Summary
New shocks are threatening to cut the global post-pandemic recovery short. This time last year, successful vaccination programmes, as well as a shift in strategy away from containing to living with the pandemic, had reduced the threat of health restrictions. Economies were expected to re-open, households were expected to deploy savings accumulated during the pandemic and, although it would take some time to restore global supply chains, strong growth was expected for all regions of the world.
Indeed, this picture broadly played out in the second half of 2021. Economies gradually reopened and the gaps between post-pandemic recoveries narrowed. By Summer 2022, Europe’s GDP recovery had nearly caught up with that of the US. However, especially in the US, the recovery may have been too fast for its own good.
US and Eurozone: real private consumption
Source: BEA, Eurostat and Citi Research
Turbocharged by the extremely generous post-election fiscal stimulus, the American economy began overheating to which, with hindsight, the Fed may have reacted too late. As a result of (belated) hikes in short-term policy rates, plus sharp increases in longer-term government and corporate borrowing costs, the US dollar strengthened against most other currencies and exported the US inflation problem to the rest of the world.
In these already challenging circumstances, a new and major speed bump appeared in the form of the conflict in Ukraine. Energy prices in general, and natural gas prices in Europe in particular, surged to extreme levels. This ‘tax’ on the economy is starting to take its toll on household real income and confidence. Europe looks set for a potentially deep recession. This will eventually probably reduce (and potentially eliminate) Europe’s inflation problem, leaving less for monetary policy to do. In the US, however, monetary tightening will likely have to go a lot further to restore the balance between supply and demand in the labour market and bring inflation under control. While potentially strengthening the dollar further, that will probably also imply a recession, albeit a milder and later one than in Europe.
Germany: pipeline gas inflow from Russia
Source: Bloomberg and Citi Research.
Key findings
1. This year’s global economic outlook is far less rosy than in 2021. We expect the global economy to grow by 2.9% this year and 2.5% next year, both well below the long-run average of 3%. Europe, in the short term, and the US, later in 2023, are likely heading for recession.
2. Post-pandemic supply–demand imbalances have proved more severe and persistent than expected. Indicators of supply chain disruption such as shipping prices have declined, but not normalised. Expansive government policies have driven up public debt ratios by up to 20% of GDP and boosted money supply by 20–40%. Even leaving aside volatile food and energy prices, where, in our view, idiosyncratic shifts in supply and demand dominate, the ranking of the rises in core prices in the US, the UK and the Eurozone between 2019Q4 and 2022Q2 by 4%, 3% and 2% annualised, respectively, mirrors the ranking of the fiscal and monetary expansions.
3. The war in Ukraine and the stand-off with Russia have aggravated the inflation crisis by eliminating 40% of the EU’s gas supply, triggering a severe energy crisis in most of Europe. The increase in gas prices alone is imposing a burden of up to 8% of GDP on European households and firms. European gas prices peaked at double Asian rates and 10 times the US’s. This price shock is likely to trigger a recession, but also lead to structural changes in the European economy, weighing on growth for many years.
4. The Ukraine conflict also raises questions about the West’s reliance on China. Reducing dependence on the 22% of EU goods imports coming from China, including even higher shares for technology and consumer goods imports, may be an even greater challenge than reducing dependence on Russian energy. And unlike Russia, China remains tempting as an export market, absorbing 10% of EU exports and growing at triple the rate of overall exports. Improved resilience of supply chains may come at the cost of a permanent reduction in expected economic potential.
5. The series of supply shocks has driven global inflation to 7% this year. Recession, as well as base effects in energy and the gradual unwinding of supply chain disruptions, will likely bring inflation below 6% in 2023 and to 3.5% in 2024. But even that is still above the 3% long-run average. Inflation in energy and goods prices is being replaced by inflation in the price of food and services. High inflation looks set to stay and should trigger further significant interest rate hikes from central banks.
6. Governments can arguably be more effective in fighting inflation than central banks. They can invest and deregulate to boost energy supply and unclog supply chains, but also reduce demand by fostering industrial adaptation. Many are acting to preserve supply by guaranteeing loans or nationalising critical energy infrastructure, but also by supporting demand with tax cuts and subsidies. In the EU, fiscal measures related to the crisis amount to 3–4% of GDP already and are expanding rapidly. While direct interventions in energy prices have lowered measured inflation rates by 3 percentage points, some measures cause inflation elsewhere or in the future.
7. However, fiscal policy has to tread a fine line, as it can also distort incentives to save energy and raise the risk of blackouts as well as lower long-term incentives for the economy to adjust to potentially permanently higher energy prices and less efficient supply chains. So far, finance ministers are enjoying a tax revenue bonanza due to high inflation, but as they expand their support, risks to debt sustainability will grow and limit fiscal space, forcing hard choices.
