01 July 2024

BIS Annual Economic Report: So far, so good

Challenges remain. The recent stickiness of inflation in some key jurisdictions reminds us that central banks' job is not yet done. Financial vulnerabilities have not gone away. Fragile fiscal positions cast a shadow as far as the eye can see.

So far, so good. The world economy appears to be finally leaving behind the legacy of the Covid-19 pandemic and the commodity price shock of the war in Ukraine. The worst fears did not materialise. On balance, globally, inflation is continuing to decline towards targets, economic activity and the financial system have proved remarkably resilient, and both professional forecasters and financial market participants see a smooth landing ahead. This was by no means a given a year ago. It is a great outcome.

Still, there is a "but". Challenges remain. The recent stickiness of inflation in some key jurisdictions reminds us that central banks' job is not yet done. Financial vulnerabilities have not gone away. Fragile fiscal positions cast a shadow as far as the eye can see. Subdued productivity growth clouds economic prospects. Beyond the near term, laying a more solid foundation for the future is as difficult as ever. It could not be otherwise: it is an arduous task that requires a long-term view, courage and perseverance.

As is customary, this year's Annual Economic Report (AER) takes the pulse of the global economy and explores policy challenges. It also devotes particular attention to two issues. Looking back, it reflects on the lessons learned so far from the conduct of monetary policy in the tumultuous first quarter of the 21st century. Looking forward, it examines the opportunities and risks associated with the rise of artificial intelligence (AI).

The year under review

In the year under review, the global economy made further progress in absorbing the huge and long-lasting dislocations caused by the pandemic and Russia's invasion of Ukraine.

Inflation has continued to decline from its peak in 2022. Both headline and core inflation kept moving down for much of the period under review. The rotation in the contribution to inflation from goods to services proceeded further, as commodity prices edged down while services price growth proved stickier. By the end of the period, inflation had come down substantially further: monetary policy had delivered (see below). At the same time, although it was more subdued in places, particularly in Asia, it was still hovering above central bank targets across much of the world. There were signs that the decline had become more hesitant in some key jurisdictions, notably the United States.

Economic activity held up surprisingly well, indicating that a "normalisation" in both demand and supply had helped disinflation. Employment remained unusually buoyant in relation to output, supporting demand further in the near term. Households again dipped into savings accumulated during the pandemic. The lingering effects of extraordinarily generous fiscal support, and in some cases additional fiscal expansion, boosted activity. Having borrowed at longer maturities and at fixed rates, households and firms were partly shielded from higher interest rates and the burden of debt.

The resilience of the financial system and financial market sentiment underpinned activity. There were no renewed serious banking strains à la March 2023. And while banks were rather cautious in granting credit, conditions in financial markets remained quite easy. Equity prices rose, with those in the technology sector reaching heady heights, and bond spreads remained quite narrow by historical standards. For much of the period, buoyant investor sentiment reflected eager expectations of an immediate and substantial easing of monetary policy that did not materialise.

Against this backdrop, the most intense and synchronised monetary policy tightening in decades gave way to a somewhat more differentiated picture, in line with the growing differences in domestic inflation outlooks. Central banks prepared the ground for easing, such as in the euro area and much of Asia, or made the first cuts, such as in some countries in Latin America, where policy had been tightened ahead of the rest, and in Asia. The People's Bank of China eased further in response to weak domestic conditions and given subdued inflation. In Japan, the central bank finally exited the negative interest rate policy era and abandoned yield curve control while retaining an accommodative stance.

This more differentiated picture has raised the prospect of larger interest rate differentials and pressures on currencies. In particular, following the latest monthly inflation readings in the United States, financial market participants expect greater divergence in policy rate trajectories, especially between the Federal Reserve and other central banks. This has reinforced a broad-based dollar appreciation, which has been especially marked vis-à-vis the yen. The appreciation has already elicited policy responses, including in some cases foreign exchange intervention or adjustments in the policy stance. And it has raised broader questions about the impact on capital flows and financial markets.

