NN IP: A bird’s eye view of developed economies

NN IP: A bird’s eye view of developed economies

Outlook
Outlook vooruitzicht (09) koers omhoog koersgrafiek

By Willem Verhagen, Senior Economist, Multi-Asset, NN Investment Partners

It’s useful to think of the recovery as consisting of a foundation of solid fundamentals and an overlay of various crosscurrents that are injecting a large degree of noise into the data. The most important question is to what extent these crosscurrents will damage underlying fundamentals. If central banks misread the signals and tighten policy too soon, there could be grave implications for the economy for years to come.

Willem Verhagen, Senior Economist, Multi-Asset at NN Investment Partners shares his insights on the matter in the recent macro column.

Today’s solid fundamentals stand in sharp contrast to the developed market “rehab” recovery after the global financial crisis.

Back then, consumer and bank balance sheets were impaired, while economies also suffered from a large fiscal drag between 2010 and 2013.

This time around, consumer balance sheets look very healthy, business profits have bounced back sharply, credit is flowing freely, labour markets are tightening at a solid pace, private sector confidence is above its long-term average and fiscal policymakers are keen to avoid the mistakes that were made 10 years ago. 

The crosscurrents stem from various sources that are interacting with each other: widespread supply bottlenecks in goods and labour markets, additional disruptions to production and confidence induced by the resurgence of the virus, and structural changes in consumption and production patterns.

From a historical perspective, the most useful analogy here is the switch from a wartime to a peacetime economy. This requires a large-scale redeployment of labour and capital away from the war effort towards the production of consumer goods and services and capital goods. Meanwhile, on the demand side there is often a temporary surge as wage and price controls are lifted, releasing excess savings and pent-up demand. 

Today’s supply bottlenecks are the result of disruptions on both the demand and supply sides of the economy. On the demand side the main issue is not so much that the overall level of aggregate demand is excessive. After all, in most developed economies, GDP is still well below its pre-Covid trend, and this holds to an even greater degree for employment.

Rather, we have seen a big change in the composition of demand over the past 18 months: goods demand has surged to well above its pre-Covid trend, whereas service sector demand remains well below trend. As the composition of demand normalizes, the pressure on global value chains for goods should ease. 

On the supply side, the main issue is that global supply chains are geared towards achieving maximum efficiency. This works well whenever the world is reasonably stable and predictable. However, large, unforeseen shocks can cause severe strains in the system.

Supply restrictions in one part of the system are transmitted to other parts, often in an amplified manner because of inventory hoarding: businesses fear that inventories will become even leaner, so they overorder. This effect can be compared to the effect of liquidity hoarding in the financial system; if left unchecked, it can lead to a financial crisis.

Inflation: transitory or persistent?

Inflation rates in developed markets have been significantly higher than expected over the past few months. High inflation is essentially the other side of the nominal GDP coin, and is induced by the disruptions in the real economy that have led to large, widespread changes in relative prices and wages. Provided inflation expectations remain well anchored, policymakers should allow these relative price changes to wash through the system.

One way in which these crosscurrents could damage the underlying fundamentals is if the inflation spike triggers a break-out of inflation expectations to the upside. If that were to happen, what started as a transitory inflation spike would morph into a persistent inflation problem. Transitory thus does not mean “short-lived”, but rather that the inflation spike will die out of its own accord. History suggests that transitory inflation spikes can last for two years or slightly longer.

Unfortunately, it is not inconceivable that the current inflation spike could last well into next year as there is no way to tell for sure how long the ongoing supply bottlenecks will persist.

The only certainty is that as long the bottlenecks do persist they will cloud the view of what is happening to underlying inflation and longer-term inflation expectations. It is therefore very important to gauge what is really driving inflation expectations. The theory of inflation that best fits historical observations is the one that sees it as the result of distributional conflict between wage earners and profit owners for their respective shares of the economic pie.

The crucial question, then, is to what extent society will allow this conflict to heat up. In this respect the deeper driver of well-anchored inflation expectations could well be widespread social aversion to inflation and the existence of strong institutions to enforce this aversion.

Since the 1980s, most developed economies have benefitted from powerful institutions in the form of a high degree of central bank independence and labour market reforms that have kept the lid on workers’ bargaining power. The latter trend has been greatly enhanced by globalization. It is reasonable to assume that these strong institutions are still in place, but this does not necessarily mean that inflation will not develop into a persistent problem.

Developed labour markets are currently characterized by two important kinds of disruption: labour supply is generally still well below pre-Covid levels, and there has been an increase in the degree of mismatch between the skills required in vacancies and the skills available in the pool of the unemployed. If these disruptions persist, they could trigger a larger and more persistent increase in workers’ bargaining power, which, in turn, could ignite a wage-price spiral. Because of the changes in relative prices we referred to above, central banks could be too late to recognize this.

The risk of policy mistakes is quite high

In general, the uncertain environment means there is quite a high risk of ex-post policy mistakes. Still, it is important to recognize that the pay-offs are highly asymmetric. If the central banks fail to tighten while inflation becomes persistent, this problem is relatively easy to cure. The cure will be painful, but the dose of tightening medicine required will be much smaller than in the early 1980s.

If, on the other hand, central banks tighten in response to transitory inflation, the damage incurred could have a more permanent character: not only will growth be lower, but inflation expectations may slip further downwards over the medium term and any future commitment to a dovish reaction function will suffer from a lack of credibility.

Central banks in developed markets are moving towards providing less accommodation, or even outright tightening, to various degrees. The Bank of England is the most hawkish in this respect and therefore also in most danger of making a hawkish policy mistake.

That said, the UK is suffering more from supply-side restrictions than other developed economies because of Brexit, while UK inflation expectations were not really subject to downside risks in the previous decade.

So far, the Fed has made a very successful moderate hawkish pivot as it has convinced markets it is maintaining its dovish reaction function even though the economy has made substantial progress towards its goals. The Fed will use the period of tapering to assess where the economy is going. If inflation is still well above target in the second half of next year, while wage growth has accelerated and labour supply remains restricted, the Fed will probably hike soon after the end of the taper.

The ECB is more dovish than the Fed as it strongly believes the Eurozone inflation spike will be transitory. Of course, inflation expectations fell further there than those in the US in the previous decade. What’s more, in contrast to the US, wage growth in the Eurozone has decelerated over the past year. The ECB thus remains focused on steering the economy out of the pandemic and re-anchoring inflation expectations from below. The big question is whether the ECB can enhance the credibility of its intentions by recalibrating its regular QE programme after the end of the pandemic emergency purchase programme in March 2022.

In this uncertain environment it is impossible to say whether rate hikes by the Fed or even the Bank of England in the coming year will be hawkish policy mistakes. All we can say is that there is a clear lesson to be learned from economic history, which is that fears about inflation of the sovereign debt burden often induce policymakers to tighten policy prematurely. To what extent this will apply to fiscal policy remains to be seen. In the US, the size and scope of President Biden‘s Build Back Better infrastructure plan is subject to downside risks because of the inflation spike.

Meanwhile, in Europe the big issue will be next year’s reform of fiscal rules, which will hopefully reduce the risk of excessive austerity.

Premature policy tightening is another important channel through which crosscurrents can damage solid underlying fundamentals. The central idea here is that private sector income expectations and balance sheet quality are not solid enough to make the private sector willing and able to support robust growth on its own. Policymakers should provide support until this is the case, and this support should come in the form of fiscal policy focused on improving the supply side of the economy and monetary policy that ensures sovereign and private borrowing costs are low.