For the past three quarters, global GDP growth has been running well above trend, displaying sustained momentum across both developed markets and emerging markets. Morgan Stanley Research believes that trend may continue in 2018, with global GDP growth forecast to be nearly 4% this year, up from the trough of 3.1% in 2016.
However, this acceleration in growth—particularly across the G3 economies of the U.S., Japan and the EU—has yet to translate into higher core inflation. As of the end of 2017, core inflation in these regions remained well below their respective central banks’ target and was either close to or below the levels at the start of the year.
However, we think that the inflation dynamic will shift decidedly in 2018.
This year, we project a rise in core inflation towards central banks’ targets. While structural factors such as technological change-related disruptions and globalization will put a cap on underlying price pressures, the strength of cyclical factors will outweigh the structural factors, in our view.
Our confidence is shaped by the following three observations:
1) A shift from weak aggregate demand to synchronized and self-sustaining recovery
Significant economic slack emerged in major developed markets (DM) since the global financial crisis and in emerging markets (EM) following the macroeconomic adjustment in 2014-16. During 2012-16, the global economy was undergoing a period of demand deficiency and, reflecting this, global growth averaged a sub-par 3.3% over this period.
During the last four quarters, the underlying global growth dynamic began to shift. As the private sector in DMs has moved decidedly out of the deleveraging phase and EMs are now in a recovery phase, global growth has become synchronized and accelerated above trend.
Moreover, risk attitudes and returns expectations in the private sector have improved. This is best reflected in accelerating private sector credit demand growth in DMs and also in the synchronous recovery in capex growth, which has already led to an upside surprise in GDP growth relative to our forecasts in recent quarters.
Our DM investment tracker in 4Q17 suggests that investment growth has likely picked up further. While we have already nudged up our GDP growth forecasts by 0.1pp to 3.9% for 2018 and 3.8% for 2019, following U.S. tax reform and an implicit upward revision to investment growth, the capex recovery in 2018 may turn out even stronger than what we pencil in currently.
2) A negative to positive feedback loop and spillover effects
In 2012-15, there was significant economic slack in DMs, reflected in still meaningful unemployment gaps. In addition, the EM growth shock led to a widening in EM output gaps during 2014-16. In combination, these factors formed a negative feedback loop, which reinforced disinflationary pressures, as they transmitted via trade linkages, FX and weaker commodity prices.
However, there is evidence that this trend is shifting towards a positive feedback loop. Unemployment gaps in DMs have largely closed and wage growth is accelerating, which should contribute to a gradual rise in core inflation. In EMs, GDP growth has picked up, from 3.6% in 3Q16 to 4.4% in 3Q17, leading to a reduction in excess capacity and bottoming of inflation.
Most notably, the impact of the supply-side reforms in China is demonstrated in producer prices moving out of deflation on a sustained basis. Finally, oil and commodity prices have begun to rise more recently, which is transmitting to higher headline inflation.
3) Rising inflation expectations
Survey-based measures of inflation expectations across G3 regions have improved recently. In some ways, this has been supported by a narrowing gap between actual inflation outcomes and their 20-year averages. In 4Q15, headline inflation in major DMs and China was on average 100 basis points below the long-term average, while in 4Q17 the gap had narrowed to 10 basis points. Our forecasts suggest that by the end of 2018, inflation will be, on average, 30 basis points above the long-term average across countries.
Against this backdrop, we project a meaningful rise in G3 core inflation. Indeed, in the euro area and Japan, our core inflation forecasts are above consensus for 2018, penciling in an increase to 1.6% and 1.1% at year-end, respectively.
On the other hand, while our forecasts for U.S. core inflation at 1.7% are largely in line with consensus expectations, we see upside risks due to tax reform. Indeed, given the shifts in the global macro dynamic, we think that the risks to the consensus forecasts are shifting to the upside.
Get ready for a shift in central banks’ rhetoric
As inflation picks up, central banks will likely shift towards a more hawkish tone. We expect the Fed to continue to lift rates while the European Central Bank and the Bank of Japan shift their rhetoric in a more hawkish direction in preparation for an eventual tightening.
As the global macro environment transitions from the high growth, low inflation environment that prevailed in 2017 towards a high growth, rising inflation and hawkish central bank rhetoric environment in 2018, asset markets are likely to face greater volatility over the course of 2018 as a whole.
Adapted from a recent edition of Morgan Stanley Research’s “Sunday Start” (January 21, 2018) series.