26 June 2023

BIS Annual Report 2023: A tale of three journeys

...an exploration of not one but three interwoven journeys: the journey that has taken the global economy to the current juncture; the journey that may lie ahead; and, in the background, the journey that the financial system could make as digitalisation opens up new vistas.

Introduction

The global economy has reached a critical and perilous juncture. Policymakers are facing a unique constellation of challenges. Each of them, taken in isolation, is not new; but their combination on a global scale is. On the one hand, central banks have been tightening to bring inflation back under control: prices are rising far too fast. On the other hand, financial vulnerabilities are widespread: debt levels – private and public – are historically high; asset prices, especially those of real estate, are elevated; and risk-taking in financial markets was rife during the phase in which interest rates stayed historically low for unusually long. Indeed, financial stress has already emerged. Each of the two challenges, by itself, would be difficult to tackle; their combination is daunting.

This year's Annual Economic Report explores the global economy's journey and the policy challenges involved. It is, in fact, an exploration of not one but three interwoven journeys: the journey that has taken the global economy to the current juncture; the journey that may lie ahead; and, in the background, the journey that the financial system could make as digitalisation opens up new vistas. Much is at stake. Policymakers will need to work in concert, drawing the right lessons from the past to chart a new path for the future. Along the way, the perennial but elusive search for consistency between fiscal and monetary policy will again take centre stage. Prudential policy will continue to play an essential supporting role. And structural policies will be critical.

What follows considers, in turn, each of the three journeys.

The macroeconomic journey: looking back

How did the global economy fare in the year under review? Even more importantly, what forces shaped its journey?

The year under review

High inflation, surprising resilience in economic activity and the first signs of serious stress in the financial system – this is, in a nutshell, what the year under review had in store.

Inflation continued to hover well above central bank targets across much of the world. Fortunately, there were clear indications that headline inflation was peaking or had started to decline. But core inflation proved more stubborn. The reversal of commodity prices and a marked slowdown in manufacturing prices provided welcome relief even as stickier services prices gathered steam. Several forces were playing out, including easing global supply chain bottlenecks, the post-pandemic rotation of global demand back from manufacturing to services, and the effects of repeated generous fiscal support packages. Labour markets remained very tight, with unemployment rates generally at historical lows.

Global growth did slow, but proved remarkably resilient. The widely feared recession in Europe did not materialise, thanks partly to a mild winter, and China rebounded strongly once Covid restrictions were suddenly lifted. Consumption held up surprisingly well globally, as households continued to draw on savings accumulated during the pandemic and employment remained buoyant. As the year progressed, professional forecasters revised their growth projections upwards, although they still saw slower global growth in the year ahead.

Even as growth held up, signs of serious strains emerged in the financial system. Some milder ones appeared among non-bank financial intermediaries (NBFIs). In October, following the announcement of fiscal measures that undermined policy credibility, the UK government bond market saw a sharp increase in yields and a sudden evaporation of liquidity: leveraged investment vehicles through which pension funds were matching the duration of their liabilities were forced to sell to meet margin calls. Other signs of strain, perhaps more serious and surprising, appeared in the banking sector. A number of regional banks in the United States failed as a result of a combination of losses accumulated on long-maturity, mostly government, securities and lightning runs. And in an environment of fragile confidence, Credit Suisse – a global systemically important bank – went under, as it abruptly lost market access following long-standing concerns about its business model and risk management.

Once again, the strains prompted large-scale official intervention on both sides of the Atlantic to prevent contagion – worryingly, an increasingly familiar picture. Central banks activated or extended liquidity facilities or asset purchases. Where necessary, governments supplied solvency backing, implicitly or explicitly, in the form of guarantees and ultimate support for enlarged deposit insurance schemes. The response restored market calm.

In the meantime, the highly synchronous and forceful monetary policy tightening continued. Central banks across the globe hiked policy rates further. What's more, those that had engaged in large-scale asset purchases began to unwind them: albeit gradually, quantitative easing turned into quantitative tightening. At the same time, policy rates often remained below inflation rates, ie negative in real terms.

In response to the tightening and the economic outlook, financial conditions reacted unevenly. In general, banks tightened credit standards. But financial markets were less responsive. To be sure, on balance, conditions there did tighten compared with those prevailing at the time of the first hike. But in the second half of the year, they loosened somewhat, as bond yields declined and risky asset prices rose. Central banks contended with a disconnect between their communication, which pointed to a more persistent tightening, and financial market participants' views, which saw an easier stance ahead....

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