In the depths of last summer’s global recession, we made the case for optimism about the economic outlook. Where the prevailing consensus was that the pandemic had dealt permanent damage to GDP, we argued that this downturn was unlike others: COVID-19 may change everything from how we work to the size of government, but it will have only a limited lasting effect on output. In the jargon, the “economic scarring” from COVID would be small. More than a year on, this view looks prescient. Our estimates show global GDP returned to its pre-crisis level in March of this year and, based on the third quarter GDP data released so far, is now running at around 1% above its pre-crisis level.
Of course, simply returning to pre-COVID levels of GDP is not the same as there being no economic scarring. What matters in this regard is GDP relative to trend, and on this measure, the global economy is still running at around 4% below its pre-COVID path. But this shortfall is due in large part to extremely weak recoveries in a handful of large emerging markets, particularly India and Indonesia. Most developed economies are much closer to their pre-COVID trends and there is now a growing acknowledgment that the long-term hit to GDP in these countries will be small compared to previous crises.
In the UK, the Office for Budget Responsibility revised down its scarring assumption to 2% from 3% in last month’s Budget. The Bank of England now thinks scarring will be just 1%. To put these estimates in perspective, the global financial crisis caused a permanent hit to UK GDP of more than 10%. Viewed in the context of the 25% peak-to-trough fall in GDP that the UK suffered during the early stages of the pandemic, the various scarring estimates by policymakers now look like rounding errors.
Stepping back, while some emerging economies are likely to suffer economic scarring as a result of COVID, the evidence so far suggests that scarring in most advanced economies will be relatively modest. The contrast with the global financial crisis is stark. (See Chart 1.)
Chart 1: Global GDP (Constant Prices, 2018 = 100)
Sources: Refinitiv, Capital Economics
However, despite our relative optimism about the long-term effects of the pandemic on GDP, the hardest part of the recovery still lies ahead. Having been too gloomy about the prospects for recovery over the past year, consensus forecasts for 2022 now look too optimistic.
For one thing, the brake on growth is increasingly coming from the supply side rather than the demand side of economies. The raft of business surveys released last week provided the latest evidence of this, with firms reporting shortages of everything from workers to raw materials and that supplier delivery times lengthened further. (See Chart 2.)
Chart 2: Manufacturing PMI Supplier Delivery Times
Sources: IHS Markit, Capital Economics
This poses a substantial challenge to governments and central banks. Weak demand can be combated by dialling up fiscal and monetary support, but supply constraints are more difficult to remedy. For a start, policymakers must separate those shortages that are likely to be temporary – for example due to frictions around reopening economies – from those that are likely to be more persistent, such as workers having left the labour force, or permanent shifts in the demand for different goods and services caused by the pandemic.
The response to the former should be to step back and let the market do its work. The solution to the latter lies in a complex web of policy measures, covering everything from labour market reform to investment to repurposing commercial property. But even if policymakers formulate the optimal policy response, it will take time for the supply side of economies to adjust. Labour and goods shortages are likely to persist in some form for the next year.
There is an associated risk that over-stimulating demand against a backdrop of constrained supply leads to higher inflation. Admittedly, most of the rise in inflation this year can be chalked up to factors that will prove temporary. We estimate that around six-tenths of the rise in inflation in advanced economies since the turn of the year can be attributed to a rebound in energy and food prices, with a further one-tenth due to what we’ve called “reopening inflation” (for example a rebound in airfares).
The upward pressure on headline inflation from these sources should ease over the next year. But underlying price pressures are also starting to build in some places as supply constraints bite. This is particularly true in the US. The recovery in GDP to pre-crisis levels justifies the removal of emergency policy support in most economies but, as I noted last week, calibrating this withdrawal will be fiendishly difficult.
Three points stand out from all of this. First, GDP growth in the world’s major economies is likely to be weaker than most expect over the next 12 months. This is especially true of the US and China. Second, while inflation is likely to drop back next year, it is likely to fall at a slower pace than most currently anticipate and will remain elevated in several countries. Once again, the US stands out in this regard. Finally, while central banks are likely to withdraw emergency levels of policy support, interest rates are likely to rise at a slower pace than markets are currently pricing in.
What emerges is a complex picture that is considerably less benign than the consensus forecast suggests. What’s more, all of this is without considering the significant tail risks that are bubbling under the surface. Asset prices across the globe are stretched and vulnerable to a sudden upward shift in interest rate expectations; the authorities in China appear to have contained the immediate financial spillovers from the problems at Evergrande, but the country’s property downturn is accelerating and could in time lead to renewed financial stability risks; and although bonds spreads between Germany and Italy have since narrowed, the blowout in spreads following last month’s ECB meeting is a reminder of the fragilities that still exist at the heart of the eurozone.
The recovery so far has been impressive. But we’re in a more challenging environment and the optimists are risking disappointment.
PS: Our new Central Bank Hub provides Capital Economics clients with a one-stop-shop for our central bank coverage, including access to our latest research on major DM and EM authorities, a table of policy rate forecasts out two years and a curated research archive on longer-term changes in monetary policy-making.