Tighter labour markets to finally lift global wages

• Wage growth has been relatively slow since 2007 in advanced economies, but an upturn may be in sight. Slow productivity growth remains an issue but tighter labour markets make a positive response by wages to rising inflation more likely and there are signs that compositional and crisis‐related effects that dragged wage growth down are fading – though Japan may be an exception.
• Overall, our forecasts are for a moderate improvement in wage growth in the major economies in 2017–18, with the pace of growth rising by 0.5–1% per year relative to its 2016 level by 2018 – enough to keep consumer spending reasonably solid.
• Few countries have maintained their pre‐crisis pace of wage growth since 2007. In part this reflects a mixture of low inflation and weak productivity growth, but other factors have also been in play: in the US and Japan wage growth has run as much as 0.5–1% per year lower than conventional models would suggest.
• The link with productivity seems to have weakened since 2007 and Phillips curves – which relate wages to unemployment – have become flatter. A notable exception is Germany, where the labour market has behaved in a much more ‘normal’ fashion over recent years with wage growth responding to diminishing slack.
• ‘Compositional’ factors related to shifts in the structure of the workforce may have had an important influence in holding down wage growth, cutting it by as much as 2% per year in the US and 1% per year in the UK. There are some signs that the impact of these effects in the UK and US are fading, but not in Japan.
• The forecast rise in inflation over the next year as energy price base effects turn positive is a potential risk to real wages. But the decline in measures of labour market slack in the US, UK and Germany suggests wages are more likely to move up with inflation than was the case in 2010–11 when oil prices spiked and real wages fell.

     

How low can U go?

• ? Although there is growing evidence that wage growth is building in response to low and falling unemployment in the advanced economies, there is scope for unemployment rates to fall further without triggering a pay surge.
• ? For a start, current unemployment rates in comparison to past cyclical troughs overstate the tightness of labour markets. Demographic trends associated with the ageing ‘baby boomer’ bulge have pushed down the headline unemployment rate – unemployment rates among older workers are lower than those of younger cohorts. And in a historical context, Europe still has a large pool of involuntary part‐timers.
• ? In addition, rising participation rates mean that demographics are less of a constraint on employment growth than widely assumed. In both 2017 and 2018, had it not been for increased activity rates (mainly for older cohorts), unemployment would have had to fall more sharply to accommodate the same employment increase. We expect rising participation rates to continue to act as a pressure valve for the labour market.
• ? Finally, unemployment rates were generally far lower during the 1950s and 1960s than now. If wages stay low relative to productivity, as was the case during that prior era, employment growth may remain strong, with unemployment falling further. In the post‐war era, low wages were partly a function of a grand bargain in which policy‐makers provided full employment in return for low wage growth.
• ? There is evidence to suggest that many post‐crisis workers have opted for the security of their existing full‐time job and its associated benefits despite lower wage growth, rather than change job and potentially earn more; the rise of the ‘gig economy’ has led some workers to value what they already have more. Put another way, the non‐accelerating inflation rate of unemployment (NAIRU) has fallen. So, the role of labour market tightness in pushing wage growth higher may continue to surprise to the downside.

     

Japan

An acceleration in global trade helped to boost Japanese GDP growth to 1.7% in 2017. But an expected slowdown in demand from China in 2018 means that the contribution from external trade will be lower this year. And while we expect growth to continue to become more broad‐based, with investment playing a prominent role, given the recent increase in protectionist tensions, we have revised down our forecast for GDP growth in 2018 to 1.5% (from 1.7% three months ago). With an expected slowdown in construction and a planned consumption tax hike in 2019, we forecast that GDP growth will ease further to 0.9% next year. The short‐term outlook is influenced by the following factors:

