding net wealth. The risks to growth are firmly on the downside.

We see the ECB lifting all three policy rates by 25 basis points in July, with another rise of at least that much in September. Unlike for the U.S. Federal Reserve, we see ECB policy rates peaking at neutral (around 1.5%).

To read our latest Europe macro report, see "Economic Outlook Eurozone Q3: Inflation Dulls The Post-COVID Bounce," June 27, 2022.

Asia-Pacific

Despite war, higher inflation, and interest rates, the prospects for Asia-Pacific are broadly favorable. The exception is China, which we expect to fall short of its growth target because of COVID-19-lockdown generated weakness. Considering the slower-than-expected easing of COVID restrictions and the shallow recovery of domestic demand in China, we have further lowered our baseline 2022 growth forecast for the country to 3.3%.

Outside China, the post-COVID domestic recovery is mostly continuing. We expect solid economic growth in 2022-2023, especially in economies relatively more led by domestic demand such as India, Indonesia, and the Philippines. However, rising inflation has been a key factor behind the start of the monetary policy normalization in many economies: all but four central banks in the region have started raising their policy rates. The other key motivation is staving off external pressure amid rising global interest rates. Capital outflows and currency depreciation against the U.S. dollar have so far been contained. But we expect most central banks to continue to raise their policy rates to anchor inflation expectations and guard against external vulnerability.

To read our latest Asia-Pacific macro report, see "Economic Outlook Asia-Pacific Q3 2022: Overcoming Obstacles," June 27, 2022.

Emerging markets

GDP growth forecasts for emerging markets (EMs) have been driven by upside growth surprises in in the first quarter, and by weakening growth momentum in the second quarter onwards. All told, this has led to a small upward revision for 2022. The forecast for 2023 is unchanged as many countries face protracted recoveries to pre-pandemic trends amid lingering inflation and financial-condition shocks.

We raised our consumer price inflation forecast across the board. Annual average inflation in a median EM will be 7.1% in 2022 and 4.1% in 2023 (1.2 and 0.6 percentage points higher, respectively, compared with our March forecasts), reflecting the sharper hit to consumers' purchasing power and subsequent lower real domestic demand for the remainder of 2022 and 2023.

Even as we expect inflation to move back down in the coming quarters, it's likely to remain well above many EM central banks' target for some time. This combined with the U.S. Federal Reserve and other major central banks indicating swifter policy tightening, we now expect the pace of monetary policy tightening to pick up across most EMs, despite weakening economies.

To read our latest emerging markets macro report, see "Economic Outlook Emerging Markets Q3 2022: Testing Times Ahead For Emerging Market Resilience," June 28, 2022.

Risks Still On The Downside

As in recent reports, the risks around our baseline are skewed firmly to the downside. These relate mainly to more stubborn than expected inflation dynamics--potentially leading to stagflation and a sharper downturn--and an escalation of the conflict in Ukraine. An upside risk to our baseline would be lower inflation and policy rates as growth cools and recent strong price dynamics dissipate.

Market expectations around central bank normalization paths have shifted sharply of late. This has four dimensions: the timing of lift-off, the size of rate moves, the speed of tightening, and the terminal rate. The question now is whether what is priced in is sufficient to bring inflation--and expectations--down to the target rate over the forecast horizon. This is not necessarily a one-way bet: market pricing was until recently running ahead of central banks' forward guidance but has since pulled back.

Should inflation stay higher for longer than expected, real rates will remain correspondingly lower and central banks will need to do more. This runs the risk of more financial pain as well as a sharp decline in output and employment. In an extreme case of stagflation, inflation could remain elevated even if the economy is slowing sharply. In this case, supply-side-driven price pressures spill back into broader inflation pressure, requiring an even stronger policy response.

The second risk, one that we covered in our previous report, relates to the economic consequences of the conflict in Ukraine. As the war drags on, the downside to our baseline involves a trade rupture between Russia and Europe centered on oil and gas, plus a host of industrial commodities used as inputs in the German industrial complex. While higher food and fuel prices are manageable for Europe, this trade fallout would materially disrupt production and employment in key sectors such as automobiles. This would hit markets in ways that would reverberate well beyond Europe.

How Deep And For How Long?

A growth slowdown across a wide swath of economies has already begun. Despite the strong and optimistic start to the year, this deceleration became inevitable once it was clear that central banks needed to raise rates sooner and faster to get inflation under control. Market participants drove rates higher and spreads wider and pushed asset prices down in response to the new path for interest rates. This tightening of financial conditions foretells a slowdown. The invasion of Ukraine, with spillover effects on food and energy markets and confidence, has exacerbated this dynamic.

The depth and duration of the slowdown turns mainly on the labor markets in our view, but also on the production side as it relates to inventories. Employment levels are high and households still have savings cushions to draw down. This has led to spending resilience despite lower wealth and, in some cases, lower real wages. If employment starts to slide, a recession is almost inevitable. The other variable to watch is production in light of ongoing low inventory levels and supply constraints. Activity could be supported by an easing of bottlenecks, which would allow ramped-up production to meet the demand for more normal inventory levels.

The central macro question for the coming quarters is whether central banks can bring inflation under control while preserving the strength of labor demand, perhaps boosted by some timely inventory rebuilding. We will soon find out.

Related Research

• Economic Outlook Emerging Markets Q3 2022: Testing Times Ahead For Emerging Market Resilience, June 28, 2022
• Economic Outlook U.S. Q3 2022: The Summer Of Our Discontent, June 27, 2022
• Economic Outlook Eurozone Q3: Inflation Dulls The Post-COVID Bounce, June 27, 2022
• Economic Outlook Asia-Pacific Q3 2022: Overcoming Obstacles, June 27, 2022