Central bankers face big messaging test as strains of recovery show - Capital Economics
The Chief Economist's Note

Central bankers face big messaging test as strains of recovery show

One important point that’s easy to miss in the ebb and flow of the monthly data is just how quickly the global economy has rebounded from the COVID crisis. Global GDP fell by just over 10% between Q4 2019 and Q2 2020 – the biggest decline in recorded history. But it returned to its pre-virus level in the second quarter of 2021, just one year later, and is now more than 5% above this level. Chart 1 illustrates just how remarkable this turnaround has been by showing the path of GDP of several major advanced economies during the pandemic alongside the global financial crisis. The picture that emerges is clear: the COVID recession was much sharper than previous recessions, but also much shorter. 

Chart 1: Real GDP (Pre-Crisis Peak = 100)

Sources: Refinitiv, Capital Economics

There are two reasons why this was the case. The first has to do with the nature of the crisis itself. Recessions are normally caused by a collapse in aggregate demand. The most damaging recessions tend to have their roots in the bursting of asset price bubbles, particularly housing, and come against the backdrop of high levels of leverage. This bursting of the bubble causes a sharp and sustained contraction in aggregate demand as households, firms and banks are forced to retrench and repair their balance sheets. 

In contrast, the pandemic recession was caused by the imposition of restrictions on movement and activity in order to limit the spread of the virus. In other words, it had its roots in the supply side, rather than the demand side, of economies. Accordingly, once restrictions were lifted and economies re-opened, output rebounded. Unlike in the global financial crisis, banks have remained in good shape, credit to the economy has continued to flow and household balance sheets have emerged from the crisis in better shape than they went into it. Underlying demand conditions have remained strong. 

This has been made possible by the second factor that explains the rapid rebound: the size and nature of policy support. Much has been made about the scale of policy support in the wake of the pandemic. Central banks slashed interest rates and restarted asset purchase (or QE) programmes, and governments put in place huge fiscal support packages. Total global fiscal stimulus in the wake of the financial crisis in 2009-10 amounted to around 2% of world GDP. In contrast, fiscal support in the wake of the pandemic was equivalent to 12% of GDP. In the US, it was closer to 25% of GDP. 

But an equally important point that tends to get overlooked is that monetary and fiscal policy worked together during the pandemic in a way that didn’t happen in the aftermath of the global financial crisis. The Fed was the first major central bank to begin a programme of QE in late-2008, during which fiscal policy in the US was expansionary. But at a global level, most asset purchases took place between 2010 and 2013, which was a period in which fiscal support was being withdrawn by most governments. 

In contrast, during the pandemic, central banks’ purchases of government debt came alongside an expansion of fiscal policy. Accordingly, the money created by central banks made its way into the real economy rather than getting gummed up in the financial system. The result has been a surge in demand at the point when supply has opened back up, thus creating the rapid rebound in overall output. 

The flip side of this rapid rebound in demand is that economies are now running into supply constraints. Some of these shortages, for example in semiconductors, are likely to ease over time as supply adjusts, although this is likely to take another 6-12 months to work through. More worryingly, some shortages – particularly in the US labour market – may be longer lasting. As a result, while headline inflation is likely to fall in every major economy next year, underlying price pressures will build in countries where the demand/supply imbalance is most acute. This is especially the case in the US, where we expect core inflation to remain above the Fed’s 2% target throughout our forecast horizon. 

The response of central banks – and how this is communicated to markets – is now crucial. Until now, central banks have accommodated this year’s surge in inflation on the basis that it has been driven by factors that are likely to be mostly transitory. In the case of the Fed, that has been made easier by the adoption of a new Flexible Average Inflation Target. But the increase in core price pressures will test this new, more tolerant, approach to inflation. 

The focus in recent weeks has been on when central banks around the world might start to lift interest rates from their current record lows. But the more important question for markets is how much policy might ultimately be tightened by and, related to this, how effectively central banks message their intentions.

As our Chief Markets Economist, John Higgins, argued earlier this month, sky-high valuations do not necessarily imply there is a bubble in the equity market if one believes that real interest rates are likely to remain at ultra-low (negative) levels for several years to come. Asset markets, including equities, may take a modest increase in real interest rates in their stride, particularly if it comes against the backdrop of a strong macroeconomy. But if markets start to believe that central banks have fallen behind the inflation curve, expectations about the future path of real rates could shift suddenly. Were this to happen, a much bigger shake-out in asset markets would surely follow. 

In case you missed it:

  • Our Senior US Economist, Andrew Hunter, argues that the Build Back Better programme is likely to provide only a moderate boost to economic growth over the next year.
  • Our Senior China Economist, Julian Evans-Pritchard, argues that Chinese property sales may soon start to bottom out – but that the construction downturn has further to run.
  • We’ve brought together all of our analysis of Turkey’s currency crisis in one place – you can view it here.