• Export growth easing over 2018 : exports grew by 6.6% y/y in yen terms in January–February 2018 combined, down from 13% growth in Q4 2017. While the slowdown was less marked in volume terms, with real exports up 5.2% y/y and imports 7.8% higher (in January–February), we see a smaller contribution to growth from net trade in 2018 than in 2017, as external demand cools. The recent easing in export growth is in line with our expectations following last year's acceleration. Our baseline is for trade momentum to ease through 2018 as Chinese import demand moderates. While US protectionist measures threaten the outlook, we believe that the overall impact of the likely US tariffs will be limited, as Japanese trade continues to shift towards Asia.
• Solid investment growth to continue : we expect the momentum behind business investment to remain solid in 2018, with growth of 2.9% little changed from the 3% recorded in 2017. Overall investment will be supported by strong corporate profits, construction for the 2020 Tokyo Olympics and high levels of confidence. Although dropping among large enterprises recently, overall business sentiment (and among SMEs) remains healthy and planned capex for fiscal year 2018 got off to a good start. Protectionism is also a downside risk to the investment outlook, but we believe that the actual impact on Japan will be limited.
• Weak wage growth to weigh on consumer demand : monthly data suggest that consumption has continued to edge higher this year. Moreover, rising employment in Q1 may provide additional upside momentum. However, despite a tight labour market, wage growth has been disappointing and we expect sluggish wage growth to constrain household demand and inflation going forward.

     

Why ‘King dollar’ is reigning supreme

• ▀ After a pause in late 2017 and early 2018, the dollar has resumed its rise. Our analysis suggests the long-term factors influencing the dollar are likely to remain supportive in 2020, ebbing only in 2021.
• ▀ Alongside positive interest rate differentials, several key factors explain the recent dollar strength including relatively strong economic growth, a contained external deficit and significant equity market outperformance.
• ▀ Over 2018–2019 US growth has been faster than the rest of the G7, which suffered more downside surprises this year. Meanwhile, the deterioration in the US external deficit was less than expected, despite the Trump fiscal stimulus.
• ▀ The massive improvement in the US oil balance over recent years looks like an important long-term structural support for the dollar. It allows the US to grow faster and have a stronger currency than would otherwise have been the case.
• ▀ The dollar is also supported by its still-dominant position in global financial markets. Recent talk of ‘de-dollarisation’ looks to be largely hype - the dollar's share of cross-border transactions, trade invoicing, and FX reserves is high and either stable or rising.
• ▀ The conditions necessary to create another dollar bear market like that in 2002–2008 may be hard to reproduce. A period of relative underperformance in US stocks is conceivable, but the 2002–2008 period also featured large US basic balance of payments deficits and persistently negative long-term real yield differentials, which look less likely to materialise.

     

The paradox of rising wage growth and falling inflation

• ? Strong labour markets and rising wages in advanced economies stand in sharp contrast to recent declines in economists’ inflation forecasts and market expectations. In our view, though, these developments are not necessarily contradictory. Even if wage growth edges higher, we think demand factors will limit any pick‐up in prices. Instead, we expect firms’ margins will be squeezed.
• ? Although the labour share has risen more sharply than we had expected over the past couple of years, we are sceptical that this will translate into substantially stronger underlying inflation. Not only has the rise been small, it has been employment rather than wages that has surprised to the upside. The strength of employment is probably more about firms’ production preferences than workers’ capitalising on a stronger negotiating position.
• ? True, wages adjusted for productivity now look high by historical standards. But neither theory or empirical evidence suggests that this must inevitably lead to stronger CPI inflation in the short‐term. Our forecast for flat wage growth in 2019 and the absence of strong cost pressures elsewhere are also a comfort.
• ? Inflation tends to be more responsive to demand indicators – and the recent GDP growth soft patch suggests any further pick‐up in underlying inflation pressures will be limited (see Chart below).
• ? More generally, we think that the consensus view on inflation for the key advanced economies is high. Market‐based inflation expectations are typically lower than our own, which may reflect the perception that inflation risks are skewed to the downside. Positive economic surprises could lead downside risks to narrow, but ageing expansions and secular stagnation worries suggest this is unlikely, limiting any future pick‐up in bond yields.

