Has the time come to slow the monetary tightening or even reverse it? That the answer to these questions is “yes” is becoming an increasingly common view. Markets are certainly behaving as if the days of tightening were numbered. They might even be right. But, crucially, they will only be right on the future of monetary policy if economies turn out to be weak. The stronger economies are, the greater the worry of central banks that inflation will not return to a stable 2 per cent and so the longer policy is likely to stay tight. In essence, then, one can hope that economies will be strong, policy will ease and inflation will vanish, all at the same time. But this best of all possible worlds is far from the most likely one.
The World Economic Outlook Update from the IMF does confirm a somewhat more optimistic view of the economic future. Notably, global economic growth is forecast at 3.2 per cent between the fourth quarters of 2022 and 2023, up from 1.9 per cent between the corresponding quarters in 2021 and 2022. This would be below the 2000-19 average of 3.8 per cent. Yet, given the huge shocks and surges in inflation, this would be a good outcome.
True, growth is forecast at only 1.1 per cent in the high-income countries over the same period, with 1 per cent in the US and just 0.5 per cent in the eurozone. But the UK’s economy is the only one in the G7 forecast to shrink over this period, by 0.5 per cent. The UK forecast for 2023 has also been downgraded by 0.9 percentage points. Consider this one of those “Brexit dividends”. Brexit is the gift that keeps on giving.
The striking feature of the forecasts, however, is the strength of emerging and developing countries. Their economies are forecast to grow by 5 per cent between the fourth quarters of 2022 and 2023 (up from 2.5 per cent in the preceding period), with emerging and developing Asia growing by 6.2 per cent (up from 3.4 per cent), China growing by 5.9 per cent (up from 2.9 per cent) and India growing by 7 per cent (up from 4.3 per cent). China and India are even forecast to generate half of global economic growth this year. If the IMF proves right, Asia is back, big time.
The reopening of China and falling energy prices in Europe are considered the most important reasons for the improving prospects. Global inflation is also forecast to fall from 8.8 per cent in 2022 to 6.6 per cent in 2023 and 4.3 per cent in 2024. The IMF’s chief economist, Pierre-Olivier Gourinchas, even said that 2023 “could well represent a turning point”, with conditions improving in subsequent years. Above all, there is no sign at all of a global recession.
The risks remain weighted to the downside, says the IMF. But the adverse risks have moderated since October 2022. On the upside, there might be stronger demand or lower inflation than expected. On the downside, there are risks of worse health outcomes in China, a sharp aggravation of the war in Ukraine or financial turmoil. To this might be added other hotspots, not just Taiwan, but the risk of an assault on Iran’s nuclear weapons programme that would trigger bombing of Gulf oilfields.
Some might argue that the downside risks to growth in high-income countries are being underestimated: consumers might retrench, as the funds they received during Covid run dry. The opposite risk, however, is that the strength of economies will prevent inflation from falling to the target fast enough. Headline inflation might have passed its peak. But, the IMF notes, “underlying (core) inflation has not yet peaked in most economies and remains well above pre-pandemic levels”.
Central banks confront a dilemma: have they already done enough to deliver their target and anchor inflation expectations? If the Federal Reserve looked at the optimism in markets, it might conclude it has not. But, if it looked at fund forecasts for US growth, it might conclude the opposite. These may not be disastrous, but they are weak. The same applies to the European Central Bank and, even more so, to the Bank of England when they look at their own economies. These central banks might quite reasonably wait, in order to see how weak their economies become, before their next moves. Indeed, Harvard’s hitherto hawkish Larry Summers recommends just such a pause.
That the world economy looks a bit stronger than expected not so long ago is surely a good thing. Yet, for central banks (and investors), this also creates difficulties. The strategic goal of the former must after all remain that of returning the annual inflation rate to 2 per cent and, in the process, firmly anchoring expectations at that level.
The dilemma for central banks then is whether today’s greater optimism is consistent with achieving that strategic goal, while that for investors is whether the markets’ implicit view of how central banks will view this question is correct. The analytical difficulty is trying to work out, in a world in which there is an interactive “game” between central banks and economic actors, whether the former have done just enough to deliver the economy needed to put core inflation on target, too much or too little.
Given the uncertainty, there is now a good case for adopting a wait and see position. But a crucial point is that in an inflationary world, good news on economic activity today is not necessarily good news for policy and so activity later on, unless it reveals that the short-term trade-off between output and inflation is also favourable. If it is, central banks can relax policies earlier than previously expected. If it is not, they will have to tighten more than now hoped. At the moment, one can hope for the former outcome. But it is still far from certain.
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