Forecast update: will doves cry?

The Democrat sweep and President Biden's announcement of a $1.9 trillion stimulus bill has led us to upgrade our forecast for US GDP growth with a knock-on effect to the rest of the world. We now expect US GDP to increase 4.7% this year and 4.9% next, an upgrade of just over 1 percentage point for both periods. The rest of the world benefits through stronger trade and the impact is most noticeable in our 2022 global growth forecasts which are raised from 4.1% to 4.6% as the world economy normalises.

For 2021, stronger US fiscal policy helps, but at the global level the gains are largely offset by a significant downgrade to our Eurozone growth forecast from 5% to 3.5% as a result of an extended lockdown and a slow vaccine roll-out. Meanwhile, despite also experiencing an extended lockdown, UK growth is upgraded slightly to 5.3% assisted by a successful vaccine roll-out. Japan and the emerging markets are also upgraded, but the net result is that our global growth forecast is only marginally stronger for 2021 at 5.3%.

Alongside higher growth comes increased inflation, largely driven by higher oil and commodity prices. We now expect global consumer price inflation to rise 2.6% this year (previous forecast 2.2%) before easing back to 2.4% in 2022. Given current concerns, the moderation next year is critical for policy and financial markets. Overall, the forecast moves in a more reflationary direction with stronger growth and higher inflation than in our last forecast in November.

A new inflationary era?

Concerns are increasing that we are now entering a new inflationary era and we do expect headline consumer price indices to pick-up sharply in coming months as powerful base effects feed through.

We are expecting the headline US CPI inflation to rise to 3.5% in Q2 before falling back as the base effect washes through. Unless one-off price shocks feed through into wages and a broader rise in costs, the impact on inflation will be temporary.

Our view is that the economy has spare capacity and can absorb the increase in demand without causing a second round of price increases. Inflation tends to decline after recessions and during recoveries as firms get back to work and use the slack created by the downturn to raise output. Productivity strengthens and unit labour costs fall allowing companies to keep prices competitive.

As a consequence, we see US and world inflation falling back later on in 2021 and into 2022. The time for a more sustained pick-up in inflation will come in the second half of next year when we estimate that the output gap will have closed in the US and economic slack will have been largely used up. Although there are pressures on prices in specific sectors at present it is too early in the cycle to see inflation taking off.

Fed policy

The focus on inflation is understandable as it could undermine one of the key supports for the market: loose monetary policy. However, we have to remember we are dealing with a new policy framework where there is scope for inflation to run above 2% for a period.

Average inflation targeting is designed to avoid the persistent undershoot of core inflation seen over the past decade. There is also the requirement to reach maximum employment. There is a strong desire to see the benefits of economic growth spread more widely to low paid and minority workers. Judging by the disproportionate impact of the pandemic on lower paid workers where employment rates are down by a fifth, there is much to be done before maximum employment is reached.

On this basis we do not see the Fed raising rates during the forecast period and probably not before end-2023. We do expect a gradual scaling back of QE before then with the purchase of bonds being reduced from its $120billion/month rate in Q2 next year.