     

World Economic Prospects

Overview: Emerging sell‐off to restrain global growth

• Emerging financial markets have come under renewed downward pressure since mid‐January, with evidence of a general retreat by investors.
• There have been significant currency depreciations in several countries, and interest rates have been forced up in Turkey, India, South Africa and Brazil – with further hikes likely. Emerging stocks have plunged.
• This has prompted a sequence of downgrades to our growth forecasts for the emergers. We now expect Indian growth to be 0.2% lower this year than previously, South African growth 0.6% lower and Turkish growth 1.3% lower. In China and Brazil, growth in 2015 has been cut by around 0.5%.
• Weaker emerging growth will also constrain activity in the advanced economies. Emerging markets account for a modest share of advanced economy exports, but their share in export growth is higher. For the Eurozone, heavily dependent on external demand, this share has been 30–40% since 2010.
• Meanwhile, European listed firms get almost 25% of their revenues from emergers, and US firms 15% (while exports to emergers are 10% and 5% of GDP respectively). There has also been a sharp rise in bank loans to emergers in recent years.
• The biggest risks for global growth relate to China, which dwarfs the other emergers, and where concerns about possible financial instability, especially linked to shadow banking, have risen this year.
• Thanks to robust growth in the US, Japan and the UK, we still expect global growth to pick up in 2014, but downside risks have risen over the past month. With the US Fed set to press on with ‘tapering’ asset purchases, driving up global long‐term interest rates, emergers face potential further pressures.
• US tapering will be only partially offset by more expansionary monetary policy in Japan. What could make a big difference, and reduce the downside risks from emerging weakness, would be aggressive expansion in the Eurozone. At present, however, this seems unlikely – despite lingering deflation risks.

     

World Economic Prospects Monthly

Overview: Outlook bright despite fears of protectionism

• ? President Trump's decision to impose tariffs on some steel and aluminium imports has increased the downside risk of a surge in protectionist measures. But for now, our view is that the direct impact of the US move will be small. Our global GDP growth forecasts for 2018 is unchanged at 3.2% while we have nudged up 2019 from 2.9% to 3.0%.
• ? Available data suggest that the healthy pace of world GDP growth in Q4 has been maintained into Q1. The global composite PMI rose again in February, to its highest level in almost three and a half years. And in the first two months of the year, Chinese import growth remained solid, suggesting that, for now, it is still an important support for world trade. Although our advanced economy leading indicator has fallen back a touch since the turn of the year, it remains consistent with robust growth.
• ? Another plus is that the recent equity market sell‐off has not yet morphed into a fullblown correction. As with other ‘tantrums’ over recent years, we do not expect this to have any notable spill‐overs for growth.
• ? But the bigger concern is now the potential for a sharp increase in economic protectionism. While the imposition of tariffs on some US steel and aluminium imports will have repercussions for foreign producers and worsen US cost competitiveness, the sector is too small to have major knock‐on implications for global growth. The main worry is if this triggers retaliation that spins into a damaging trade war. Although this downside risk has grown, in our view it remains a tail risk. Neither the US nor its trading partners will benefit from a raft of tariffs being imposed. And the political gains for Trump may prove illusory if retaliatory measures disproportionately affect US regions where he and the Republican party are politically vulnerable.
• ? In all, our baseline view remains little changed and we still see another year of healthy GDP growth. Although downside risks to the outlook have risen since the start of the year, they are still lower than two or three years ago.

     

Deciphering the UK's business investment performance

• ? Absent June 2016's Brexit vote, growth in business investment would have been much faster and the UK would be sharing in a global “investment boom”. Or so the Bank of England claims. But the reality is more complicated. What is striking is just how subdued investment growth has been across countries.
• ? Survey evidence presented by the Bank suggests that recent business investment growth has been less than a third of what might have been achieved absent Brexit. The UK has also been highlighted as an investment laggard among major economies.
• ? Headline investment growth has certainly been relatively weak since 2016. Uncertainty around future UK‐EU trading arrangements may have resulted in some investment being deferred or cancelled. And the Brexit‐related fall in sterling will have pushed up the cost of imported capital equipment, cutting demand.
• ? But a collapse in investment in the North Sea sector has had a significant effect on headline investment growth. On an excluding‐extraction basis, UK business investment rose at the same pace as the US (ex‐extraction) and faster than Japan in 2016 and 2017, while average annual growth rises from 1.0% to 2.4%.
• ? What is striking about the recent performance of business investment in the UK and other G7 members is how subdued growth has been across economies. Despite a favourable environment, no major advanced economy has seen investment rise at the type of rates that the Bank predicts the UK, but for Brexit, should be now enjoying.
• ? Sectoral shifts, the rise of intangible investment and the consequences of technooptimism offer some reasons as to why measured investment may have become less sensitive to economic upswings. These same factors suggest that 1990s‐style growth in private investment is unlikely in the UK (or elsewhere) even once Brexit uncertainty has cleared. Indeed, our own medium‐term forecasts see business investment growth across major economies continuing to run at a relatively subdued pace.

