Nordea chief economist: Inflation more stubborn than expected

The global economy got off to a good start in 2023. The sharp fall in energy prices, the surprisingly rapid reopening of the Chinese economy and the fact that the war in Ukraine has not spread have all provided the backdrop for an increase in confidence indicators for businesses and households globally.

However, that said, it is mainly the services sector that benefits from better conditions. Consumers have a pent-up need for leisure activities after the pandemic, while the manufacturing sector is more affected by the high inflation and rising interest rates. 

That’s why we have not found any reason to revise down our forecast for the global economy very much. We still expect global growth in the region of 3% this year, whereas 2024 will see slightly weaker growth. But this forecast is subject to a lot of uncertainty, not least related to the significant monetary policy tightening. It thus remains an open question whether central banks will manage to administer just the right dose of monetary policy tightening to lower inflation without a hard landing of the economy.

Also, the geopolitical situation is unstable to put it mildly. There is still a risk that the war in Ukraine could escalate and that tensions between the US and China will increase the risk of a fresh upsurge of the trade war between the two superpowers.

The strong demand for services has been decisive for the labour markets’ surprising resilience to monetary policy tightening. Consequently, unemployment is still record low basically everywhere and the demand for labour is strong.

The result is historically high wage growth in many countries over the coming years, increasing the risk that high inflation will take hold; there are already signs that inflation will be more stubborn than previously expected. 

For while headline inflation is falling sharply thanks to lower energy prices, underlying inflation – core inflation – is more stubborn and causing growing concern among central banks. Monetary policy easing is therefore not expected until core inflation is also under control and approaching the 2% target. This will most likely happen in 2024 at the earliest. 

It should also be noted that commercial banks have tightened loan conditions for households and businesses in these uncertain times. The stricter loan conditions reinforce the impact of interest rate hikes on lending. It also means that central banks will likely end rate hikes as early as this summer and then stay sidelined, knowing that the effect of monetary policy tightening will not be fully reflected in the real economy until year-end.

While monetary policy has a dampening effect on economic activity, fiscal policy has the opposite effect. Crisis packages, acceleration of the green and digital transitions and steeply rising defence spending are increasingly making demands on society’s resources. This unavoidably happens at the expense of demand in the private sector, where spending as well as investment activity are expected to abate due to permanently higher inflation and interest rate levels than before the pandemic and the war in Ukraine.

The same pattern will likely emerge in the Nordic countries, which are incidentally among those economies that made it through the pandemic most unscathed. But economic activity is also slowing down in the Nordic countries, and near term the greatest uncertainty is related to the effect of high inflation and monetary policy tightening. This cocktail is severely affecting property and retail markets everywhere, not least in Sweden. 

On the other hand, these sectors also had glory days during the pandemic, but nonetheless had to face a slowdown at some point. To which extent the rest of the economy will follow suit largely depends on the resiliency of the labour markets. As noted earlier, labour markets have proven to be very robust so far, but it must again be pointed out that it usually takes several quarters before monetary policy changes fully impact the real economy.

However, long term, there is reason for optimism in the Nordic countries, which have a comparative advantage in the green and digital transition and can boast very strong macroeconomic balance sheets, including good public finances. This provides strong support during these uncertain times.

This article originally appeared in the Nordea Economic Outlook: The Inflation Standoff, published on 9 May 2023. Read more from the latest Nordea Economic Outlook.