Economists’ forecasts have been strongly ‘framed’ in the aftermath of the global financial crisis. Faced with massive uncertainty, economists have stuck to the simple rules of thumb that growth should return to its long-term trend while inflation comes close to central banks’ arbitrarily defined targets.
However, these rules of thumb have not worked well. Growth has been persistently lower than expected. Where it has popped up it has often been associated with an alarming deterioration in the balance of payments position. Either the post-crisis financial hangover is longer lasting than expected or the world economy has succumbed to a lower structural rate of growth.
Financial markets have mostly performed very strongly but the lack of follow-through to economic activity is disappointing
Inflation has also been far below forecasts. Traditional approaches to gauge likely inflationary pressures – the output gap or inflation expectations – have proved next to useless. Europe, in particular, is suffering from a deflationary malaise with echoes of 1990s Japan.
Our 2014 global growth forecasts have been shaved again. We now expect an overall expansion of 2.4 per cent, down from 2.6 per cent three months ago and a long way short of the 3.5 per cent to 4.0 per cent pre-crisis range.
Our UK forecast has been increased from 2.9 per cent to 3.2 per cent and Japan’s from 1.0 per cent to 1.4 per cent. But we have made sizeable cuts elsewhere, especially for the US (down from 2.5 per cent to 1.7 per cent), Brazil (1.7 per cent to 1.1 per cent) and Russia (0.6 per cent to zero). Inflation as a whole remains relatively stable but Sweden and Switzerland are already in outright deflation with the eurozone close behind.
The ‘wildcard’ is higher oil prices, given the uncertainty in Iraq. However, the impact is more likely to affect growth than inflation, particularly for emerging economies with weak balance of payments positions.
Financial markets have mostly performed very strongly but the lack of follow-through to economic activity is disappointing. Strong asset prices and exceptionally low inflation create ambiguity for policymakers – nowhere more so than in the UK, where there is now a good chance of interest rates having to rise early in 2015 even though inflation is falling fast.
While the US Federal Reserve is likely to raise interest rates in 2015 too, the European Central Bank will continue to fight the deflation threat with purchases of asset-backed securities likely this year and outright quantitative easing in the first half of 2015. Beijing, meanwhile, will keep walking a tricky tightrope, trying to avoid both financial excess and a marked slowdown in coming quarters.
However, the biggest problem will continue to be the gap between forecasters’ hopes and economic reality. Those hopes are heavily ‘framed’, suggesting far more uncertainty than is typically recognised. The risk of policy error thus remains uncomfortably high.
This research was first published on 26 June 2014.