The global economic growth outlook has brightened in January and February making reducing inflation a more challenging task for central banks. In the US the tight labour market and growth in real household income are priming spending and renewed optimism about the US economic outlook. The pronounced slowing in annual inflation evident in late 2021, however, is showing signs of faltering causing reassessment of how high interest rates may need to be pushed up by the Federal Reserve. The same trade-off between stronger-than-expected growth and less progress reducing high inflation placing pressure on central banks to lift interest rates more is also in play in Europe, parts of Asia and also Australia, notwithstanding recent Australian data pointing to less tight labour market conditions than expected.

While near-term economic growth prospects are better than expected previously the risk of recession later this year or in 2024 has increased. Reducing but still high inflation lingering for longer increases the risk that central banks will raise interest rates too high and hold them at their peak too long. In Australia, even though the RBA’s cash rate at 3.35% is comparatively low set against the US Federal Reserve’s 4.75% fund rate it is more demand-restricting than the US interest rate setting because of Australia’s still predominantly variable-interest-rate loan environment, high level of household debt and deeply negative real income growth. If the RBA continues to hike the cash rate, as seems likely from its guidance and concern about high inflation, we see a high risk that Australia will experience recession later this year.

Returning to the US, most economic reports released in February show some improvement. At the leading edge, the January ISM manufacturing purchasing managers’ index is an exception to the improvement slipping to 47.4 from 48.4 in December and reflecting that the post-covid-restriction demand-surge for goods is fading. Demand for services in the US is strong, however, and reflected in the lift in the ISM non-manufacturing PMI in January to 55.2 from 49.6 in December. Housing activity is looking stronger at the leading edge with pending home sales up 2.5% m-o-m in December, January new home sales up 7.2% m-o-m, and the February National Association of Homebuilders’ index lifting to 42 from 35 in January.

Household spending in the US appears to be regaining strength. Retail sales rose by 3.0% m-o-m in January with core retail sales up 2.3%. January personal spending lifted 1.3% m-o-m. These large increases in spending are being assisted by strong labour market conditions. January non-farm payrolls jumped up by 517,000 and the unemployment rate fell to a new cycle low of 3.4%, the lowest unemployment rate since 1969. Average hourly earnings in January were up by 0.3% m-o-m, 4.4% y-o-y.

The resilient US economy is threatening less reduction in inflation than expected previously. In January, annual CPI inflation decreased only marginally to 6.4% y-o-y from 6.5% in December and with core inflation (excluding food and energy prices) down to 5.6% y-o-y from 5.7% in December. There were also signs of acceleration in the prices of services threatening a slower and longer battle ahead getting inflation down. The Federal Reserve’s preferred inflation measure, the core personal consumption expenditure deflator, also showed less deceleration than hoped for in January at 4.3% y-o-y, down from 4.4% in December. All of the inflation measures are still well above the Fed’s 2% inflation target and are driving the Fed towards further rate hikes and to possibly a funds rate peak above current market expectation around 5.3%.

In China, Lunar New Year celebrations mean that little economic data have been released in February. At the beginning of the month, January purchasing manager reports show a noticeable improvement in the wake of China’s various policy about-turns away from restriction and towards promoting economic growth. The official January manufacturing PMI lifted to 50.1 from 47.0 in December and the non-manufacturing (services) PMI jumped to 54.4 from 41.6. The Caixin PMI’s show less pronounced improvement – the manufacturing PMI lifting to 49.2 from 49.0 in December and the Non-manufacturing PMI lifting to 52.9 from 48.0 – but what is still clear is the post-restriction unleashing of pent-up demand for services. China still faces significant challenges reviving an over-supplied, over-indebted residential property market and repairing international trading relationships harmed during earlier industry sector crackdowns, but unlike other major economies where monetary policy tightening threaten weaker growth ahead, China’s growth rate will lift materially this year on policy reversal.

Perhaps the most pronounced improvement in the near-term economic growth outlook relative to earlier expectations has occurred in Europe. Warm winter weather and bigger than expected energy savings by European businesses blunted feared energy price hikes removing one big constraint on European growth. The EU economy grew 0.1% q-o-q in Q4, 1.9% y-o-y in Q4 2022 and now seems likely to register positive GDP growth again in Q1 2023. The January manufacturing PMI rose to 48.8 from 47.8 in December, while the non-manufacturing (services) sector PMI rose to 50.7 from 49.8 in December. Labour market conditions remain very tight with the unemployment rate holding down near a quarter-century low at 6.6%. Labour disputes pushing for higher wages are widespread and annual CPI inflation, although falling is very high at 8.6% y-o-y in January. The European Central Bank is promising to get inflation down and again hiked by 50bps at its early-February policy meeting taking the deposit rate to 2.50%. It is promising more rate hikes ahead, a reason to believe that the recession threat in Europe has been delayed, but not removed.

In Australia, economic growth has been strong and high annual inflation has not peaked yet in the data. Both strong growth and high inflation predispose the RBA to hiking the cash rate further and reflected in statements in February that it expects more rate hikes over coming months. This week, Q4 GDP data will be released and is expected to show quarter-on-quarter growth of 0.9% compared with 0.6% in Q3 which will leave Q4 annual real GDP around 2.8% y-o-y, strong by international comparison. There are signs in early Q1 2023 economic readings, however, that point to some near-term softening in economic growth.

There is a hint of softness showing in the labour market with employment falling in both December, -19,900, and January, -11,500. The unemployment rate has risen from a low-point of 3.4% late last year to 3.7% in January. Special factors may be in play in the first post-pandemic-restriction summer holiday season that explain away some of the softness as potentially temporary, but other factors are consistent with a less tight labour market than expected. Wage growth, for example, was not as strong as expected in Q4, with the wage price index up 0.8% q-o-q, 3.3% y-o-y (RBA and market forecast 1.0% q-o-q, 3.5% y-o-y). Annual wage growth in Q4 was well below annual CPI inflation at 7.8% y-o-y. Record negative real wage growth at -4.5% y-o-y adds to the demand restraining impact of rising interest rates.

Retail sales showed an unusually big 3.9% fall in December again possibly reflecting unusual changes in seasonal spending this pre-Christmas period. January retail sales are out this week and will probably show some rebound – analysts expect 1.2% m-o-m lift. But January lift of the size expected, or even a little bigger, will leave retail sales running well below October and November levels.

The RBA at its policy meeting next week will have to hand data reports that show possible softer turn in economic growth in Q1 and in key labour market conditions. Inflation is still too high and that alone implies the need for a further rate hike. But each rate hike is now twisting the screws on weak housing, softening retail spending, and possibly a softening labour market too. When the RBA presents the next quarterly Monetary Policy Statement in May it may need to lower its forecasts of growth, wages and inflation in 2023 and raise its forecast of the unemployment rate. It seems unlikely that the RBA will hike each month ahead of those forecast changes, because if it does it will be courting recession later this year.