Oxford Economics Chief Global Economist Innes McFee joins the Live Show to discuss the risks to financial stability amid an expected prolonged advanced economic downturn and the impacts it may have on the economy.
- Well, as investors continue to focus on 2023's edition of political punt and the ongoing debt ceiling dilemma, our next guest says, risks to financial stability may be far from over. And that a prolonged advanced economic downturn may be on the horizon. Innes McFee, Oxford Economics Chief Global Economist joins us now.
Innes, as we're continuing to try and grapple with the fact that there is so much theater that continues to take place in Washington, and the markets are trying to look through the theater to the best of that ability, more internationally, there's still part of this equation that has to be taken into consideration as well. So walk us through that perspective.
INNES MCFEE: Well, I think the key point I would make is that on top of what was going on in the debt ceiling, we're really seeing a slow motion problem unfolding in the banking sector. So we've already seen earlier on in March the collapse of SVB and several other banks.
But that really hasn't gone away yet. We're still seeing continued borrowing by US regional banks at the Federal Reserve. We're still seeing problems on the liability side of the banking sector, if you like. And that also be combined with ongoing falls in asset prices, particularly commercial real estate, but also home prices as well. And there is a fear, as we've set out in our recent notes, that this risks choking off the credit supply to the economy, and, therefore, reducing economic growth, not necessarily immediately, but playing out over a number of years.
And one of the historical parallels that we draw here is with the savings and loans crisis, of course in the 1980s, which saw these ongoing rolling bank failures. And that really impact on growth over a long period of time. And we think that's certainly a risk at the moment.
- It's interesting to hear you say that it will take place over a period of years. Because even if the Fed is not going to cut interest rates this year, one could conceive of a scenario where if you see this slowing, then they could cut next year or even the year after. And we know that that operates on a lag. But nonetheless, explain out to me how it could be a prolonged credit tightening cycle as a result of this.
INNES MCFEE: Yeah. Well, as you rightly say, monetary policy takes a long time to act. We've not yet seen the peak impact of all the rate rises from the end of last year, let alone, ones from this year yet. So that's still working its way through the system. even before, in fact, SVB collapsed, we saw credit conditions tighten very significantly. And certainly, the recent bank sector turmoil has helped to exacerbate that a little bit.
But even from that tightening in credit conditions, we think it takes around three, maybe even four quarters for the real impact to happen on the economy. That's because it takes a while for debt to come up to be refinanced. We know that a lot of household debt is very long term in nature, but also in the corporate sector as well now. So it takes a while for that to come up to be refinanced. And it takes a while for businesses to adjust to the new environment. So that can mean, initially cutting back on spending.
But then further down the line, starting to cut back on hiring plans as well. We know there's a shortage of labor. We know that firms have found it very difficult to get new workers. And they're going to be a bit reticent to get rid of them, we think. And so all of this adds up to a bit of a delay in the way in which tightening credit conditions works its way through to the impact on the overall economy.
- And so walk us further through some of the simulations that you've been running on that front.
INNES MCFEE: Yeah. So what we essentially did was say, OK, we know that there's a tightening coming. We think if we look back to historical examples, that'll be equivalent to around a third of the tightening that we saw in 2008, '09. And we know that usually, it takes quite a few quarters for this to have an impact. So we used our global economic model to simulate the impact on the economy, both in the US, but also internationally. And let that feed through into things like firms hiring decisions, consumer spending. And through imports and exports in the international economy.
And basically, what we found was the majority of the impacts come through in 2024. For the US and global economy knocking around more than 1.1% of US GDP in 2024. and a little bit less in 2025, and around half of that for the global economy. So pretty sizeable impacts. But certainly, not the kind of deep recession that we've seen in previous periods. Notably 2008, '09.
- What does that imply for what happens with inflation as well as we go throughout this year?
INNES MCFEE: Yeah. Well, as you said earlier on, we really don't expect the Fed to cut this year. We think that a lot of the inflation we have now is as a result of a price to wage spiral. So consumers, businesses have seen this big rise in prices. That's having an impact on how much certainly workers are demanding in terms of pay. Layer on top of that supply chain issues and some shortages of labor supply in certain segments of the market.
And that implies that now, rather than a goods price inflation story, the goods prices have come off a lot in recent months. We expect them to continue to do so. And maybe even be falling year-on-year by the second half of 2023. Now, it's much more of a service sector story. Services sector still growing very strongly. Wages are still growing very strongly. And that tends to be much stickier. And it takes a while to feed through.
So we expect core inflation, non-energy, non-food inflation to remain pretty elevated throughout next year. That's going to keep the Fed on a restrictive stance. We don't think there are any more rate rises to come in our baseline scenario. But we do think that it's going to take them a while to start cutting rates. And certainly, we've got the first cuts for the Federal Reserve not happening until 2024, which is quite different to the market, actually. We've got higher rates for longer, basically, because we think that on the way down, inflation will be relatively persistent.
It will come down. But that cooling in demand is going to take a while to have an impact on inflation.
- So even though you heard Bullard yesterday say that there's potentially two more. And we should caveat it with Bullard's been bullish since or at least hawkish since the second grade probably. All of that considered, even if he's still saying there's probably two more that still need to happen, you're still saying there's no more really coming this year.
INNES MCFEE: Yeah,. That's right. And I think there's an element here of trying to keep financial conditions tight. So yes, policy rates, the Fed funds, it matters. But it also matters an awful lot the shape of the yield curve, how that feeds through into credit spreads. And what the Fed really does want that to happen is for markets to get ahead of themselves. So I think there's an element of trying to manage financial conditions to remain tight, whilst we're in this pausing phase.
I think what will really matter is what you hear from Chair Powell and some of the other directors. And I think they'll take a slightly more data-dependent stance, a slightly more wait and see stance. And as I say, we don't expect them to raise rates. But we also don't expect them to start to admit, no, that's it. We're done for the rate rises and wait for the cuts to come because that would be counterproductive.
- Innes McFee, thank you so much for taking the time here with us today, Oxford Economics Chief Global Economist. We appreciate the perspective and insights.
INNES MCFEE: OK.