What Now for the Global Economy?
In our latest conversation on current economic developments, Paul Mortimer-Lee talks to Dr Corrado Macchiarelli, Research Manager for Global Macroeconomics, about the issues on his mind as we prepare for our upcoming Global Economic Outlook, due early next month.
What’s the state of the global economy as we go into 2022 and is there anything that surprises you?
Omicron continues to maintain high levels of uncertainty but, so far, it appears that the trend from the previous quarter is unchanged. The high transmissibility of Omicron is creating a global surge of infections, that is higher than past waves. Nevertheless, due to the advancement of the vaccination campaign, particularly in the West, the impact it is having on real activity when compared to other variants is more limited. However, most of the economic impacts of the winter waves are predicted to be felt in late December and early January. This implies the first quarter of 2022 is the most vulnerable to weakness, and therefore I expect the global economy will see a further deceleration in activity this quarter.
Another important question concerning the virus’ variants will be its impact on supply chains. These effects were high for much of last year but have now begun to ease. Demand and supply disruptions might place further strain on global supply chain networks. With demand still strong this will result in inflation, with consequences – particularly in the US – for monetary policy normalisation.
Inflation is the highest for over a generation, are we going back to the 1970s and 1980s? What are the parallels and what the differences between then and now?
Inflation is on the rise and the 1970s-80s spectrum looms large. However, unlike then, today’s policymakers have learned from the mistakes of the past and inflation is more clearly targeted. Policy makers appear more inclined to examine different policy options, namely, avoiding keeping interest rates at historically low levels. Since the pandemic, soaring inflation has been fuelled by a mix of increased consumer demand, supply chain disruptions, and high energy prices. However, in the 1970s there was an explosive confluence of events, including a collapse of the Bretton Woods system, which co-ordinated international monetary policy. The policy framework is more stable now so that, despite the similarities, things are structurally different today. Back then, prices rose for a variety of reasons, not least President Johnson’s Vietnam war spending. The Fed did not really attempt to get on top of inflation until 1979, when Paul Volcker took over as Chairman of the Federal Reserve and began a campaign of interest rate hikes to bring inflation under control.
In addition, the world saw two major oil price shocks in 1973 and 1979. The end of the Gold Standard and the implementation and removal of Nixon’s wage and price restrictions, between 1971 and 1974, represented another supply-side factor contributing to a wage-inflation spiral.
Today, importantly, the Fed does not appear prepared to let inflation run free. The central bank is signalling three rate hikes in 2022 and has accelerated the tapering of its emergency assets purchasing program. Furthermore, there is an additional caveat to the conventional 1970s story. The equilibrium unemployment, what the Dallas Fed now refers to as the Noncyclical Rate of Unemployment (formerly NAIRU), is far lower than in the 1970s. Despite the issue of labour scarcity and higher levels of absenteeism, particularly in the face-to-face sectors, a low equilibrium unemployment rate could imply the US economy may continue to grow without causing a long-term inflation problem.
How differently are the major central banks responding to the inflation surge? Why do they differ and what are the possible implications of divergent central bank behaviour?
Inflation overshooting targets is likely to prompt many central banks around the globe to dial back monetary policy accommodation, but cautiously, especially where fiscal policy starts to take back some of the earlier extraordinary stimulus. For instance, in the US, the present inflation rate is expected to return to central bank targets by the end of 2022 or shortly afterwards. How central banks will respond to inflation will have an impact on bond prices with a combination of ending quantitative easing and higher policy rates.
Many G10 central banks have considered discontinuing central bank balance sheet asset purchase policies and/or tightening policy rates, whereas other central banks have already done so. The Bank of Norway was the first major Western European central bank to start tightening, while South Korea’s central bank increased interest rates in August and signalled that more tightening was on the way. On 27 October, the Bank of Canada ended its bond purchases with immediate effect and flagged an earlier than previously expected rise in interest rates. On 16 December, the Bank of England tightened interest rates for the first time in three years.
Several economies in emerging markets such as Turkey, Russia, Ukraine, Brazil, and Mexico have also moved to tighten policy. This has included interest rate increases to suppress inflation, avert a capital outflow, and stabilise currencies. In fact, higher long term interest rates and tighter monetary conditions in advanced economies pose a particular risk to emerging market economies with high external debt and expected low growth, leaving them exposed to financial market stress should investors’ risk appetite reverse.
What are the major risks facing the global economy?
In the short term, the primary risk to the economic outlook remains from the spread of Covid-19, which could lead to containment measures that would reduce economic activity. While the vaccines offer a route to the return of the full range of economic activity, the number of reported new cases of the virus globally has risen again recently, and vaccine efficacy varies greatly across regions suggesting additional lockdowns might be necessary (e.g., in China).
Second, concerns about higher inflation in the medium-term could dampen demand and lead to rising market yields and consequently to an earlier than anticipated tightening of monetary policy. The end of the US ultra-accommodative monetary policy stimulus might lead some emerging currencies to experience a depreciation against a stronger US dollar, potentially causing some economies to raise their interest rates to limit any adverse effects from foreign exchange market movements such as sharp depreciations vis-à-vis the US dollar. We will discuss this issue in more depth in our next Global Economic Outlook, which will be published on 8 February.
Third, reduced labour market participation in advanced economies also remains a major concern, as the pandemic has widened the gender gap in labour force participation, increased socio-economic inequalities and the likelihood of long-term unemployment.
Fourth, if higher inflation persists and leads to increases in interest rates, pressure on fiscal positions would intensify, particularly for economies facing risks from currency depreciation and limited fiscal space. Higher interest rates at a time of substantial increases in government indebtedness would add to dilemmas over the sustainability of such debt, creating vulnerabilities for countries that are already subject to high-risk premia on interest rates.