At the start of 2023 the Bloomberg consensus for US GDP growth this year was 0.3%; it is now 2.1%.

At the start of 2023 the Bloomberg consensus for US GDP growth this year was 0.3%; it is now 2.1%, and this is in spite of the fact that the Fed has taken rates up to levels more than 100-bps above those the market expected at the start of the year. And it is not just the US. Economists saw UK GDP falling 1% this year at the start 2023 but now see 0.4%, while the same comparison for euro zone forecasts yields -0.1% and 0.5% respectively.

The customary explanation for this outperformance seems to be the post-pandemic tightness of G10 labour markets. It’s an easy excuse to make, particularly in light of the fact that all developed countries are experiencing the same issue. But the “ease” of the explanation does not necessarily mean it is correct.

It is a bit like the story we’ve talked about before about the person who is walking down a darkened street and comes across a man who is standing underneath a streetlamp looking down on the ground. When he asks if he has lost something the man explains that he has lost his keys. If the labour market is the equivalent of the streetlamp, what’s in the dark alley?

The Standard Bank suspects that it is huge expansion of central bank balance sheets bought about by quantitative easing (QE), which is also common to G10 countries. Former Fed Chair Bernanke famously quipped that QE worked in practice but not in theory. It’s the sort of comment that suggests central banks did not really know what they were doing, but were desperate because policy rates were stuck around the zero lower bound. It could be said that QE worked a treat but now there could be substantial legacy costs, such as the fact that economies may be far less sensitive to policy rate hikes than in the past and less sensitive, therefore, than policymakers anticipate.

Now many might say that this is not the case because central banks are no longer expending their balance sheets; quantitative easing has given way to quantitative tightening. But as we have always argued, QE is a stock concept, not a flow concept.

For instance, if the Fed had grown its balance sheet at its pre-financial crisis pace (before 2008), which was broadly in line with the public’s rising demand for cash, it would probably be close to USD2tr right now. But the Fed’s balance sheet is actually around four times this level at close to USD8tr and we can say similar things about other central banks. Balance sheets of this size help explain why yield curves have been so inverted – but with no recessions thus far.

“We think the large balance sheets have also lifted riskier asset prices over time and so produced a huge cushion for consumers and firms; something we saw when the global economy astounded everyone by bouncing back so quickly after the pandemic. Of course, none of this is to deny that the tightness of labour markets has been a factor as well, it is just that we feel this does not tell the whole story. If, for one second, we accept that quantitative easing is the key reason why economies are proving quite impervious to the sharp rise in policy rates, what does it mean for the future?”, said the Standard Bank.

For one thing, it suggests that an easing of the labour market won’t necessarily reduce growth and inflation in the way central bankers might be hoping. It might also suggest that rather than have quantitative tightening working passively in the background, it needs to be bought to the forefront so that more of the tightening process is accounted for by QT than rate hikes.

Of course, these balance sheet issues should be seen as a stock concept not a flow concept and that implies it could take some considerable time to bring back some sort of balance, but that does not mean that policymakers should stay in the light and avoid the “dark alley” of more aggressive balance sheet contraction.