By Andrew Sentance, Senior Economic Adviser – Cambridge Econometrics & Former MPC Member
At the beginning of this year, there was a lot of optimism about prospects for the global economy. In January, the IMF was forecasting global growth of 4.4 percent, above its longer-term average of around 3.5 percent. The world’s major economies were bouncing back from the pandemic and the resulting lockdowns. Inflation was picking up but the rise was expected to be short-lived.
Over the past couple of months the outlook has darkened. Economic growth forecasts are being rapidly revised down and inflation projections are being pushed up. The forecasts announced by UK Chancellor Rishi Sunak in his recent Spring Statement show this very clearly. Projected 2022 economic growth has been revised down from 6 percent last autumn to 3.8 percent. The expected peak for inflation this year has doubled – ratcheting up from 4.4 percent to 8.7 percent.
Similar adjustments are taking place for the forecasts in many other countries. Even China – which is normally very optimistic about its economic outlook – has set its lowest growth target for 30 years. Meanwhile, the global inflation surge is already showing up in major economies around the world. US consumer price inflation has hit 7.9 percent, in Germany prices are up 7.6 percent on a year ago, and in Spain the latest figure is a staggering 9.8 percent.
The impact of the Russian invasion of Ukraine is clearly a major factor here. The oil price rose briefly to around $140/barrel. Even though they have since settled back to around $100/barrel, this is significantly above the $60/barrel we saw around this time last year. Gas prices have risen sharply. Meanwhile, food and other global commodity prices have been pushed up.
Wheat prices hit a record high in March with the expectation that exports from Ukraine and Russia would be severely disrupted. In the UK, the price of a humble takeaway meal of fish and chips has been pushed up sharply as fish supplies from Russia are cut back sharply and other food and energy prices have risen.
But the Russia-Ukraine conflict is not the only factor at work raising inflation. The bounce-back from the pandemic has put upward pressure on inflation in many ways – as demand has exceeded supply in many markets. Supply chains have become stretched leading to cost increases for manufacturers. And labour markets have tightened in many countries, resulting in upward wage pressures.
Recent research by my colleagues at Cambridge Econometrics has highlighted three main ways in which the surge in global energy prices is affecting major economies.1 First, it is hitting consumer spending through the “cost of living” squeeze on households. Though wages may be bouncing back from the pandemic, they cannot keep pace with inflation rates approaching double-digit levels. So there is an inevitable squeeze on real household incomes. While better-off households may be able to dip into savings to maintain their spending, poorer households are not able to do so.
The second area of impact is on trade flows. Big shifts in energy and commodity prices create winners and losers across the global economy. Generally, the producers of oil, gas and other commodities will benefit from higher prices and consuming countries will face higher import costs, potentially displacing imports of other products. However, this is complicated by the impact of sanctions on Russia, which will clearly take a heavy economic toll. The Centre for Economic and Business Research calculates that the current sanctions in place will cut Russian GDP by 14 percent.2
The third impact on the global economy could be more positive for economic activity. With Western countries seeking to cut back on energy supplies from Russia, and oil and gas prices remaining high, there will be a strong incentive to invest in alternative sources of energy. That will include investment in sources of oil and gas outside Russia, including shale oil in the US, UK and other western countries. There will also be an incentive to invest more heavily in renewable energy resources, which will be a positive development from perspective of meeting the global environmental challenge of climate change.
Taking all these impacts together, however, we cannot escape the broad conclusion that the developments of the past few months mean a period of weaker economic growth and significantly higher inflation. That creates a dilemma for both monetary and fiscal policy.
Central Banks have been caught unawares and now face the challenge of rapidly reversing the stimulatory policies adopted in response to the pandemic. However, they must strike a balance between the need to tighten policy in response the threat of inflation and the risk of destabilising the growth path of the economy.
Gradual interest rate rises and a cautious approach to unwinding Quantitative Easing (QE) still seem the best course of action. By consistently and gradually raising interest rates – and communicating this policy clearly to the public and the markets – Central Banks will be signalling that they are committed to heading off a longer and more sustained surge in inflation.
On the fiscal policy front, the dilemma is between the objective of moving the public sector finances to a more sustainable position and taking steps to ease the cost of living squeeze from soaring energy prices – particularly on poorer households. But while there needs to be a long-term plan to bring government borrowing down gradually, there is no urgency about the timing of this reduction.
Governments in most Western economies are still borrowing very easily at low rates of interest, and still maintain the confidence of financial markets. There is no need to target budget surpluses or aggressive debt reduction with short-term tax rises. A long-term fiscal programme of deficit reduction and tax reform can safely be implemented over a number of years (eg 5 years or longer).
In terms of both monetary and fiscal policy, policy-makers around the world need to take a gradualist approach to countering the current inflation surge in the face of a weakening global outlook. That would be better than the alternatives of a kneejerk aggressive tightening of policy – which could trigger a recession – or neglecting the rise in inflation, and then having to take much more dramatic policy action later this decade.