Now for the hard part - Capital Economics
The Chief Economist’s Note

Now for the hard part

The return from summer holidays is a good time to take stock of developments in the global economy. The results are not entirely encouraging. 

The most obvious place to start is with the latest activity data which, generally speaking, point to a marked slowdown in the pace of recovery across the world’s major economies. This was evident most recently in US payrolls data for August. But everything from the manufacturing PMIs to data on retail sales have also suggested that growth has slowed over the summer. At some point, what can initially be dismissed as a series of unfortunate one-offs becomes a trend, and it’s now clear that recoveries in the US, UK, euro-zone and China have lost steam in recent months. All told, we expect GDP growth in advanced economies to slow from 1.7% q/q in Q2 to 0.8% q/q in Q3. And we think China’s economy may actually contract in quarter-on-quarter terms. 

A slowdown in growth was to some extent inevitable given that impressive rebounds in the first half of the year had left most economies either at or close to their pre-virus levels of output. The low-hanging fruit of this recovery has now been picked. But there is growing evidence that supply constraints are now weighing on activity in some goods sectors. This is particularly true of autos, where semiconductor shortages are continuing to constrain output. And the rapid spread of the highly-contagious Delta coronavirus variant has also played a part in slowing growth too. 

Delta effects have been particularly severe in countries where governments are still pursuing zero-COVID strategies, most notably China. The fact that the Delta variant has spread among highly-vaccinated populations has meant that governments in these countries have had to reinstate restrictions on movement in order to suppress transmission of the virus. The result has been a renewed hit to activity, particularly in COVID-sensitive parts of the service sector such as leisure and hospitality. 

Delta has also affected output – albeit to a much smaller extent – in countries with a less stringent approach to containing the virus, including the US and the UK. This is because, while governments have resisted reimposing new lockdowns, the surge in Delta cases has caused individuals to voluntarily adopt restrictions. If nothing else, this serves as a reminder that the ebb and flow of the virus will continue to have a significant bearing on the recovery, and means that there are likely to be more bumps in the road ahead. 

While the data on activity and output have surprised to the downside, the data on inflation have generally surprised on the upside. Inflation is now running above target in the US and the euro-zone, and is likely to breach its target once again in the UK over the coming months. Consumer price inflation in China has edged down (and is extremely low), but producer price inflation remains elevated.

Most of the increase in inflation can still be attributed to effects of the pandemic that are likely to be temporary. This includes a sharp rebound in global commodity prices, but also increases in the prices of everything from used autos to airline tickets and restaurant meals. The effects on measured CPI remain widespread but have been particularly acute in the US. 

The good news is that there are signs in the latest data from the US that we’ve passed the peak of pandemic-related “reopening” inflation. We continue to expect inflation in all major economies to drop back in 2022. The bad news is that digging a little deeper, there are some signs that underlying price pressures are building in the US. We’ll have more to say about whether the pandemic will presage a new era of higher inflation in a major series of work starting today. Keep an eye out for a series of CE Spotlight publications on the “Rebirth of Inflation” running between now and then end of the month,, and sign up for our week of online discussions starting 27th September here

All of this has created something of a headache for central bankers, who will be starting to detect a whiff of stagflation in the incoming data. This is made worse by the fact that they have fewer levers to pull to support output in the event that Delta concerns continue to rise. The history of COVID so far is that spending pivots from services to goods when pandemic fears escalate. Yet as I noted earlier, there is now growing evidence of supply constraints in goods production – thus making it more likely continued policy support in the face of renewed virus concerns pushes up prices rather than output. 

The bottom line is that central banks find themselves in an impossible situation – attempting to sustain economic recoveries in the face of Delta fears, while at the same time maintaining their commitment to monetary and financial stability against a backdrop of elevated inflation and high and rising asset prices. And, to compound matters, they’re doing all of this with a set of policy tools that have become less effective at supporting output in the real economy. 

The big question is what comes next. The most likely outcome is that the global recovery continues, albeit at a slower pace, that inflation peaks in the coming quarters before dropping back next year, and that central banks dial back policy support in a gradual and well-signalled manner. But compared to the start of the summer, the terrain that policymakers will have to negotiate has become significantly more difficult. 

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