TalkingEconomics: World economic recovery faces inflation headwind
In the monthly summary of our views on the global economy we highlight the growing threat inflation poses.
3 March 2017
- The world economy has started 2017 with strong momentum and we have nudged our global growth forecast higher as a result. However, we remain sceptical as to whether current strength will be sustained further out. Our 2018 forecast is unchanged as upgrades to the BRIC (Brazil, Russia, India and China) economies, Japan and the UK are offset by a downgrade to the US
- Our scenario analysis shows that the risks around the baseline are slightly more balanced, but are still skewed toward stagflation with rising protectionism the highest probability alternative. Stagflation is an economic condition in which economic growth slows but inflation rises.
- We have also revised up eurozone growth and inflation. We expect the European Central Bank (ECB) to begin tapering its quantitative easing (QE) programme over 2018. In the UK, we also forecast higher economic growth and anticipate that the authorities will trigger Article 50, starting the formal negotiation process for the UK to leave the EU
- We are broadly more positive on the outlook for emerging markets (EM) with the US likely to prove more supportive for global growth. Recovery continues in Brazil and Russia, and India seems to have suffered less than the market feared from demonetisation. Chinese policy, meanwhile, looks unlikely to deliver upsets
World economic recovery faces inflation headwind
Strong economic momentum from the end of last year is carrying over into 2017. We have therefore nudged our global growth forecast higher for 2017 to 2.9% (previously 2.8%). However, the drivers behind the recovery are set to fade as the inventory cycle turns and rising inflation erodes purchasing power and spending.
For 2018 the growth forecast is unchanged at 3% as modest improvements in the BRICs, Japan and the UK are offset by a downgrade to the US, where we have scaled back our expectations for fiscal expansion.
Inflation is rising and we have raised our 2017 global forecast to 2.7% (previously 2.4%) following 2% in 2016, driven by the rebound in commodity prices. However, higher oil prices are expected to stabilise in 2018 with the result that inflation moderates to 2.3% in 2018.
The exception to this is in the US where we see core inflation rising throughout the forecast period. Policy-wise, we expect the Fed funds rate to rise to 1.25% this year (two hikes) and to 2% by end-2018 (three hikes).
Elsewhere though, interest rates are expected to remain on hold reflecting the earlier stage of the economic cycle in Europe and Asia. Against this backdrop, we still expect the US dollar to appreciate but by less than in our previous forecast.
Having been through a long period where the risks were skewed toward deflation and stagflation we now have a much broader spread of outcomes reflecting the introduction of two productivity boosting scenarios (“old normal” where the trade-off between growth and inflation returns to pre-financial crisis levels and “OPEC deal breaks down” such that a lower oil price revives consumer spending and lowers inflation).
We have also removed the “secular stagnation” scenario because this risk has diminished in probability. Overall, the risks are now more evenly balanced although are still slightly skewed toward more stagflationary outcomes with “rising protectionism” (China responds to US tariffs by devaluing the renminbi) being the highest individual risk scenario.
European forecast update: cautiously more optimistic
We have revised the eurozone growth forecast up from 1.2% to 1.5% in 2017, given strong signals from private business surveys, and left the 2018 growth forecast unchanged at 1.8%.
We have also lifted the eurozone annual average inflation forecast from 1.3% to 1.6% for 2017, although most of this is related to the faster-than-expected rise in oil prices.
We have not changed the forecast for 2018 (0.9%). We expect the ECB to taper its monthly purchases again in January 2018 (to €40 billion per month) and in Q3 and Q4 of 2018 to land up at €10 billion per month by end-2018. This should pave the way for interest rates to rise in early 2019.
Note, we no longer assume the ECB will cut the deposit rate any further, but do not rule out further stimulus should one of our adverse scenarios materialise.
Political risk update
Dutch, French, German and Italian elections all pose a risk to the political status quo. The biggest worry for most investors is the French presidential election but our baseline forecast assumes that the National Front’s Marine Le Pen is defeated, thus avoiding potential market instability.
UK forecast: another upgrade, but downside risks are elevated
As regards UK growth, our forecast has been revised up for 2017 from 1.4% to 1.8%, although almost half of this revision has been caused by base effects. We have also raised the forecast for 2018: from 1.5% to 1.7%.
The upward revisions reflect our view that households are prepared to save less (borrow more) in order to smooth consumption in the face of higher inflation and a squeeze on real incomes.
The Bank of England appears in no rush to hike interest rates, citing downside risks to growth. Policy is therefore likely to remain very loose for some time yet.
Triggering Article 50 to fire the starting pistol on Brexit
Finally, we expect the UK to trigger Article 50 in March to start the proceedings to leave the European Union in around two years’ time. The triggering of Article 50 itself will largely be a non-event for investors given that it has been widely flagged for some time.
Long-term, we assume that a transition deal will be agreed between both parties, but that ultimately, the UK will leave the single market, Europe’s customs union, and halt the free movement of labour. The impact is likely to be more inflationary than anticipated while the transition occurs and negative for potential GDP growth over the long term.
EM: not Trumped yet
We have raised our growth forecast for the BRICs, thanks to stronger commodity prices and better US growth.
China: no significant policy tightening yet
We have upgraded Chinese growth expectations for 2017 (to 6.6% from 6.5%) on the back of stronger forecast growth in the US. We continue to believe that stability and continued growth will remain policy priorities. Policy announcements may be made at the National People’s Congress, though we would be surprised to see anything too disruptive on the reform front, or a change to the growth target from the current 6.5% – 7%.
Brazil: policy turning more growth supportive
Although we have raised our 2017 growth forecast (from 0.6% to 0.7%), we expect an even bigger change in 2018, where growth is anticipated to rise to 2.1% (previously 1.5%). This is on the back of a more favourable policy outlook, both from the central bank and government. The central bank appears to be turning more dovish, while our conversations with politicians in Brasilia left us feeling more positive about the reform outlook.
India: demonetisation a speed bump but not a roadblock for growth
India is the only BRIC to be downgraded (from 7.7% to 7.5% in 2017) as the impact of demonetisation becomes more obvious. That said, we view it as more of a hiccup than likely to derail growth entirely. Our base case is for no more interest rate cuts this year or next, given that we see inflation rising slightly in 2018.
Russia: real reforms?
We have upgraded Russian growth expectations to 1.6% in 2017 and 1.7% in 2018. 2017 inflation has seen a significant downward revision to 5% from 6.1%. Both changes are linked largely to a stronger oil price (thanks to the OPEC deal). The central bank has proved more hawkish than anticipated, and easing now looks unlikely to resume until the second half of the year.
We remain sceptical on the likelihood that the finance minister’s proposed reforms will be enacted any more successfully than in the past, but acknowledge the upside risk to growth from sentiment, should Putin endorse the programme in June.
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