Monetary and fiscal policy forecasts in 2023
Facing inflation levels not seen in the United States or in the eurozone in decades, the central banks initially reacted with caution and a little late, under the assumption that the increase in inflation in 2021 would be temporary. In 2022, the Fed and the ECB (and previously other central banks in emerging countries) have staged the most aggressive cycle of interest rate hikes in decades. This response sought to smother the most adverse scenarios, such as an inflationary spiral similar to that of the 1970s. One risk has been avoided. At the same time, rate increases have contributed to the necessary tightening of financial conditions, without causing undue commotion in the markets.
The cycle of interest rate hikes is not over yet. Our forecasts indicate there's still some way to go in the first half of 2023. And let's not forget that, while these increases are taking place, the Federal Reserve and the ECB will also be reducing their balance sheets, transitioning from the quantitative easing of recent years to the new quantitative tightening, which will drain the existing excess liquidity.
With a view to 2023, there are three important questions regarding the expectations for monetary policy. Firstly, with regard to rate increases, they will start to scale back both in the United States and in Europe, as has already started happening in late 2022. Secondly, as for the level-off point, we expect rates to increase to 5% in the case of the Fed and 2.75% in the case of the ECB, although further upward movements can't be ruled out. These levels are clearly above the interest rates that would be present under neutral monetary conditions, so the monetary policy will clearly be restrictive for some time in order to reduce inflation. This leads us to the third question, about when the cycle of interest rate reductions toward neutral conditions will begin. Despite the strong slowdown in growth expected for 2023, inflation forecasts suggest that the ECB will not lower its interest rates until 2024, although the Federal Reserve could start a little earlier.
Meanwhile, fiscal policy had a strong expansive tone throughout the pandemic, during the subsequent recovery and also in 2022, especially in Europe as a response to the energy crisis. The combination of expansive measures adopted in response to the COVID-19 crisis (especially in the US) and measures to mitigate the impact of the energy crisis (especially in Europe) have led to a sharp increase in public debt, which has resulted in some clear vulnerability given the interest rate hikes.
Against a backdrop in which inflation is the main risk factor to the global economy and with monetary policy imposing aggressive interest rate hikes, it is essential that economic policies be well coordinated and that fiscal policies not undo what central banks are trying to accomplish. The tax measures of European countries should be temporary, selective and targeted at the most disadvantaged groups. In general, for 2023 we expect fiscal policies to become restrictive and for markets to start focusing on the necessary fiscal consolidation. To avoid any glimmer of volatility in bond markets, it is important that the European Union return to tax rules that involve credible multiannual and stable budgets hammered out in consensus with the European Commission and that facilitate the implicit backing of the ECB.
