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The strengthening global economic recovery

LiveMint logoLiveMint 09-04-2017 Livemint

Is the global economy finally turning the corner? The global economic outlook has improved, the risk of deflation has abated in many parts of the developed world with prices firming up, and trade is recovering, which is also reflected in the rebound in Indian exports. The reflation trade has been playing out in financial markets; investors in a market like the US have sold bonds to buy stocks in anticipation of higher growth and inflation. The outlook for emerging markets has also improved and fears related to China have receded for now. According to International Monetary Fund (IMF) projections, the world economy is expected to grow by 3.4% in 2017, compared with 3.1% in 2016.

Improvement in the growth outlook and higher oil prices due to the production cut deal by the Organization of the Petroleum Exporting Countries (Opec) have pushed inflation to desirable levels in some of the advanced economies after many years. Average inflation in Organization for Economic Co-operation and Development countries touched a five-year high in February and was well above 2%, according to Bloomberg data. The personal-consumption expenditures price inflation in the US is at 2.1% and has exceeded the 2% target of the Federal Reserve. Inflation in the eurozone also inched up to 2% in February but dropped unexpectedly to 1.5% in March. The outlook has also improved in Japan. The Bank of Japan has raised the growth forecast for the year, although attaining a 2% inflation target on a durable basis is likely to remain a difficult ask.

Reflation in advanced economies will have implications as central banks move to normalize policy. The Federal Reserve managed to raise rates in March—for the second time in three months—and is poised to move forward on the policy normalization path. The minutes of the March meeting, released last week, showed that officials are also evaluating the possibilities of shrinking the Federal Reserve’s $4.5 trillion balance sheet. Higher rates and shrinking of the balance sheet can significantly tighten financial conditions in global markets. Even though policymakers in the eurozone have shown confidence in economic expansion, there is no clarity on how and when the European Central Bank will start winding down its massive stimulus programme.

While prices have moved favourably in the advanced economies in recent months and deflationary pressures have diminished, stabilization of inflation, apart from commodity prices, will also depend on economic activity in specific economies or regions. For example, the US economy is operating at close to full employment levels and the pace of increase in prices can accelerate further if the Donald Trump administration is able to push an expansionary fiscal policy. Meanwhile, the eurozone still has unemployment rate in excess of 9%—one of the reasons why policymakers in the region are divided on changing the policy stance.

Oil prices have contributed a great deal to the recent reflation, but Opec has not been able to influence prices as desired. A lot will now depend on what the oil cartel decides in its May meeting as higher production of US shale oil has restricted the increase in prices. A sharp fall in oil prices will once again hurt demand in oil-exporting countries and affect inflationary expectation in advanced economies—reversing some of the recent gains.

As the inflation and growth outlook improve, questions are being raised about whether central banks in the developed world should stick to a 2% inflation target. For instance, in a recent paper—Monetary Policy In A Low Interest Rate World—Michael T. Kiley and John M. Roberts of the Federal Reserve noted: “Nominal interest rates may remain substantially below the averages of the last half century…. Persistently low nominal interest rates may lead to more frequent and costly episodes at the effective lower bound (ELB) on nominal interest rates.” But the concern is not new. Olivier Blanchard, then chief economist of the IMF, and others had proposed raising the inflation target from 2% to 4% in 2010. Notably, Federal Reserve chairperson Janet Yellen, after the March meeting, indicated that the central bank will allow inflation to temporarily overshoot the target. However, shifting the inflation target will not be easy as it will affect long-run expectations and can lead to serious disruption in the financial market.

Overall, while the global economy is recovering, there are still a number of risks to economic expansion. For instance, government policy in the US is a major risk. The Chinese debt situation and currency continue to remain a source of uncertainty. The possibility of populist policies in Europe and significant volatility in commodity prices could also test the pace of recovery.

Will the global economic recovery strengthen from hereon? Tell us at views@livemint.com

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