Opinion – Martin Wolf: When good economic news may not be good news

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Is it time to slow the monetary crunch or even reverse it? Answering “yes” to these questions is becoming more and more common.

Markets certainly behave as if the tight days are ending. They may be right, but crucially, they will only be right about the future of monetary policy if economies prove weak. The stronger the economies, the more central banks worry that inflation will not stabilize again at 2%, and therefore long-term policy is likely to remain tight.

In essence, therefore, one can expect economies to be strong, politics to relax and inflation to disappear all at the same time. But this best of all possible worlds is far from the most likely.

The IMF’s Updated World Economic Outlook confirms a slightly more optimistic view of the economic future. Notably, global economic growth is forecast at 3.2% between the fourth quarters of 2022 and 2023, versus 1.9% between the same quarters of 2021 and 2022. That would be below the 2000-19 average of 3.8 %. However, given the huge shocks and surges in inflation, it would be a good result.

True, growth is forecast at just 1.1% in high-income countries over the same period, with 1% in the US and just 0.5% in the eurozone. But the UK economy is the only one in the G7 forecast to shrink this period, by 0.5%. The UK forecast for 2023 was also lowered by 0.9 percentage points. Consider it one of those “Brexit dividends”. Brexit is the gift that keeps on giving.

What draws attention in the projections, however, is the strength of emerging and developing countries. Their economies are forecast to grow by 5% between the fourth quarters of 2022 and 2023 (up from 2.5% in the previous period), with emerging and developing Asia growing by 6.2% (up from 3.4%). China growing 5.9% (up 2.9%) and India growing 7% (up 4.3%). China and India are forecast to generate half of global economic growth this year. If the IMF is really right, Asia is back in a big way.

The reopening of China and falling energy prices in Europe are seen as the most important reasons for the improved outlook. Global inflation is also expected to fall from 8.8% in 2022 to 6.6% in 2023 and 4.3% in 2024. The chief economist of the IMF, Pierre-Olivier Gourinchas, went so far as to say that 2023 “could very well represent a turning point”, with conditions improving in subsequent years. Above all, there is no sign of a global recession.

Risks remain weighted down, says the IMF. But downside risks have diminished since October 2022. On the upside, there could be stronger demand or lower inflation than expected. On the downside, there are risks of worse health outcomes in China, a sharp escalation of the war in Ukraine or financial turmoil. To this can be added other sticking points, not just Taiwan, but the risk of an attack on Iran’s nuclear weapons program that would trigger the bombing of Gulf oil fields.

Some might argue that the downside risks to growth in high-income countries are being underestimated: consumers may pull back as the funds they received during Covid run out. The opposite risk, however, is that the strength of the economies prevents inflation from coming down to the target quickly enough. Nominal inflation may have passed its peak. But, as the IMF notes, “Underlying (core) inflation has yet to peak in most economies and remains well above pre-pandemic levels.”

Central banks face a dilemma: Have they done enough to meet their target and anchor inflation expectations? If the Federal Reserve analyzed the optimism of the markets, it might conclude that it is not. But if you looked at the funds’ forecasts for US growth, you might conclude otherwise. These may not be disastrous, but they are weak. The same applies to the European Central Bank and, even more so, to the Bank of England when assessing their own savings. These central banks can reasonably wait to see how far their economies weaken before making their next moves. In fact, Harvard’s once-aggressive Larry Summers recommends just such a break.

The fact that the world economy appears to be a little stronger than was expected not so long ago is certainly a positive thing. However, for central banks (and investors) this also creates difficulties. The strategic objective of the former, after all, must continue to be to return the annual inflation rate to 2% and, in the process, firmly anchor expectations at that level.

The dilemma for central banks is whether today’s heightened optimism is consistent with achieving this strategic objective, while for investors it is whether the markets’ implicit view of how central banks will view this issue is correct. The analytical difficulty is trying to find out, in a world where there is an interactive “game” between central banks and economic actors, whether the former did just enough to deliver the necessary savings to bring core inflation to target, too much or too little.

Given the uncertainty, there is now a good case for adopting a wait-and-see position. But a crucial point is that, in an inflationary world, good news about economic activity today is not necessarily good for policy, and therefore for future activity, unless it reveals that the short-term trade-off between output and inflation is also favourable. In that case, central banks may relax policies sooner than previously expected. Otherwise, they will have to harden more than is expected today. At the moment, one can expect the first result. But it is still far from guaranteed.

Translated by Luiz Roberto M. Gonçalves

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