The world is back at growth levels last seen before the global financial crisis, and despite elevated geopolitical risks, this will likely remain the case for the rest of the year.
Europe’s growth is above trend and the lack of significant monetary tightening by the European Central Bank (ECB) should sustain it. Asia is still the main driver of global growth and we see stable growth in China.
Monetary policy was the only game in town after the global financial crisis. The prospect of another game – in the form of fiscal stimulus following Donald Trump’s election – led to euphoria. We, on the other hand, believed that such stimulus was highly unlikely to materialise. Financial markets have since shifted to the same view.
Slowdown potential, but not this year
Today, monetary policy is still the only game in town, but this time tightening by major central banks is the key risk.
The ECB, the Federal Reserve (Fed) and the People’s Bank of China are all moving to ‘normalise’ policy. This means some form of monetary tightening. But they intend to do so without spooking markets or derailing growth.
We believe tightening will be moderate and things will go according to plan this year. But monetary policy works with a time lag, and economies could begin to show signs of a slowdown next year.
Expect one more rate hike
What the Fed does with interest rates has implications for the rest of the world. US inflation data has been soft for the past three months, which could make it trickier for the Fed to go ahead with its intended rate hikes. However, we believe that it will hike once more in 2017, and twice in 2018 – a call that is slightly above consensus, and for three reasons:
First, the Fed is basing its decisions on future rather than current inflation rates. Three consecutive months of soft inflation cannot be dismissed, but the Fed will also be paying attention to the falling unemployment rate. At some point, limited slack in the labour market should exert upward pressure on wages. And wages do not have to increase much before they become inflationary, especially given low US productivity growth at around 1 per cent.
Second, monetary policy can work with a lag of longer than 12 months. If the Fed waits to see inflation before hiking, it could end up behind the curve. This is something the Fed will seek to avoid. The fact that the economy is performing well should help justify further hikes.
Financial conditions are not being tightened. This is positive both for markets and the economy
Also, ultra-low interest rates leave the Fed with no room to react to an adverse shock to the economy. The Fed has its own scenarios – policy rates will be at 3 per cent before the next recession under the main scenario, and at 2 per cent under the extreme scenario. Interest rates are still below these levels, and the current state of the US economy allows the Fed to proceed cautiously and take the Fed funds rate to at least 2 per cent.
Finally, financial markets are giving the Fed room to hike policy rates. While it has been hiking, long-term interest rates have been coming off and the dollar is stable. As a result, financial conditions are not being tightened. This is positive both for markets and the economy. We see the current hiking cycle as front-loaded and short lived, with policy rates peaking in the first half of 2018.
Maintaining growth – a tough balancing act
So for the second half of 2017, expect the world economy to stay on track. Geopolitical risk is difficult to price in, and we expect this to continue in the coming months, but it has declined significantly in the euro area.
A policy mistake is the biggest risk to our outlook as central banks normalise monetary policy. Tightening without derailing growth is a tough balancing act. But given the lagged effect of monetary policy, this is likely to be more of a concern in the second half of 2018.