Pressure points and risks ahead

Looking ahead, the central scenario painted by professional forecasters and priced in financial markets is a smooth landing. Price stability is restored, economic growth picks up, central banks ease, and the financial system remains strain-free. Compared with past expectations, which were generally that a significant economic slowdown could be required to lower inflation, this is an impressive outcome. That said, risks persist. Some are more near term, others further out. Some reflect an incomplete adjustment to the pandemic dislocations, others longer-standing weaknesses. To varying degrees, they all stem from the same root cause analysed in previous AERs: the pandemic hit a global economy that, while enjoying low inflation and growing briskly, had been relying for too long on an unsustainable debt-fuelled growth model. Hence worrying signs emerged, such as the historically high levels of private and public debt and the drastically reduced monetary and fiscal policy headroom.

Consider several pressure points pertaining to inflation, the macro-financial nexus and real economy factors, respectively. While somewhat arbitrary given the tight interconnections involved, this classification can help organise the discussion.

At the heart of the risks to inflation is the partial adjustment of two, closely related, relative prices thrown out of kilter by the pandemic. One is the price of services relative to that of (core) goods; the other is the price of labour (wages) relative to that of goods and services (the price level), ie real wages.

The pandemic-induced dislocations interrupted the secular increase in the price of services relative to that of goods. As demand rotated away from services to goods and clashed with inelastic supply, the price of goods rose by much more. And as demand subsequently rebounded strongly after having been first artificially suppressed by public health measures and then turbocharged by economic policies, its rotation back to services failed to re-establish the pre-pandemic relative price relationships even as services became the prime inflation driver. It is possible that the pandemic, and associated aggregate demand stimulus and supply disruptions, has permanently altered the trend relative price relationship between goods and services. However, it is not clear why this should be the case, to the extent that the trend reflected deep-seated structural forces. These include a growing relative demand for services as incomes rise, slower productivity growth in services than in goods and nominal wage increases that do not compensate for the productivity growth rate differential in the two sectors. If the relative price between goods and services did return to its previous trend, it would raise overall inflation significantly above pre-pandemic rates for some time, unless disinflation in goods proceeded sufficiently fast, with prices growing below those rates. It might be hard for goods prices to grow that slowly in a world in which globalisation tailwinds are waning.

The pandemic-induced dislocations also interrupted the secular increase in real wages, as the surprising inflation flare-up eroded purchasing power. Real wages have recovered somewhat since then, but generally languish considerably below the previous trend. The shortfall could add to wage pressures ahead, especially given continued tightness in labour markets and sluggish productivity growth (see below). To the extent that profit margins have benefited from surprise inflation, there should be room for adjustment. But having regained a taste for pricing power during the inflation phase, firms might be tempted to use it again.

The two relative price adjustments are closely linked because the services sector is more labour-intensive. This is one reason why services price increases tend to be stickier than those of goods. And it helps to explain why the pass-through from wages to prices is much higher in this sector.

These incomplete relative price adjustments could provide fertile ground for other sources of inflationary pressures. Any commodity price spikes linked to, say, geopolitical tensions or the withdrawal of price subsidies would be more likely to trigger second-round effects. And the likelihood is higher following the long phase of above-target inflation, which can encourage and entrench inflation psychology.

Macro-financial pressure points reflect the combination of higher interest rates and financial vulnerabilities in private sector balance sheets in the form of high debt and stretched valuations. The current configuration is rather unique. The previous globally synchronised and intense monetary policy tightening took place during the Great Inflation era of the 1970s, when a repressed financial system had not allowed widespread vulnerabilities to develop (see previous AERs).

The outcome, so far, has been surprisingly benign, but tougher tests may lie ahead. The significant banking strains in March 2023 stemmed in many cases from the materialisation of interest rate risk alone, as higher interest rates shook valuations without causing borrowers to default; the materialisation of credit risk is still to come. The only question is when and how intense. The lag is typically quite long, and yet it can appear deceptively short as memories fade. There are indications that financial cycles have started to turn. Savings buffers are dwindling. Debts will have to be refinanced....

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