EcoTV Week

The outlook for growth: it’s (almost) all about confidence


Elevated inflation has forced central banks across the globe to tighten monetary policy aggressively. When we look at the United States and at the Eurozone, we observe nevertheless that many hard data show a high degree of resilience.


Elevated inflation has forced central banks across the globe to tighten monetary policy aggressively. When we look at the United States and at the Eurozone, we observe nevertheless that many hard data show a high degree of resilience. In the United States we can look at growth, the growth performance which keeps on impressing, and also the labour market. In the Euro area in particular, the labour market has also been very resilient to witness the low degree of unemployment and the high participation rate.

On the other hand, business sentiment has been on a declining trend. When we look at the Euro area, judging by the S&P Global PMI Index, we are now for the composite index which combines data for manufacturing and services, we are well into contraction territory. Looking at the US, for the same measure, what we observe there is that we are at the edge between expansion and contraction. Given the extent of cumulative tightening in this cycle and the weakening of sentiment and the concern that this could actually worsen going forward, the tone adopted by certain central banks has become more cautious. The European Central Bank for instance has signalled that we may already be at the peak of the cycle in terms of policy rates. The Bank of England has refrained from hiking rates further. In the US there was a pause in rate hikes, although the signal there is that there will be more rate hikes before the end of the year.

In any case, what this all shows is that central banks are concerned about doing too much, about tightening too much. But on the other hand, they cannot stop their tight policy either, because disinflation is going to be a slow process and at present inflation remains well above target.

The combination of weaker sentiment, slow disinflation and tight monetary policy creates some discomfort. It raises the question whether resilience can last or whether at some point confidence would drop significantly. What could cause confidence to drop suddenly? I see two possible catalysts.

One is that there would be a feeling that we are gradually reaching a tipping point. That is that the impact of the past rate hikes makes itself felt increasingly. The second reason would be that there is a layering of shocks. We have elevated interest rates, energy prices are increasing again and then there are other headwinds as well that have appeared. For instance, the very soft growth environment in China, which is a relevant topic for certain countries, think of Germany, for instance. The second catalyst is, I would say, more psychological, but it is, however, very important. It would mean that economic agents come to realize that assumptions that have held thus far, assumptions about the future, turn out to be too optimistic. It would mean, for instance, that households come to realize that their expectations about the labor market outlook, about the employment outlook, are too optimistic and that the risk of losing a job is on the rise. In such case, households would become more cautious, and they would refrain from spending as much as they have done thus far. Companies could come to the conclusion that their assumptions about the top-line growth or the assumptions about their profitability have been too optimistic.

It would force them to cut back on spending, to cut back on marketing budgets, to stop investing, to stop recruiting people or even to let people go. So again, cutting back. And then finally, financial market investors could come to the conclusion that probably their earnings forecasts are too optimistic when you confront them with the latest economic information. And in that case, it could cause a flight to safety. What this all means when you're looking at these psychological factors is that this could trigger the reaction in terms of spending, what happens in the real economy, could trigger an acceleration of negative momentum.

To conclude, when assessing the future possible evolution of household spending and of corporate spending, two things really matter. On the one hand, you have the ability to spend and on the other hand, the willingness to spend. With respect to the ability to spend, what matters is how this household income will evolve, what will be the evolution of corporate profits, what is their access to financing, what is the cost of that financing, what is the level of interest rates. All these things are very important. But what also matters is the willingness to spend. The willingness to spend by households and companies is a function of what they expect about what the future may bring, how is the economy going to evolve. But also, and importantly, it depends on how confident they are that the assumptions that they use for the future will be the right ones, will be the appropriate ones. And that last point means that if it would turn out that there is a big gap between the assumptions and what is happening in reality, it would cause a far more cautious stance with respect to household spending and with respect to corporate spending. That would then be a factor that is driving down economic activity.