Where has inflation gone? A review of the economic outlook

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Please note that this article may contain technical language. For this reason, it is not recommended to readers without professional investment experience.

This is an extract from our Investment Outlook for 2018. To obtain a full copy of the outlook, please click here

The global upswing in economic activity has strengthened…

What a difference a year makes! “The global cyclical upswing that began midway through 2016 continues to gather strength,” wrote the International Monetary Fund (IMF) in the World Economic Outlook report (published October 2017). The same goes for the OECD, while private economists have also raised their growth forecasts in recent months, especially with regard to the eurozone.

… but inflation is conspicuous by its absence

There’s one thing missing from this landscape, and in 2018, economists, investors and central bankers may well be gripped by a sense of déjà-vu: what’s still absent is inflation.

In recent years, it has become a very docile beast, running at a rate below 3% for the global economy and at around 2% in OECD member-countries. And this at a time when the pace of economic growth in major economies is running faster than their potential growth rate with close to full employment.

Economists are questioning the pertinence of the Phillips curve in linking changes in inflation (through wages) to a higher or lower unemployment rate.

What is the economic outlook for 2018?

  • Economic growth in the major developed economies is likely to remain largely on its current trajectory. This scenario discounts any external or internal shocks and, hence, any recession. It is in line with the scenarios of international institutions such as the IMF and the OECD, which suggest, respectively, that ‘the global upswing in economic activity is strengthening’ and that the ‘recovery is now more synchronised on an international scale’. Both institutions have the same doubts on the emergence of ‘strong, sustained and inclusive medium-term global growth’ and stress how important it is for policymakers to ‘maintain a longer-term vision […] and to implement structural reforms’.
  • We share this point of view, in particular as regards the structural risks arising from the deepening of inequalities. However, we will limit our analysis to the short-term economic outlook, which is more likely to influence financial markets in the coming months.

Our view on the economic outlook

The major economies are growing at a rate near their potential, which is causing output gaps to close in the US and Japan and to narrow in the UK and the eurozone. The global economy is expanding at cruising speed with no major imbalances apparent in either developed or emerging markets.

In reaction, central banks can be expected to continue to normalise their monetary policy, but in doing so are taking notably different paths.

What are the real dangers for 2018?

Drawing up a list of the potential risks to the economic outlook – whether geopolitical, political, natural or financial in nature – does little to help us understand the nature of the challenges involved. Moreover, if one or more of these risks were to materialise, it would not be surprising to see markets shrug them off or react in a totally unexpected manner. For proof, just look at how the markets reacted just after the election of Donald Trump in November 2016. We therefore think it a better idea to review those factors that are more structural in nature.

The main risk, in our view, is a rapid and sustainable increase in inflation if potential growth is weaker than thought and central banks are unable to react quickly enough to this state of affairs and/or tried for too long to extend the ‘Goldilocks’ moment of constant economic expansion without inflation. The scenario of a monetary policy error would then come to the fore, with a bearish reaction from bond markets worldwide.

Regarding potential exogenous shocks, we still see the risk of a return of protectionism, given the manner in which the Trump administration approached renegotiations of the North American Free Trade Agreement (NAFTA) in late 2017. As we pointed out last year, protectionist measures in one country tend to spread like wildfire, with trade partners then bidding up the stakes to ‘protect’ their own economies, with the ultimate victim being global growth.

What can we hope for in 2018?

  • The best-case scenario for both economic agents and financial markets would be an acceleration in global growth beyond current levels to achieve ‘escape velocity’ with no acceleration in inflation because potential growth is higher than expected. Let’s go back to the concerns we expressed as economists at the start of this article about measuring productivity. On top of the issue of how to measure it, a productivity shock assumes the emergence of a major innovation, which is by its nature unpredictable, and its dissemination throughout the economy and/or its adaptation to changes in the organisation of production, which could require structural reforms.
  • This is also the hope expressed, in essence, by the OECD and the European Commission. After emerging stronger from the sovereign debt crisis, Europe looks better equipped to put through reforms that could help boost potential growth in coming years.
  • As 2017 draws to a close, the broad-based global recovery is still on track without any acceleration in inflation. Along with other factors, this makes it more likely in our view that Goldilocks will wake up no later than in 2018. This reference to the fairy tale “Goldilocks and the Three Bears” is used by the financial markets to describe an economy that is solid enough to ensure corporate earnings growth, but with no risk of overheating, which would lead to more hawkish monetary policy to stave off inflation. The economy is indeed “just right”, like in the three bears’ house, where just one bowl of porridge was warm enough and only one bed was comfy enough.

Out now – our 2018 Investment Outlook

For more on our Investment Outlook for 2018

Investment Outlook 2018 – The tide is high

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For more articles on our 2018 Investment Outlook, please click here

Nathalie Benatia

Strategist

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