Introduction

Last week the Bank of England (BoE) outlined a very negative outlook for the UK economy in its Monetary Policy Report, with consumer price inflation expected to lift much further from current levels and the UK economy to enter a recession in early 2023. In this Econosights we look at whether the BoE’s projections are a warning for other central banks or whether the UK’s individual circumstances are different and the same economic projections should not be extended to other countries.

The Bank of England’s Projections

Central banks often get criticised for being too slow to adjust their forecasts and they rarely forecast recessions (this is probably because recessions are relatively rare and also because central banks want to be seen as a source of stability). In this sense, the Bank of England’s appraisal of the UK economy is novel (although the Reserve Bank of New Zealand also recently published updated growth forecasts which are close to recession-like levels) but do look appropriate for the UK given the combination of higher interest rates, high inflation and an energy crisis. The key takeouts from the Bank of England’s latest forecasts include:

• A new peak in consumer price inflation of ~13% in early 2023 from prior expectations of a 10% year on year peak (the highest on record of the inflation data – see the chart below) with large contributions from gas prices
• A decline in GDP growth worth 2 ¼ % peak to trough
• These estimates are based on expectations of interest rates increasing to 3% (current market pricing) from current interest rates of 1.75%.
  

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There are many similarities to the UK economy in the US and Australia at the moment. GDP growth rebounded strongly in 2021 from government and monetary stimulus. Labour markets are tight, wages are rising and the central bank is tigtening rates (BoE +1.65%, RBA +1.75% and Fed +2.25%). But, the key difference between the UK and the US/Australia is around inflation and energy prices. Inflation in the UK is expected to peak at a much higher level compared to the US and Australia at ~13% year on year because of extremely ghigh energy prices (European gas prices are up by over 250% over the year while US gas prices are 97% higher). In comparison, US inflation is likely to peak at around 9.5-10% year on year and Australia at 7.5-8% year on year.

Other differences include the political instability in the UK, with the resignation of PM Boris Johnson, and the potential impact to government spending and longer-term impacts of Brexit and European trade deals. So, the growth trajectory set out by the BoE is not directly comparable to other major developed markets.

Recession indicators

Some financial market indicators have been signalling recession risks for months. The US yield curve remains inverted on the measure of the 10-year bond yield minus the 2-year yield. An inverted yield curve (when the yield on long-dated bonds falls below short-dated bonds) can often be an early signal of a future recession (but it has also given false signals in the past) because it means that the central bank may need to cut interest rates in the future. As well, the yield curve as measured by the 10-year yield and the US Fed Funds rate is also close to inverting as the Fed has been raising rates (see the chart below).

As well, the US Conference Board Leading Economic index has moved into recession-like territory (see the chart below).

There is also a lot of concern that the contraction in GDP growth over the March and June quarters of 2022 will be classifed as a recession by the National Bureau of Economic Research (NBER), as it meets the technical definition of a recession. While the strengh in income and payrolls is being used as an argument against calling the decline in activity as a recession, every prior consecutive contraction in GDP growth over 2 quarters has been classified as a recession. The GDP data is still subject to a lot of revision, so the June quarter figures may be revised higher into positive territory. Either way, the risk of a current or near-term recession is very high.

For those that are forecasting a US recession, most estimates expect it to be shallow. However, the Bank of England estimates of a 2¼% decline in GDP growth peak-to-trough is not shallow. In Australia, that level of decline would mean a larger fall in GDP growth than compared to the 1991 recession.

In Australia, the yield curve has not inverted yet (see the chart below), athough it is no longer steepening.

A confirmation of a recession would be negative for sharemarkets, as earnings expectations are still holding up higher than they would in a recession, so analysts would downgrade their forecasts for company earnings growth.

Implications for other central banks

The Reserve Bank of Australia’s latest economic forecasts show that economic growth is expected to be around 1¾% by late 2024. We also expect GDP growth to be similar in 2023 and assume rate cuts in the second half of 2023 and a slightly lower profile for the cash rate (peaking at 2.6%) compared to the median economist and market pricing (of over 3%) in early 2023 which would be one of the most aggressive tightening cycles in history (and comparable to the 1994 rate hike cycle – see the chart below).

While we don’t think that the BoE’s expectation of a 2022/23 recession is directly transferrable to Australia and the US, the forecasts outlined by the BoE are a risk for Australia and the US and need to be considered as downside risk scenarios as interest rates are hiked aggressively.