The 2014 Economic Outlook
Editor's note: The following is an excerpt of an in-depth economic research report recently published by J.P. Morgan. To read the complete report, please visit www.jpmm.com or contact your J.P. Morgan representative.
Over the past year, the global economy completed the transition to a self-sustaining expansion. Early cycle vulnerabilities related to U.S. private sector deleveraging faded and the threats surrounding the U.S. public sector— from going over a fiscal cliff or missing a debt payment—were largely removed. At the same time, Euro area policymakers successfully bolstered their firewall to contain sovereign stress, removing an existential threat to monetary union. Japan, meanwhile, took a momentous step forward in beginning to right the corrosive damage inflicted by prior deflationary policies.
Overall we expect global growth to move higher and average 3 percent over 2014 and 2015," but "the return of above-trend growth is not a return to health.
Global growth returned to trend in the middle quarters of last year as these decisive policy actions lifted the Euro area and Japanese economies out of recession and significantly calmed financial market fears. Indeed, developed market (DM) GDP looks to have accelerated from an extremely weak 0.5 percent (4Q/4Q) pace in 2012 to an above-trend 1.8 percent pace in 2013. By contrast, the emerging market (EM) economies underperformed. Despite the 1.3 percent pickup in DM growth, EM GDP decelerated 0.4 percent to a below trend pace of 4.5 percent. This decoupling marks a break from the traditional "unit-beta" linkage between the two regions and reflects a range of headwinds holding back EM domestic demand. At their source, these headwinds—from tightening credit conditions, deteriorating terms of trade and a corporate profit margin squeeze—reflect the start of a necessary unwinding of excesses built up over the past decade.
Forecasting above-trend global GDP growth
As EM economies continue to work through their adjustments, the prospects for DM growth are improving. A positive policy impulse is in the pipeline as the fiscal drag in the U.S. and Western Europe abates. Meanwhile, the benefits of solid 2013 growth and continued accommodative monetary policy are bolstering confidence and risk appetite. The strength of the global economy over 2014 and 2015 will likely be determined by the balance between the lift these forces generate in DM private demand and the ongoing drags in EM. Overall we expect global growth to move higher and average 3 percent over 2014 and 2015, modestly above our estimate of a 2.7 percent global trend pace. Thus, the striking sustained EM-DM growth gap is a central theme—representing the first extended period of EM underperformance since the 1997 Asian crisis.
Growth leaders and laggards
While the Euro area is expected to see the sharpest acceleration, the U.S. and UK should grow fastest relative to trend. Japan will slow due to fiscal tightening and the Euro area lift will likely stall close to trend in the face of a still-fragmented financial system and an overly cautious European Central Bank. Although our forecast has EM growth stabilizing at a below-trend pace, there are important differences expected within the group. Those EM economies that are levered to DM demand should do well if they are less burdened by tight credit conditions. Leading this group are Mexico, Poland and Taiwan. China and Brazil are expected to lag as growth remains below trend.
Disinflation rotates toward EM this year
Disinflation played an important role in the global growth dynamic over the past year. Diminished pricing power in goods-producing industries contributed to the demand rotation away from business and toward consumers. Growth in capital expenditures looks to have stalled in 2013, while global consumer goods spending advanced at a solid 3.6 percent annualized pace as of October 2013. Regionally, the disinflationary impulse rotated demand toward the DM as EM producers were hurt most by weak goods demand.
We project the two-year global disinflationary trend to have ended but do not expect inflation to rise much in 2014. DM core inflation will move modestly higher as a result of the Japanese consumption tax hike and the fading of imported disinflation from EM. Perhaps more importantly, DM wage inflation is expected to firm this year, but this move should be fully offset by rising productivity gains. In EM, the fading of currency weakness and the lagged effects of slower employment gains on unit labor costs should lower core inflation where growth is to remain below trend. On balance, global inflation will remain below central bank objectives, absent natural or geopolitical shocks to commodity prices.
