Nordea Group Chief Economist: Central banks face a delicate balancing act

2022 was a dramatic year. The pandemic, Russia’s invasion of Ukraine, the energy crisis, record-high inflation and significant monetary policy tightening resulted in huge swings in the financial markets and a sharp slowdown in economic activity.

These developments will also affect the early months of 2023, but we have nonetheless revised up our forecast for global economic growth this year compared to the September forecast, while our 2024 forecast is basically unchanged. The slightly improved growth prospects are partly attributable to the sharp decline in energy prices, giving new tailwind for the European economy. Moreover, China’s surprising decision to quickly reopen the country following the massive protests in December will really boost economic growth. But it could also fuel inflation further, as China is the world’s absolute largest consumer of many commodities.

The improved growth prospects for the euro area and China will of course also increase the growth potential in other countries. However, it should be underlined that the forecast is subject to much uncertainty. The geopolitical situation is very uncertain and there are also risks related to the pandemic and not least the effect of the most aggressive monetary policy tightening in recent history.

Monetary policy had to be reviewed in 2022 when central banks realised that the mounting inflationary pressure towards end-2021 was not transitory. Inflation generally rose in the Western world to levels not seen in the past 40 years, requiring a resolute response. And today, central banks are largely drawing on the lessons learnt in the struggle to curb inflation in the 1970s and 1980s. This was evident from US Fed chair Jerome Powell’s speech at the Jackson Hole summit in August 2022, when three lessons learned from the past were emphasised. Firstly, that central banks can and should take responsibility for delivering low and stable inflation. Secondly, that inflation expectations must not get out of control. Thirdly, that they must keep at it until the job is done.

Or in other words: Monetary policy will not be eased again until the inflation target has been met and inflation expectations are in line with the target. When that will happen is still uncertain. But it will most likely be in H2 2024 at the earliest, even though there are many signs that inflation has already peaked.

The sharp decline in energy prices and transportation costs since the autumn will feed fully through to inflation over the coming months. However, there is still a risk that relatively high wage increases as a result of strong labour markets and erosion of wage earners’ purchasing power over the past year will be passed on to consumer prices later in the year. If so, it could lead to a longer period with an inflation rate above central banks’ target.

Many years of an ultra-easy monetary policy has led to exorbitant price increases of, for instance, owner-occupied homes, which are in many places at historically high levels in relation to income and rental prices. On the other hand, rising interest rates are now putting pressure on property markets and the demand for loans, resulting in falling investment activity and personal spending.

Central banks worldwide are thus now performing a delicate balancing act, with monetary policy suddenly being turned upside down. If the tightening is not sufficient, the inflation crunch may drag out for even longer. If monetary policy is tightened too much, it may lead to a deep and protracted recession.

This is also the case for the Nordic countries. Particularly in Sweden, where the aggressive monetary policy tightening has already triggered a strong correction of property prices, with the economy hovering on the brink of a technical recession. This is also a latent risk in the other countries, although the starting point differs from country to country.

But before we expect the worst, it is worth bearing in mind that home prices skyrocketed to record-high levels during the pandemic. So initially, we are witnessing a correction from a basically unsustainable price level. But the risk of an even sharper drop in prices should not be underestimated. Experience shows that property market trends often turn into a self-reinforcing and lengthy process. This may turn out to be the case again, even though the supervisory authorities over the past few years have tightened the macroprudential regulation significantly to help prevent new housing and credit bubbles. 

This article originally appeared in the Nordea Economic Outlook: The Balancing Act, published on 25 January 2023.