     

World Economic Prospects Monthly

Overview: Reflation enthusiasm is tempered

• ? We have kept our world GDP growth forecasts unchanged this month, at 2.6% for 2017 and 2.9% in 2018. But our outlook for inflation has been lowered to 3.0% this year (from 3.3% last month) as inflation is close to a peak in several economies and oil prices have fallen recently.
• ? Global indicators continue to point to buoyant activity, driven by manufacturing. The global manufacturing PMI rose to its highest level in almost six years in February, which in turn is boosting world trade. Despite the exuberance shown by the surveys, we remain cautious. We continue to expect a slowdown in consumer spending as households are squeezed by higher prices.
• ? Although we still see GDP growth in the US accelerating this year, we have lowered our forecast to 2.1% as economic data have been weaker than expected at the start of the year. Large uncertainties around our central forecast persist given the unpredictability of President Trump's policies, and markets have tempered their initial enthusiasm regarding the success of ‘Trumponomics’.
• ? With the Federal Reserve now close to meeting its dual mandate, the pace of policy normalisation will accelerate. We now expect the Fed to raise interest rates this month and three times overall this year. This means that US bond yields are likely to continue to rise and the euro will remain under pressure due to the widening interest rate differential between the US and the Eurozone.
• ? The Eurozone economy remains resilient ahead of key elections in France, the Netherlands and Germany. Our view remains that populist fears are overstated and that Emmanuel Macron is still favourite to become the next French president.
• ? Many emerging markets have started 2017 with positive momentum, but caution remains the name of the game as the Fed prepares to raise rates faster than previously expected and the future of US trade policy remains uncertain.

     

World Economic Prospects

Overview: 2016 – unhappy New Year?

• 2016 has got off to a shaky start, with sharp declines in global equity markets and renewed jitters about China and its currency. Recent asset market trends have prompted some observers to suggest a high risk of a global recession this year.
• A glance back at recent history suggests why. Since last May, global stocks and non‐fuel commodity prices have both dropped by 12–13%. Over the last forty years, such a combination in a similar time frame has usually been associated with recession.
• There have been exceptions to this pattern; there were similar sell‐offs in stocks and commodities in 2011, 1998 and 1984 without associated recessions. Notably though, in at least two of these cases, expansionary US policy helped reverse market movements – but US policy is now headed in the opposite direction.
• More heart can be taken from the relative resilience of real economy developments in many of the advanced economies over recent months. There are few signs, for instance of sharp declines in consumer or business confidence, or in property prices.
• Policy settings also remain expansionary in the Eurozone, Japan and China – where broad money and growth has moved higher in recent months.
• Industry remains the problem area, both for commodity price‐sensitive extractive sectors and manufacturing. The global manufacturing PMI continues to suggest very subdued output growth.
• Services output remains more robust, and should be supported during 2016 by tightening labour markets – December's strong US payrolls release was encouraging in this regard.
• But there are downside risks to services, too, should stock price declines hit consumer spending. Our Global Economic Model suggests a 15% fall in world stocks may cut global GDP by 0.4–0.7%.
• As a result, there is a real danger that our global growth forecast of 2.6% for 2016 proves too optimistic with growth instead slipping below last year's already‐modest 2.5% reading.