Calendar year 2013 ended with positive momentum, adding upside risk to our forecast for the year ahead. Based on the filtering of global aggregates, our nowcaster1 of global GDP growth is tracking 3.3 percent annualized for 4Q13, 0.4 percent stronger than our bottom-up official projection, and suggests activity expanded at a nearly 4 percent pace as of November, a full percentage point above our 1Q14 forecast. The recent news shows particularly strong signs that the manufacturing sector is accelerating and points to a broadening in the base of global growth to those EM economies most levered to the industrial cycle. It is also encouraging that the latest indicators on demand have been stronger in the United States. The combination of fading fiscal drags, strong corporate balance sheets, easy access to credit and rising wealth suggests that if upside risk materializes, the U.S. is likely to lead the way.
A broad deterioration in the global supply-side is a huge concern
As existential threats wane and the global economy strengthens, attention will increasingly focus on how underlying structures are evolving. While 2013 showed global demand finding its footing, the past two years have delivered another dose of supplyside disappointment. The soft patch pushed already depressed resource utilization rates lower. Relative to the pre-financial crisis path, the level of global GDP is nearly 5 percent below the level projected had potential growth been maintained at its 2006 level.
To differing degrees, policymakers have written off some of this shortfall as a permanent loss in output. Recent years have also seen weak global investment and slower labor productivity gains. Last year we reassessed U.S. potential growth—based on underlying trends in productivity and labor supply— and lowered estimates 0.5 percent to 1.75 percent. For the DM as a whole, our estimate of potential growth has fallen by a similar magnitude since the financial crisis and currently stands at 1.5 percent.
While estimates of DM potential growth have moved steadily down the past two decades, it is a more recent concern for EM economies. Over the previous expansion, the combination of reforms, global integration and strong growth generally led to rising potential growth estimates. This trend has reversed in recent years, however. Some of the slowing is due to dynamics surrounding the middle-income trap, as quick advancements through the adoption of DM technology run their course and demographic dividends from urbanization fade. Of more concern is the prospect of a protracted adjustment following a long period of rapid credit growth similar to the DM's recent experience. Our EM potential growth estimate has fallen a full percentage point over the past three years to 4.9 percent and is down 2 percentage points since 2005.
The writing down of potential output levels since the global recession serves to reduce economic slack estimates. In the EM, a decade of rapid growth produced tight labor markets and building inflation pressures from 2008 to 2011. Thus, the move in the EM output gap to near zero last year can be seen as part of a needed rebalancing. However, estimates of global slack remain considerable and have increased. Our current estimate of the global output gap is -2.4 percent. For the DM, the output gap is estimated to be -3.6 percent. To put this in perspective, more than four years into an economic expansion, estimated utilization rates in the DM stand as low as any time between 1970 and 2006.
There is hope: potential growth is a cyclical variable
Hope is not lost, however. A businesscycle regularity not well appreciated is that potential growth estimates are highly pro-cyclical. During periods of weakness, underutilized resources are incorrectly perceived to have been permanently idled and investment opportunities are underestimated. The current slide in potential growth estimates should thus not be viewed as invariant to change. A period of sustained above-trend growth has the ability to spark stronger capital spending, labor supply and innovation—developments that would keep inflation at bay while providing fuel for sustained above-trend growth.
The stakes are high. Permanently lower labor utilization would raise sociopolitical threats. The lower levels of income associated with them would make it far more difficult to service the large debt burdens built over the past decade. Congressional Budget Office estimates for the U.S. make this point starkly. Cumulated over a decade, a onepercentage- point lower average real GDP growth rate would add more than $3 trillion dollars to the U.S. federal deficit.
