MFN - Is the world heading for a recession?

Has the dramatic tightening of monetary policy across world raised the risk of recession? That is the key question many investors are facing. In this Macro Flash Note, EFG Chief Economist Stefan Gerlach looks at the information contained in the OECD’s leading indicators and what it tells us about the prospects for the global economy over the next 12 months.

With inflation surging across the world – even above 10% in many countries – central banks have had little choice but to tighten monetary policy sharply. By raising interest rates by several hundred basis points in 12 months, the tightening so far has been dramatic, if not unprecedented, by the standards of modern economic history.

Higher interest rates are intended to slow demand growth to achieve a better balance between the supply and demand for goods and services. Since the peak effect of monetary tightening on demand is felt with a lag of perhaps three to six quarters, it is inherently difficult for central banks to calibrate how much to raise interest rates. Given the massive increases in interest rates, the risk that central banks have tightened too much, causing a deep recession, is obvious.

To assess that risk, it is useful to look at the behaviour of Leading Indicators (LI). The OECD computes leading indicators for a number of advanced and emerging economies (see below). These leading indicators average 100 and anticipate year-over-year GDP growth in 6-9 months’ time; values above 100 indicate expected expansion and values below 100 indicate expected contraction.

Source: OECD, data as of 6 April 2023.

The graphs show that in late 2021, economies were still expanding after the reopening after the Covid-19 pandemic. From early 2022, however, the rate of expansion slowed and by the summer of 2022 many leading indicators were well below 100, pointing to expected contraction.

In many advanced economies – with the notable exception of the US – the leading indicators have risen toward 100 in the second half of 2022. Among emerging economies, the situation is the reverse: with the exception of China, which benefits from the boost coming from its recent reopening after Covid-19, the leading indicators have fallen further below 100.

In drawing conclusions from these graphs, it should be recalled that in many cases the bulk of the monetary tightening took place in the second half of 2022. According to the OECD’s leading indicators, most countries are expected to experience a slowdown in economic growth as 2023 progresses and there is heightened risk of recession. However, the indicators suggest that any such slowdown will be much less pronounced than during the Global Financial Crisis. Furthermore, the recent uptick in the LIs of many advanced economies indicates that any macro-economic deterioration is expected to be short-lived.

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