2022 has been a wild year for financial markets as surging inflation prompted central banks across the globe to deliver unprecedented rate hikes. With the exception of just a handful of central banks, policymakers turned super hawkish last year to prevent runaway inflation from taking hold. The Federal Reserve has led the way in the developed market space, delivering a number of outsized rate hikes last year to take its benchmark rate to a 4.25% and 4.50% target range. The BoE and ECB have also raised interest rates aggressively last year as the impact of Russia’s invasion of Ukraine on commodity prices compounded the inflation crisis in Europe.
Emerging market central banks have also jacked up interest rates last year as inflation breached central bank mandates. Adding to the external price shocks caused by elevated commodity prices, in particular food and energy prices, was the broad-based depreciation in emerging market FX last year as the USD steamed ahead. 17 out of the 23 emerging market currencies were trading in the red last year, with the losses led by the Argentina peso and Turkish lira.
While the USD remains elevated, the topside momentum in the USD has faded, with the greenback correcting lower in recent weeks. This has provided some much-needed reprieve for EM currencies, helping to alleviate some price pressure. Moreover, international commodity prices have corrected lower, pulling back from the peaks seen in the first half of the year after Russia’s invasion of Ukraine spurred a supply crisis. Food and energy prices, which have been the main drivers of inflation, have fallen as supply normalizes and the demand outlook worsens.
Most of the aggressive tightening has been done
While inflation across the world continues to run hot, signs are building that global inflation has peaked. The correction in commodity prices, tighter monetary policy conditions and slowing growth are some factors helping to lower inflation. The chart below shows that the World Economy Weighted Inflation Index appears to have topped out, falling from a peak of 10.34% y/y in October to 9.69% y/y in December 2022.
Inflation in the US, UK and EU also look like it has peaked and given the high base effects of 2022, the correction lower in energy and food prices is expected to persist and likely accelerate in the months ahead. With inflation slowing and central banks front-loading their rate-hiking cycles against the backdrop of slowing growth, it appears as though most of the tightening has been done.
Inflation pressures are moderating as energy and food prices fall
As mentioned above, given that much of the inflation recorded last year has been a function of soaring food and energy costs, it is encouraging that food and energy prices have fallen in the backend of last year. While global food prices, as reflected by the United Nation’s FAO Food and Agriculture World Food Price Index, remain buoyed well above pre-pandemic levels, it appears as if food prices have peaked. For context, the index has fallen by more than 15% from its peak in March amid an improvement in supply-side dynamics. Annual growth in food prices has plunged to 0.3%, which will provide some much-needed relief for policymakers.
Oil prices, which we proxy using the front-month Brent contract, have fallen from a high of almost $140 per barrel in March to $80/bbl at the time of writing, a drop of more than 40%. With the world now normalizing following the post-pandemic reopening, global economic growth is set to slow into 2023, and we could potentially see major economies, such as the United States, suffer a meaningful slowdown. With a global slowdown comes lower demand for fuel and other oil products, which could drive down prices even further than the current slide we have seen since the start of November. Our base case is for oil prices to head lower into 2023 but stay above $60 per barrel.
High base effects to come into effect from the end of Q1 2023
With commodity prices now well below the peaks seen earlier this year following the eruption of the war in Ukraine, we expect to see the high base effects of this year take effect from around March 2023. Note that Brent crude averaged around $100/bbl this year. Therefore, should Brent crude remain around $80/bbl in the first few months of 2023, we would see some considerable deflation in energy prices next year. Food price inflation has already fallen sharply and is expected to turn negative in 2023.
The high statistical base effects of this year and slowing growth should help drive inflation around the globe and bring inflation back to levels that will make policymakers comfortable. Breakeven rates, which we use as a proxy of market-implied inflation expectations, have fallen sharply as traders lower their inflation expectations. The US 1-year breakeven rate has fallen from a peak of 6.3% in March last year to sit at 1.9% at the time of writing. The chart below, which reflects consumer inflation expectations, bolsters the notion that inflation expectations in the US are falling.
Falling inflation expectations have led to a readjustment in interest rate bets
While we expect central banks to remain hawkish in the first months of 2023, there is abundant evidence that inflation will moderate next year. This has resulted in a significant repricing in interest rates bets, particularly in the US. The US Fed funds futures market is pricing in the end of the current rate hiking cycle mid-way through next year. The professional market sees US rates topping out at around 5% in 2023, implying another 50bps worth of rate hikes in the first half of this year. Whether this comes in the form of one 50bps hike or two separate 25bps hikes remains to be seen. Although the Fed is expected to remain relatively hawkish at the start of the year, the market is pricing in the risk of potential rate cuts in the second half of 2023.
The chart above shows that the professional market is pricing in around 25bps worth of rate cuts in 2023, followed by deeper rate cuts in 2024. The market pricing aligns with ETM’s base case view on US interest rates. While the macroeconomic outlook remains extremely cloudy and inflation risks are skewed to the upside, our analysis suggests that it is highly probable that we will see rate cuts in H2 2022.
China’s economic performance will be key to the monetary policy conundrum in 2023
In a world where higher interest rates, buoyant inflation, and rising tax burdens are knocking the wind out of global growth sails, China’s potential slowdown is another major headwind to navigate. The timing of their move away from zero-covid is unfortunate and will give central banks something additional to consider. It may well be the factor that makes central banks less restrictive in their stance. Weaker demand, alongside more logistical and production disruptions, would almost certainly translate into weaker growth projections.
Global central banks are already walking a tightrope. There are many indications that the world economy is already on the verge of a recession. The UK and the EU will not escape a recession, and the US will likely suffer a shallow one. Many other countries are equally faced with challenging growth prospects, especially those that have strong trade linkages with China. However, should China’s economy rebound sharply in 2023, it would almost certainly push up commodity prices and reignite the inflation bandwagon, something that would make policymakers more reluctant to loosen policy.
Monetary policy is expected to remain extremely tight in the first half of the year, given that near-term inflation risks remain to the upside. Although most of the policy tightening has been done, we expect the Fed to raise rates by between 50bps and 75bps in the first half of the year. That said, 2023 will more than likely mark a shift in monetary policy as global growth decelerates. Against this backdrop, we expect the Fed and other major central banks to conclude their rate-hiking cycles within the first half of the year. As the high base effects of 2022 take hold against the backdrop of lower commodity prices, we expect inflation to fall sharply, prompting central bankers to turn dovish and loosen policy in the second half of 2023. As was the case last year, emerging market central banks will move in lockstep with the Fed in 2023 in order to maintain their respective monetary policy differentials.