Poor supply-side performance would also shorten the interval to the central threat to the current expansion: that inflation pressures build, prompting the inevitable stresses associated with normalizing monetary policy stances following a long period of easy money. The mid-year interaction of Fed tapering talk and shifting market expectations on the path of U.S. policy rates in 2013 provided a sense of the potential problems that lie ahead. Not surprisingly, EM countries where economic activity was most levered by a long period of easy access to global capital came under the most stress. The Fed is working hard to relieve this pressure by taking greater care to delink the end of its asset purchase plan from the normalization of policy rates. But these pressures will undoubtedly arise once again.
G4 central banks feel pressure to help improve supply-side performance
There are significant opportunities for structural changes that can boost an economy's potential. With ample slack, accommodative fiscal policy could be used to try to bring demand back to its full employment level. Governments can also consider reform of financial and tax policies, labor markets and international trade in order to promote stronger capital deepening, labor supply and technological change.
However, high debt burdens and a fractured political backdrop in the DM limit the role of government as an agent for structural reform. Consequently, the weight on central bankers' shoulders is heavy. Before the financial crisis, monetary policy was geared toward achieving an inflation objective while stabilizing temporary shocks buffeting growth. Aggregate supply dynamics were generally viewed as exogenous once the effects of nominal rigidities faded away. But there is growing concern that part of the deterioration in aggregate supply in recent years is linked to the persistent weakness in demand. Sustained slow demand growth shifts the willingness of firms to invest. At the same time, a persistent demand shock can erode the skills of the long-term unemployed and affect the attachment of workers to the labor market. There are also arguments that the depressing effects of weak demand could harm innovation by lowering the rate of start-ups and research and development.
There are significant opportunities for structural changes that can boost an economy's potential.
Unfortunately, stretching the limits of monetary policy to induce a positive supply-side outcome comes with a number of potential costs. These ultimately relate to the risk of letting inflation and inflation expectations rise. The lessons from the 1960s and 1970s—when central banks failed to recognize a drop in potential growth, allowing a wage-inflation spiral to ensue—remain engrained deeply in current central bank thinking. Similarly, the financial instability owing to the reach for yield associated with easy money raises considerable concern, and one need not have a long memory to recognize the costs of having allowed the credit bubble to form over the past decade.
In the end, balancing the costs and benefits of these unorthodox policies is not easy. A Federal Reserve Board research paper that considered the implication for monetary policy of blurring the lines between supply and demand shocks highlights that the stakes are high and the choices facing monetary authorities are complex as they venture into uncharted territory:
Taken alone, the possibility that potential output will be affected by adverse demand shocks through hysteresis-like effects leads optimal monetary policy to be more activist, in order to mitigate the possible damage to the current and future supply side of the economy. However, other considerations may militate toward restraint in the conduct of monetary policy; these considerations include concerns about the unintended effects an unusually aggressive monetary policy might have on financial stability or the dynamics of inflation. Thus, in an uncertain world, a policymaker's choice of policy will depend not only on the extent to which he or she believes a demand shock is likely to affect potential GDP and employment, but also on his or her view of the risks associated with actively trying to offset these adverse supply-side developments through accommodative monetary policy.2
A coalition of the willing to experiment
Though varied in degree, G4 central banks have been moving in the direction of a more activist approach to support supply-side developments. They are using their balance sheets and forward guidance to signal a delay in the policy normalization process beyond the point suggested by the precrisis reaction function. This approach is not motivated by a certainty that stronger demand growth will elicit better supply-side performance. Rather, it is based on a willingness to experiment with the growth/inflation trade-off in an environment where the need to improve supply conditions is recognized as critical.
1In late 2012, the firm added the J.P. Morgan nowcaster to its toolbox of global economic indicators. This indicator provides the most current reading of global economic growth based on a statistical filtering of our latest global economic aggregates. The resulting index provides an estimate of monthly global GDP growth, a concept previously unavailable. It also provides a way to quantify the impact of incoming information on our forecast of GDP growth.
2 Dave Reifschneider, William Wascher and David Wilcox, Federal Reserve Board, "Aggregate Supply in the United States: Recent Developments and Implications for the Conduct of Monetary Policy," November 1, 2013, www.imf.org