     

World Economic Prospects Monthly

Overview: Market falls overstate loss of momentum

• ? Financial market moves in recent months suggest that there is increasing concern about a substantial global growth slowdown or even a recession. But we continue to see this as an over‐reaction to the weakening economic data; while the downside risks to the global GDP growth outlook have clearly risen, our baseline forecast for 2019 is little changed at 2.7%, down from 3% in 2018.
• ? Recent economic news confirms that the Q3 economic soft patch appears to have spilled over into Q4, particularly in the industrial sector which has seen a broad‐based loss of momentum in many economies coinciding with a further slowdown in global trade growth. But while surveys of service sector activity have also moderated, the falls have been rather less abrupt, suggesting that overall global GDP growth is slowing albeit not alarmingly so.
• ? On balance, we think that the weaker data do not provide compelling evidence that global growth is slowing more sharply than our December forecast. Although the financial market sell‐off and associated tightening in financial conditions will impinge on growth, this may at least be partly offset by weaker inflation in response to lower oil prices, now seen at US$61pb in 2019. This, combined with the continued strength of labour markets and the likelihood of further moderate wage growth, points to a further period of solid household spending growth.
• ? Nonetheless, the risk of a sharper slowdown has risen. Cyclical risks have increased over the past couple of years as spare capacity has diminished. And uncertainty over the economic and financial market impact of the unwinding of central balance sheets have added to the risk of policy mistakes.
• ? Although our central view is that the recent financial market correction will not morph into something rather nastier, further sustained weakness (particularly if accompanied by dollar strength) would have more significant implications for activity and could see world growth falling below the 2016 post‐crisis low of 2.4%.

     

World Economic Prospects

Overview: Markets rally but risks still to the downside

• Our growth forecast for 2016 is steady this month at 2.3% but the forecast for 2017 has been cut again, to 2.7% from 2.9%.
• The near‐term growth outlook has been supported by a decent rally in financial markets. Since mid‐February, world stocks have gained around 8%, US high yield spreads have narrowed around 140 basis points and a number of key commodity prices – including oil – have also risen.
• Another supportive trend is still‐healthy consumer demand in advanced economies including the US and Eurozone. Although there has been some slippage in consumer confidence, it has been modest compared to either 2012–13 or 2008–09.
• So overall, the global economy still looks likely to avoid recession and strengthen a touch next year. But risks to the outlook remain skewed to the downside.
• Despite the recent market rally, world stocks still remain below their levels at end‐2015 and well below last May's peak. Financial conditions more broadly also remain significantly tighter than in mid‐2015, and inflation expectations somewhat lower.
• And there are still negative signals from incoming data. The global manufacturing PMI for February showed output flat while the services PMI showed only very modest growth – both were at their lowest since late 2012.
• Economic surprise indices for both the G10 and emerging markets also remain in negative territory, and our world trade indicator suggests no improvement from the dismal recent trends.
• Notable growth downgrades this month include Germany, Japan, the UK, Canada and Brazil.
• In our view, policymakers still have scope to improve the outlook. The latest ECB moves – more negative rates and more QE – will help a little. Widening of QE to corporate bonds also hints that more radical policy options are coming into view. But policies such as central bank equity purchases or money‐financed fiscal expansions will probably require global growth to weaken further before they become likely.

     

Japan

Our outlook for domestic demand remains reasonably optimistic, notwithstanding recent financial market turmoil. A tight labour market and a pick‐up in wages will bolster consumption and incentivise investment in labour‐saving technology. Meanwhile, firms continue to expand capacity and raise R&D expenditure for new technologies, boosting investment. While growth in 2018 was set back by weather‐related contractions in Q1 and Q3, we expect demand to have rebounded in Q4 and look for GDP to have grown by 0.8% in 2018 as a whole. We expect growth of 1.0% in 2019 but just 0.3% in 2020, with the key drivers being:

• ? Robust labour market to support consumption: as the labour market continues to tighten, we expect household spending to continue to support growth in 2019. We project consumption to accelerate ahead of the scheduled rise of the consumption tax in Q4 2019, before falling back as the tax hike feeds through. However, given the stimulus measures planned by the government to soften the impact of the tax rise, we then expect consumption to show a faster recovery relative to previous consumption tax increases.
• ? Solid investment intentions despite rising uncertainty: business sentiment and investment intentions remain above historical averages and firms continue to expand capacity and increase R&D for new technologies, despite rising uncertainty over the durability of global economic momentum. And although softening recently, machinery orders remain high. Looking ahead, we expect investment growth to lose some momentum as the investment cycle begins to turn and global trade continues to ease.
• ? Low export growth to carry over into 2019: export volume growth has been weak of late, reflecting the softening in external demand. Import volumes have continued to grow at a robust pace, given solid domestic momentum. We expect export growth to remain weak going into 2019, in line with slowing global trade.
• ? Industrial production to continue growing: industrial output has recovered of late, after weather‐related disruption had weighed on growth earlier in 2018, while the PMI has remained stable at 52–53. We expect industrial production to continue growing in line with domestic demand, but slower than in previous years given less buoyant external prospects.
• ? No fiscal consolidation without economic revitalisation: the government is planning measures to support growth after the consumption tax rise in Q4 2019 including a diverse range of policies to incentivise consumption and an expansion of free childcare and education. It has also signalled that it stands ready to provide additional stimulus if needed.
• ? Monetary policy to stay put amid low inflation and falling bond yields: inflation has remained stagnant while 10‐year government bond yields fell into negative territory for the first time in two years, putting an end to speculation about monetary policy tweaks. With the consumption tax rise drawing closer, we do not expect the BoJ to move again any time soon.
• ? Equity sell‐off to prove temporary, but yen strength will persist: we expect current equity weakness to be temporary, but market volatility and more cautious Fed tightening indicate a stronger yen in 2019. Ongoing trade frictions and political attention on the exchange rate will also support the yen, which we see averaging 107 yen per US dollar in 2019.

     

Global growth to 2024: reversion to which mean?

• We expect global GDP growth to average 3.5% per year (at PPP exchange rates) over the next ten years. This is lower than the 3.8% recorded in 2000–14 though not dramatically so. There will be a modest recovery in advanced economy growth ‐ but not to pre‐crisis rates. Emerging market (EM) growth will slow but remain faster than growth in the advanced economies. And with EM's share in world GDP much increased from 10–15 years ago, EMs will continue to provide a large proportion of world growth.
• EM growth is expected to run at around 4.5% per year in 2015–24, well down on the 6% seen in 2000–14. This includes a slowdown from around 10% to 5–6% in China ‐ but China's share in world GDP has risen so much that China's contribution to world growth will remain very substantial.
• Advanced economies are forecast to grow by 1.9% per year in 2015–24, a big improvement from the 1% pace of 2007–14 (which was affected by the global financial crisis) but below the 1990–2014 average. Indeed, the gap between forecast G7 GDP and GDP extrapolated using pre‐crisis trends in potential output will remain large at 10–15% in 2015–24.
• Global growth will remain relatively strong compared to much longer‐term averages: growth from 1870–1950 was only around 2% per year. But a return to such low growth rates looks unlikely; China and India were a major drag on world growth until the 1980s but are now fast growing regions.
• Our forecast is relatively cautious about key growth factors; the contribution of productivity growth is expected to improve slightly, while those from capital accumulation and labour supply fall back. Demographics will be a more severe drag on growth from 2025–40. Overall, risks to our long‐term forecasts look to be skewed to the downside.

     

