Over the next three to five years, we expect lackluster economic growth on average and persistently low inflation in the advanced economies. Labor market slack has been largely eroded in what will soon become the longest-ever economic expansion, supporting a further moderate acceleration of wage gains. However, the gradual diffusion of new technologies is likely to promote slightly faster productivity advances, which along with low inflation expectations should help to keep consumer price inflation in check and should broadly offset the damping impact of a slowing and aging labor force on potential output growth.
Our secular baseline continues to include a relatively shallow recession with a sluggish recovery in the advanced economies within the next three to five years. Deep recessions are usually
caused by a combination of major economic and/or financial imbalances and aggressive monetary tightening. Although not impossible, neither looks very likely in the next several years, especially after the Fed’s recent dovish pivot. However, with monetary and fiscal policy space limited especially in Europe and Japan, the next recession, while shallow, may last longer than usual.
Potential causes of the next recession in the advanced economies include an escalating trade war, a geopolitical shock, a significant increase in policy and political uncertainty, a spontaneous sharp correction in asset prices, or a sudden downturn in China. Importantly, with trend output growth in the advanced countries relatively low, it wouldn’t take much to push the economy into recession. Moreover, even a sharp economic slowdown that doesn’t lead to a full-blown recession may feel like one in financial markets when risk asset valuations are rich.
With inflation likely to remain below target almost everywhere, we expect the major central banks to keep policy rates at or below New Neutral levels for most of the next three to five years and – where there is room – to cut them preemptively when downside growth or inflation risks materialize.
A return to the zero lower bound for interest rates and renewed asset purchases look likely in the next recession, although their effectiveness will be limited due to already low or even negative term premia. Additional central bank tools to fight the next recession could include lower-for-longer strategies, such as average inflation targeting or temporary price level targeting, currently being discussed by the Federal Reserve, and yield curve control, which is already practiced by the Bank of Japan. However, as with asset purchases, we expect such policies to face diminishing returns.
Like monetary policy, fiscal policy is likely to be biased to prop up economic growth in the advanced economies over the secular horizon. Even absent a recession, populist pressures and low borrowing costs will incentivize many governments to raise spending and/or reduce taxes on consumption and lower income earners. Moreover, in the event of a downturn, limited monetary policy space and effectiveness will increase the pressure to use fiscal policy as a countercyclical tool, with the U.S. likely having more room for further fiscal expansion and less political sensitivity than Europe and Japan.
We also expect more steps toward more – implicit or explicit – monetary-fiscal cooperation in various forms over the secular horizon. Against this backdrop, budget deficits and public debt-to-GDP ratios are more likely to increase than decline in most advanced economies, but central banks will (continue to) help finance expansionary fiscal policy by keeping policy rates low and depressing bond term premia through asset purchases. Closer monetary-fiscal cooperation implies a partial loss of central bank independence and could pave the way for higher inflation toward the end of our secular horizon or on the supersecular horizon.
Geopolitics and trade policy are likely to remain a source of volatility for economies and markets over the secular horizon. In the U.S., a more aggressive stance on trade with China has gained momentum on both sides of the aisle. Europe’s and in particular Germany’s large trade surplus with the U.S. also make it a target for further tariff action. More generally, populist pressures in many countries are likely to promote protectionism and de-globalization.
China’s economic growth is poised to slow over the secular horizon given its adverse demographics, a likely continued focus on containing the buildup of further leverage and sustained trade frictions. As the Chinese economy rebalances away from exports and investment to consumption and opens up to capital inflows, the current account will likely move from surplus into deficit. At the same time, China’s move up the value chain in manufacturing will make it more of a competitor for high-value-added producers in Japan, Europe, the U.S., and Southeast Asia.
Our economic outlook for emerging markets is relatively benign, although potential shocks to global trade and domestic populism pose risks for the secular outlook. The negative shocks over the past five years (taper tantrum, dollar rally, commodity price plunge) have masked a trend improvement in external imbalances and balance sheets as well as domestic credit gaps. Also, EM currencies are competitive in most cases and monetary policy frameworks have become more credible. However, along with de-globalization, idiosyncratic political risks will continue to be a source of economic and market volatility and contribute to increasing differentiation within the EM universe.