Global Economics: Regime Shift

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BoAML | We look for another year of muddling through, with a slight pick-up in global growth and a normal risk of recession.Aggregate demand is starting to outstrip feeble aggregate supply: look for a modest pick-up in global core inflation. The main risk to global growth comes from US: a big fiscal push could cause the economy to overheat; a big change in trade policy could trigger a recession.

Growth: the intersection of supply and demand 2016 has been another year of modest downside disappointment

For 5 years in a row, we and the consensus came into the year expecting global growth to return to its 3.5%-plus trend, only to see it remain stuck at about 3%. Despite the growth disappointment, however, we correctly forecast a pick-up in global inflation, reflecting a combination of higher core inflation in the US and the stabilization of commodity prices. How is that possible? How can core inflation be stable or rising in an environment of weak growth? In our view, economists and investors need to pay more attention to the supply side of the economy.

When Larry Summers introduced the idea of secular stagnation in 2013 we had three reactions. First, his story of chronic weakness fit Europe and Japan much better than the US. Second, part of the stagnation was cyclical—the result of post-crisis healing and tightening fiscal policy—rather than secular or permanent. And third, the stagnation mainly emanated from the supply-side of the economy—weak demographics and productivity—not the demand side—unwillingness to spend.

Three years later and that third argument seems stronger than ever. In the US, despite weak GDP growth, the unemployment rate has dropped 2.3 pp, and inflation pressures are starting to build. Clearly that is inconsistent with a story of chronic inadequate demand. A similar story holds at the global level: despite repeated growth disappointments, core inflation remains steady.

Each year forecasters have found a new demand-side explanation for weak growth. They have only reluctantly to cut estimates of potential growth and the global output gap. However, given the stability of core inflation, perhaps they haven’t cut enough. Perhaps the 3% global growth numbers we have been getting every year is the new normal?

Inflation: core call

In light of the above, two of our key out-of-consensus calls are on core inflation. As we have argued since the start of the year, the Fed can, will and should allow inflation to overshoot its 2% target. It can because the economy has hit full employment; it will because averaging 2% inflation requires overshooting when the economy is hot, and it should because both the US and the world need a period of modestly above target inflation to help heal the wounds of recent years. The data confirm our call, with many measures of core prices and wages accelerating and Michelle Meyer and team forecasting core PCE inflation to nearly reach 2.0% by end of next year.

This idea of US inflation eventually overshooting has become more accepted over time; an even more out-of-consensus view is that we expect Japan to achieve sustained 1%- plus inflation. After years of disappointment, it is hard to find an optimist in Japan, but our new Japan chief, Izumi Devalier sees reasons for optimism. With a tight labor market and with monetary and fiscal policy working together for a change, Japan is ripe for better growth and a more sustained pick-up in inflation. Netting out the temporary impact of oil price swings, currency moves and consumption taxes, underlying inflation in Japan has already increased from a low of -1.5% in 2010 to slightly positive today. If Abe delivers a real fiscal package and if Trump does not deliver a major blow to trade, the recently strong Japanese data should push core inflation higher.

In other economies we expect a mixture of rising and falling inflation. Inflation is high in countries whose central banks have limited independence and changes in exchange rates have redistributed inflation around the world, but the net effect of all of this is steady, but generally below-target inflation globally.

Policy: finally fiscal

Our inflation call is closely tied to the fiscal forecast. We expect modest fiscal easing in developed market (DM) economies and mixed easing and tightening in emerging markets (EM). In the US, president-elect Trump has proposed massive fiscal stimulus, but he still has to deal with the fiscally conservative Congress. Moreover, with the US economy already at full employment, a big stimulus will eventually trigger a much faster Fed hiking cycle. Fiscal plans in Japan always include a lot of “old water” and could disappoint. Fiscal constraints in Europe have eased in the past couple years, but Gilles Moec and team expect ongoing, rather than increasing stimulus next year. Hence one of the regions that needs a major stimulus probably won’t get it.

Meanwhile the slow monetary policy divergence is likely to continue. We expect the Fed to continue slow hikes in the near term—raising rates this December and again late next year—but we see 3 hikes in 2018 fiscal stimulus kicks in. In Europe maintenance of very easy policy seems more likely than a further experiment with negative rates. We are particularly encouraged by recent BOJ policy. By moving to yield targeting they have insulated Japan from most of the global bond market sell-off of recent weeks. The ECB should be able to reverse some of the sell-off by extending QE at their December meeting. However, QE has become less effective in controlling the bond market in Europe because the commitment is much less clear than in Japan. We expect some easing of monetary policy in countries with high policy rates such as Brazil and Russia, but we expect monetary policy to be on hold in most of EM.

Rotating risks

Each year in this recovery has brought a new modest shock: the Euro area crisis, US budget brinkmanship, China hard landing worries, Japan’s consumption tax, and the collapse in oil prices have each taken turn on stage. In the year ahead, the US is back in the spotlight. We see two risks from a Trump presidency. First, with the economy at full employment, the US could get too much of a good thing: a big fiscal stimulus, an overheating economy, faster Fed tightening and a boom-bust outcome. Second, Trump could adopt aggressive populist measures around trade, immigration and the Fed, hurting confidence and growth. Michelle Meyer and team expect a modest dose of both fiscal stimulus and populist measures, but we will not know for sure until campaign rhetoric is translated into detail proposals.

Outside the US a number of risks remain. Chinese debt continues to grow as a share of GDP although it is by no means clear if and when there will be a day of reckoning. Populists pressures are building globally and could eventually threaten the stability of Europe in particular. The Middle East is an ongoing source of concern. For example, if the Iran nuclear deal is overturned what will replace it? Back to sanctions or some kind of military action? Emerging markets are vulnerable to both extremes on US policy: big a big fiscal stimulus could drive up US rates even further drawing capital out of EM; big trade restrictions would likely hurt countries that are heavily dependent on US markets.