LONDON – Given all the uncertainty in the world economy today, we have been reminded that for all the authority economics commands, it is still a social science. Many major developments over the past year have departed from the consensus forecast, exposing the limitations of our understanding.
Most notably, many experts and forecasters predicted a recession in the United States this year. But not only have we avoided that (so far); the latest inflation figures have led many sell-side forecasters to write down the probability of a recession happening at all. Suddenly, financial markets are entertaining the idea that policymakers can indeed achieve a soft landing: inflation returns toward its target level (around 2%) without the need for a recession and a sharp increase in unemployment. Equity markets thus are rising, despite remarkably (and perhaps understandably) cautious investor sentiment.
The situation across the Atlantic is also overturning forecasts. Although the United Kingdom’s economy seems to be constantly beleaguered – with GDP growth remaining meager – it nonetheless has avoided a technical recession (defined as two consecutive quarters of negative growth). Will the next positive surprise be a sharp reduction in inflation? One issue that pessimists (including the Bank of England) focus on is wage inflation, which summons comparisons to the 1970s wage-price spiral. That episode inaugurated the long era of monetarist orthodoxy, which required that stringent anti-inflation measures take priority over most other economic-policy objectives.
Given the complexity of the UK’s macroeconomic situation, I am still waiting to see if the new optimism sticks. It is worth remembering that, before the pandemic and Russia’s war in Ukraine, the UK government was a vocal advocate of higher real (inflation-adjusted) wages. Now, its wish is being granted: labor representatives are determined to seek higher nominal wages in response to the sharp, unexpected increases in consumer prices. Policymakers thus should be praying for headline inflation to fall significantly, as that would allow them to claim credit for boosting real wages without the need for an increase in nominal pay.
Another irony, in the UK and some other countries, is the role of monetary growth as a leading indicator of inflationary pressure. Following the large monetary and fiscal stimulus packages rolled out during the pandemic, commentators who focus on the money supply predicted, accurately, that inflation would increase. But many of these commentators had been saying the same thing for the past decade, in response to central banks’ unconventional monetary policies. Their forecasts were wrong until COVID-19 arrived. If they are monetarist true believers, they should be advocating less monetary tightening now that growth in the money supply has slowed.
Between the slight weakening of commodity prices, slower monetary growth, the significant increases in interest rates, and the general stability of long-term inflation expectations, I see good reasons to side, cautiously, with the optimistic camp. But I would hasten to add that central bankers must remain vigilant in guarding against any return to the 1970s.
As always, much will depend on China. After the government abruptly ended its “zero-COVID” policy late last year, growth briefly shot up, and analysts rushed to revise their forecasts. But over the past three months, Chinese economic growth has been disappointing, forcing many to revise their forecasts once again.
Moreover, there is no sign of increased inflation in China, challenging the long-held assumption that China would eventually go from exporting deflation to exporting inflation. True, some might say that the redirection of business and investment away from China will be inflationary; but I have my doubts, considering that some of these moves will be to countries with even lower costs than China. In any case, Chinese policymakers clearly will need to address the weakening of growth and consumption, not to mention other major problems such as rising youth unemployment.
Looking ahead, a major variable to watch will be global commodity prices, which have undergone a surprising reversal since Russia’s full-scale invasion of Ukraine. But it is not clear why that happened or whether it is sustainable. My own hunch is that there have been larger-than-expected shifts toward efficient energy consumption and a wider adoption of alternatives than what was forecasted. But we will need more time and data to determine whether this is really the case.
For the past two decades, it has been fashionable among academic economists to assume that excess global savings have resulted in a lower natural rate of interest. While I respect many of those who held this view, I was never convinced by it, because I saw low interest rates as a consequence of persistently lower-than-expected inflation, which in turn justified accommodative monetary policies. Perhaps now reality is starting to catch up. If so, the long-term “new normal” would be much more normal indeed. Interest rates, finally, would remain above the actual or desired level of inflation.
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