Sept. 6, 2023
As uncertainty and inflation challenge central bankers and policymakers, they must also adapt to structural changes.
At the Jackson Hole economic symposium last week, central bankers were under no illusion about inflation. Its threat persists, they said, and its outlook is complicated by structural shifts in the global economy. Normally, the latter argument is simple to dismiss because officials always complain that their period in office is marked by unusual uncertainty. In 2023, however, they have a point. There are five important shifts happening in the global economy right now.
The first and most immediate is a necessary policy adjustment from reducing inflation to keeping it under control. The rate of price increases has slowed sharply in the US and is moderating in Europe, but Federal Reserve chair Jay Powell and Christine Lagarde, president of the European Central Bank, were clear that it is far too early for central bankers to take a victory lap.
Domestic demand in the US is surprising everyone by its strength, which is likely to keep inflation too high if it persists when unemployment is near historic lows. While the current estimates by the Atlanta Fed that the annualised rate of growth is on track to touch 6 per cent in the third quarter are almost certainly wrong, the US economy is running too hot and needs to cool. In Europe, business is gloomy but prices — especially in holiday destinations — and wages are still rising rapidly, raising the prospect of prolonged stagflation.
Both economies will need time to adapt towards low inflation and sustainable growth rates. This will require higher interest rates for longer until inflationary pressures are definitively behind us.
But judging exactly when the inflation risk is diminishing is all the more difficult now because the second important shift in the global economy is that supply conditions are far from stable.
Long gone are the days when policymakers could understand inflationary pressures simply by constructing the best available indications of demand and comparing these with a constant annual rate of sustainable growth. The pandemic and energy crisis of the past three years have made such analysis redundant.
Instead, economic analysis must encompass extreme supply shifts ranging from coronavirus lockdowns and fractures in global supply chains to energy supply conflicts following Russia’s invasion of Ukraine. Even in the labour market, the trends are very difficult to assess.
The US had an inflationary dip in prime age labour force participation in 2021, before an encouraging and rapid recovery more recently. France has also seen large improvements in the availability of labour, but these are far from universal, with a reluctance or inability to work still evident in the UK.
The Bank of England is confronting the most difficult trade off, having to deal with supply problems ranging from a persistent shortfall of business investment since the 2016 Brexit referendum, a sharp rise in long-term sickness among employees and an energy crisis. The bank cannot rectify these problems with monetary policy, but needs to ensure demand is curtailed sufficiently to squeeze inflation harder. That will take some courage.
If the BoE has the most pressing problems with constrained supply, the third shift relates to public finances and applies most forcefully on the other side of the Atlantic. Simply put, the Fed must deal with the unwillingness of US politics to show any restraint over its budget.
Ten months into the latest fiscal year, the Congressional Budget Office calculates that the federal budget deficit is more than twice that of the same period the previous year. Cash receipts are down 10 per cent, while nominal gross domestic product is about 7 per cent higher than the previous fiscal year. Compared with a decade ago, the US economy has moved from a relatively tight fiscal and loose money regime to one of loose fiscal policy and tight money. European nations face the same defence, demographic and climate challenges that make a similar shift likely to spread.
Taking a wider horizon, the fourth shift is a requirement to pay more attention to India’s economic prospects. For years, China’s fortunes alongside high-income countries have been dominant in the global economy because it produces more goods and services than any other country and its economy was growing at about 8 per cent a year.
Those days are coming to a close. Although China’s economy is more than twice the size of India’s, measured with purchasing power parity exchange rates, its underlying growth rate is slowing rapidly. You don’t have to predict that China is about to suffer a property meltdown to think that India will soon rival its neighbour, not only in population, but in its contribution to global growth. That could even happen in the second half of this year and is likely to be the norm by the 2030s.
New Delhi’s move towards the top of the league table of global growth contributions highlights the final global economic shift. India is an outlier with rapid expansion. Elsewhere, productivity growth has slowed, countries are erecting barriers to trade and promoting resilience over efficiency. In this world, normal global growth will slow.
Before the financial crisis, the global economy could expand about 4 per cent a year sustainably. That figure fell to about 3.5 per cent in the 2010s. Now it seems 3 per cent is the speed limit. With the planet’s health in mind, more sluggish improvements in living standards will reduce carbon emissions, but slower global growth will certainly not make it easier to resolve geopolitical tensions.
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