World Economic Prospects

Overview: US acceleration brings a positive start to 2014

• A series of positive data releases in the US has led us to revise upwards our growth forecasts for 2014. We now expect US GDP to rise by over 3% this year, compared to 2.7% forecast a month ago.
• A key factor changing the US outlook is a more confident consumer. In the three months to November, real consumption rose at an annualised pace of 5%, the strongest in four years. This has been partly financed by a reduced saving rate – but the saving rate has been much lower in the recent past and steady employment gains should support both income and consumer sentiment in the year ahead.
• Also supporting growth this year in the US and the broader global economy will be wealth gains. In recent years, global stock prices at the end of a given year have been a reasonable predictor of economic growth in the following year, and global equities were up over 20% on the year at the end of 2013.
• Nevertheless, the global growth outlook remains patchy. An optimistic picture in the US, UK and Japan contrasts with a rather mixed picture the Eurozone – where some economies are still contracting and where there is a risk of deflation.
• The picture is also subdued in the key emergers. In contrast to the developed economies, emerging market stocks are down 10% on the year as higher US yields draw capital away. Weak currencies, inflation and high interest rates are weighing on growth in markets such as India, Brazil and Turkey.
• These factors are likely to wane only slowly as the year proceeds and could even worsen if tapering in the US is faster than expected. A stronger US economy may not fully offset this – the US's strong competitive position could direct more of rising US demand to US products than in previous upturns.
• As a result, we expect emerging growth to firm only modestly this year, to 4.5% from 4.1% in 2013 – well below pre‐crisis levels of around 7%. Global growth too will remain below par at 2.9%, from 2.2% in 2013, but improving to over 3% next year.

     

Secular stagnation – are we stuck in Summers' long winter?

• We estimate that the UK has a relatively large output gap of around 2¾% of potential output. With the legacy of the financial crisis fading, the UK should see healthy growth in potential output of around 2.1% a year from 2015–24. Usually this would drive a period of strong economic growth, but we expect GDP growth to average a relatively underwhelming 2.4% a year over this period, largely due to the drag from aggressive fiscal consolidation.
• There is significant disagreement amongst economists about the size of the output gap. Estimation of the output gap has been problematic since the financial crisis because of the depth of the recession and relatively slow pace of the subsequent recovery, while sizeable revisions to the national accounts data have been an added complication. Our estimate of the output gap is towards the top of the range of independent forecasters surveyed by HM Treasury, but it is consistent with the literature on the impact of financial crises on potential output.
• We expect potential output growth of 2.1% a year from 2015–24, a faster pace than that seen since the financial crisis, but some way short of the experience of the pre‐crisis decade. The shortfall relative to the pre‐crisis period is largely due to a smaller contribution from growth in labour supply, which reflects the impact of an ageing population. However, labour is set to make a much stronger contribution to potential output growth in the UK than in most other major European countries over the next decade.
• The combination of a large output gap and healthy growth in potential output will provide the conditions for firm growth and low inflation over the medium term, with GDP growth expected to average 2.4% a year from 2015 to 2024. Growth could be stronger were it not for the sizeable drag from fiscal consolidation over the next four years and the dampening effect that this will have on activity. This will ensure that the output gap closes very slowly. The government's fiscal plans are heavily influenced by the OBR's view that there is limited scope for stronger growth to drive an improvement in the public finances. But if our view turns out to be correct, it will become apparent that the government has pursued a more austere path than is strictly necessary in order to comply with its fiscal rules.

     

Weak world trade could spark competitive devaluations

• World trade growth has slowed sharply in 2015, with our forecast for growth just 1% for the year. High frequency indicators suggest a stagnant picture, with trade in key emerging markets (EM) especially weak. Import growth in the US and Eurozone remains positive and is holding up world trade, but there are downside risks here also. Very slow world trade growth risks incentivising competitive depreciations and depressing global bond yields.
• In August our OE export indicator fell to its lowest level since late‐2012 –; the point when the US announced ‘QE3’. Its weakness is corroborated by other indicators such as container trade and air freight.
• The main drag to world trade is from emerging markets, especially the BRIC‐4 whose import volumes contracted sharply in H1 2015, cutting more than 1 percentage point from annual growth in goods trade.
• US and European import growth looks stronger and should be supported in 2016 by firming GDP growth. This is an important support for world trade, but the latest data suggest some downside risks here also.
• The weaker world demand growth is then the more that trade will appear like a zero‐sum game where a country can benefit only at the expense of its competitors. This has potentially important implications for asset prices: in particular, countries may turn to competitive depreciation, adding further to global deflationary pressures and holding down global bond yields.

