It is becoming a familiar pattern – global growth forecasts revised up again, inflation projections lowered again and financial markets displaying even more optimism. But the task of the developed world’s central banks is getting ever harder.
For many reasons relating to changing labour-market behaviour, technology and global supply-and-demand factors, most central banks in developed countries continue to undershoot their inflation targets.
With debt still high, this calls for continued loose monetary conditions. But growing signs of financial-market excess in a range of assets from shares to property seem to warrant higher interest rates if the banks are to avoid even bigger threats to price stability over the longer term.
History has shown that recessions typically occur after periods when expectations for the future path for the economy and asset-market returns have become excessive.
The more that signs of over-exuberance come to the surface and the longer central banks keep policy loose in a bid to meet their inflation objectives, the more the limits to macro-prudential measures and the risks associated with strict inflation targeting will become apparent. It is becoming increasingly clear that attempting to meet inflation targets in the near term can reduce the ability to meet them over the long term.
Central banks may have to risk missing their inflation targets by a small amount over the next year or two if the risk on the other side is even more financial exuberance and a much harder landing further down the road. A delicate balance needs to be struck.
Some central banks in smaller developed economies are already changing tone. After numerous rounds of macro-prudential measures, Australia, New Zealand, Norway and Sweden – all countries where real house price increases have exceeded 60 per cent since the financial crisis – are slowly moving towards interest rate rises in 2018 following Canada’s recent increases.
The price of shares and corporate bonds in the US, as in Europe, seems to have outperformed the underlying economy. But while we expect the US Federal Reserve to allow a very gradual shrinkage of its balance sheet, ongoing disappointment on inflation and productivity growth will probably mean it does not raise interest rates beyond the first half of 2018.
Largely as a result of upgrading our eurozone outlook, we have increased our global growth forecast by 0.1 percentage points to 2.8 per cent in both 2017 and 2018. This compares with a 2.5 per cent average between 2011 and 2016 so is good news, but it is much less spectacular than the recent stellar financial market performance. And our global inflation forecasts have been reduced fractionally — to 2.6 per cent in 2017 and 2.5 per cent in 2018.
Eurozone and US growth are likely to slip a little in 2019, but we remain positive on emerging markets, with robust expansion in China as it attempts to meet its targets of doubling GDP and income by 2020 from 2010 levels. Disruption resulting from reforms implemented in India over the past year will likely weigh on growth in 2017 and in 2018, but should unleash more of the country’s potential in 2019 and beyond.
This research was first published on 27 September 2017.