August 2023
What is going on with the global economy? The analogy of a plane and whether it would experience a gentle landing or a rough one is frequently used to illustrate the state of the world economy.
Pilots frequently give the image of not knowing how to fly or where they are going, it might be wiser to suggest tighten your seatbelts and prepare for turbulence.
Concerns regarding growth have become more prominent. This is clear from recent market activity, which has seen bond yields increase and equity markets decline.
It was noted in the US Federal Reserve’s minutes that were made public last week. They demonstrated the anxiety some authorities felt about tightening up the monetary system. Here, these issues are considerably more pressing.
A recession in Western economies was generally anticipated at the beginning of the year. This has not come to pass. Although lower inflation would increase purchasing power, where interest rates and bond yields end up will have the biggest impact on growth.
The risk is that because of the credit crisis, stringent lending requirements, and more risk-averse capital market climate, businesses may find it more difficult and expensive to borrow cash. This already has some obvious elements.
A good barometer of consensus thinking is the economic forecasts from the International Monetary Fund. In late July, they forecast that global growth would slow from 3.5pc last year to 3pc this year and next. This is incredibly weak.
Furthermore, the fact that Asia is predicted to account for two-thirds of global growth this year helps to explain why the recent bad economic news from China has caused such anxiety.
There is currently fear about deflation in China as some prices are declining. Low inflation, though, is more probable. If both prices and output are declining, it is more acceptable to consider a deflationary environment, which China is not now experiencing.
China has made a considerable transition to an economic policy based on dual circulation. After President Trump’s trade war with the US, China aimed to become self-sufficient in things like food, fuel, and technology. The most recent trade sanctions, started by the US and adopted by others, are ineffective.
Even in the best of circumstances, such a structural transition would have been difficult, but it has coincided with a more cautious policy climate, both to control inflation, which China has done well, and to control the debt overhang, which is proving to be more difficult.
China’s future growth rate will be slower and more unpredictable than in the past as a result of future population decline. Not panicking is the moment, but recognizing such a systemic change is. In addition, there is evidence of strong private sector activity elsewhere in Asia, and Japan, the third-largest economy in the world, is currently experiencing an economic recovery.
The longer-term forecast for global growth is one I find encouraging. However, it is important to take seriously any worries about short-term growth, especially since the full effects of the normalization of monetary policy in Western economies have not yet been felt.
Western economies have experienced cheap money for a dozen years prior to two years ago. This consisted of central banks creating money as if it were out of style and keeping policy rates too low for an extended period of time. Central banks’ balance sheets surged. Money was readily available and affordable. Liquidity was available everywhere.
Cheap money caused asset price inflation, enabled markets to underprice risk, resulted in a capital misallocation that enabled zombie companies to survive, and it also fed the recent spike in inflation.
Those countries that adopted a prudent approach to monetary policy are in a far better position to act now. These were largely in the so-called emerging economies. For instance, in recent weeks, Chile and Brazil have been able to cut interest rates. They had sensibly tightened policy before the recent surge in inflation and so are now able to ease policy to head off economic weakness.
China, too, cut interest rates last week, and while that action was in response to a slowing economy, its ability to ease was because of its previous prudence.
There is currently a legitimate worry that policy rates in the US, UK, and euro area will rise excessively. Even when interest rates reach their highest point, central banks will continue to tighten policy by reducing their balance sheets through quantitative easing. This does not support growth very effectively.
Although I would not tighten any further, it is important to prevent a return to cheap money. Therefore, policy rates may need to stabilize at a high level in the future.
It is uncertain how markets will react to this. It has already raised the query, “What exactly qualifies as a risk-free asset?” This was how people perceived government bonds. A third of all government bonds traded with negative yields during the pandemic, making them appear to investors to be genuinely safe investments. In essence, borrowing was being rewarded by governments.
Government bonds have seen negative total returns over the last three years as a result of inflation, rising policy rates, and tighter global liquidity. You would have suffered financial loss if you had purchased this sanctuary.
With the advent of shadow banking, financial markets have changed since the global financial crisis of 2008. According to the Financial Stability Board’s most recent study, the size of this increased to $485 trillion by the end of 2021. I agree, trillion. And about half of this, or $239 trillion, was provided by non-bank financial firms.
This system is supported in large part by collateral, which frequently takes the form of high-quality debt such as bonds issued by the government. If this asset’s status as a safe asset is currently under scrutiny, it signals increased financial instability as well as increased risk aversion, which would inevitably result in tighter global liquidity circumstances. Thus, stabilizing policy rates and yields may become crucial.
The emphasis is now on growth rather than inflation. I predict that the financial markets will thereafter turn their attention to debt. Global public and private debt levels are high, which restricts policy flexibility and exposes many people and businesses to a prolonged period of high interest rates. Keep your seatbelts snug.
