So far, our upbeat base case for the global economy is looking good
Back in November, we asked "What could possibly go wrong," when we described our upbeat base case for the global economy. So far, our optimism has proven well warranted. We have upgraded our economic growth forecasts for the United States, the Eurozone and the world economy as a whole.
In the U.S., we now see 2.6% growth for 2018. Since November, tax cuts and further deregulatory measures have helped boost business sentiment. The latest U.S. fiscal stimulus is quite unique coming so late in the economic cycle and at a time of near full employment. A sustained uptick in investment or consumer spending would increase overheating risks. For now, relatively low capacity utilization suggests that inflation inertia is likely to persist well into 2019. Inflation expectations have been rising but are still at moderate levels. It also remains to be seen how much tax cuts and further deregulation might boost potential growth in the medium term.
It is a similar story in Europe, where we have upgraded our Eurozone growth forecast to 2.3%, well above potential. On both sides of the Atlantic, we see inflation only slowly grinding upwards. Against this backdrop, we expect both the Fed and the European Central Bank (ECB) to remain fairly cautious. For the Fed, we expect three more rate hikes through March 2019. Meanwhile, the ECB will probably not start raising rates for at least another year. However, we do expect it to end its quantitative-easing measures in the fourth quarter of 2018.
Emerging-market growth looks solid, on the back of a strong global economy, increased domestic demand and reform momentum in key countries. Notably, political uncertainty has decreased in China, following the 19th Party Congress. Politics is also one of two potential sources of risk we are watching closely. The other, related one concerns financial markets.
Rising geopolitical tensions have long played a perhaps surprisingly minor role in both market perceptions and business sentiment. For much of the first year of the Trump presidency, it looked as if the new Republican administration might actually prove quite conventional, in terms of its economic priorities. Since then, personnel changes and major policy announcements via Twitter have repeatedly caused market jitters. For now, we remain fairly confident that major blunders, such as an escalating trade war between the U.S. and China, will be avoided.
The trade measures announced so far should only have a very moderate impact on overall economic activity. From the outside, they look more like negotiating tactics. China appears to be ready to talk. Things would clearly be different if trade frictions resulted in global supply chains coming under threat. Both sides have much to lose, giving them plenty of incentives to avoid such an outcome. Trade wars are never good and rarely easy to win. Even mere threats risk undermining the rules-based global trading system further. It is likely to take years rather than months, however, for the impact to start to appear in the economic data.
A more immediate issue could be a return of instability in markets spilling over to the real economy. This could take various forms, including concerns over rising deficits. However, the real problem may be less attention-grabbing than some kind of fiscal crisis. The more the government borrows during times of full employment, the fewer the available resources for other, potentially more productivity-enhancing things. Interest rates rise, and growth of the nation's capital stock slows. This limits the scope for fiscal stimulus during the next recession.
All of these look more like medium- or longer-term threats than like causes for concern during the next twelve months. As my colleagues describe on the following pages when looking at the various asset classes, the underlying picture in terms of corporate earnings, for example, remains strong. And any sudden deterioration in financial-market conditions would probably be muted and eventually reversed by central banks once again coming to the rescue. For now, the outlook continues to be reassuringly solid.
Outside of wartime, it is virtually unprecedented to see rising U.S. federal deficits of this magnitude at a time of near full employment.
For almost two years, breakeven inflation rates, as derived from inflation-linked securities, have been rising in both Germany and the United States.