     

World Economic Prospects

Overview: A world with higher inflation

• Our world GDP growth forecasts are unchanged this month, at 2.6% for 2017 and 2.9% in 2018. But we expect a sizeable increase in inflation, to 3.3% in 2017 from an estimated 2.8% in 2016, as the effect of higher oil prices feeds through.
• Global indicators continue to point to a pick‐up in activity towards the end of last year, driven by stronger manufacturing activity. The global manufacturing PMI rose to the highest level in almost three years in December, while the composite index – which includes services – was at a 13‐month high.
• World trade should be underpinned by stronger growth in the US (2.3% in 2017 and 2.5% in 2018), bolstered by the anticipated effects of President Trump's expansive fiscal policies. That said, uncertainties around our central forecast are unusually high given the high level of uncertainty surrounding the Trump administration. Encouragingly, there are increasing signs that the tighter labour market is leading to a pick‐up in wage inflation in the US, which will support consumers.
• Given these reflationary trends, we expect two increases in the Federal funds rate this year and US bond yields are likely to continue to rise. The widening of interest rate differentials between the US and the Eurozone will drive the euro down to parity with the US dollar by end‐2017 for the first time since 2002.
• We have revised our Brexit assumptions this month. We now assume that the two‐year period of exit negotiations is followed by a transitional arrangement lasting 2–3 years. This would provide breathing space to negotiate a free trade agreement with the EU.
• Emerging market growth on the whole will improve in 2017 but performance will differ across countries: Russia and Brazil will exit recession, but countries with weak balance of payments positions, high dollar debt and exposure to possible US protectionist actions will be at risk. In China, policymakers are moving to greater emphasis on reducing financial risks and less focus on the 6.5% GDP growth target for 2017. Continued action is also likely to dampen further depreciation of the CNY.

     

Supply surprise is a ‘nice’ reprise

• ? This year advanced economies have enjoyed a rare positive supply surprise: output is higher than expected and inflation is lower. The initial China‐related boost not only proved to be a great antidote to secularly weak global demand, but it has also engendered unexpected global momentum and a benign inflation response. As a result, 2016–17 resembles a mini‐reprise of the “nice” 1990s, a non‐inflationary, consistently expansionary decade.
• ? The global momentum has been propelled by a strong international trade multiplier. This has contributed to strength in several advanced economies, particularly the Eurozone. We expect global growth in 2018 to be bolstered by US fiscal stimulus as the impulse from China fades.
• ? It will remain “nice” in 2018, albeit in the context of weak secular trend growth. We expect the benign output‐inflation trade‐off to continue. Several of the factors that are underpinning low inflation and unemployment as well as weak wage growth are likely to be present for some time.

     

World Economic Prospects

Overview: Forecasts steady but near‐term signals mixed

• Our world growth forecasts are steady this month, at 2.3% for 2016 and 2.7% for 2017.
• One factor behind the more stable outlook is the rally in financial markets since mid‐February. This rally appears to have been the result of a number of factors including a more dovish Fed and an improvement in some near‐term economic indicators.
• The implied 12‐month ahead Fed funds rate dropped around 0.5% from its January peak to mid-February and remains around 0.35% lower now. So the Fed still apparently has the capacity to boost markets with changes in communication policy.
• The Citigroup economic surprise indicators have also improved over recent weeks, especially for emerging markets where the indicator is back in positive territory. The G10 index nevertheless remains clearly negative.
• Other economic signals are mixed. The latest reading of OE's world trade indicator (based on survey evidence for March) suggests a modest improvement, although again the indicator continues to signal weak world trade growth.
• Meanwhile, there have been some warnings of potentially softer labour market conditions. Though payrolls gains have remained solid, a weighted sum of the employment subindices of the US ISM surveys has dropped sharply over recent months. A similar index for the Eurozone is more positive, although it has also softened from its late‐2015 peaks.
• These mixed signals suggest limited likelihood of near‐term upgrades to the world growth outlook and overall we maintain our view from last month that risks look skewed to the downside – so that further monetary policy stimulus remains a possibility.
• This assessment appears to be shared, to some extent at least, by global bond markets. US 10‐year yields have dropped back to only 1.7% since mid‐March (only 0.1% above their February lows), with German yields at just 0.1% and Japanese yields at ‐ 0.1%. So the ‘great squeeze’ on G7 bond yields is still continuing.