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Global economy faces uncertainty

Countries around the world appear to be faced with economic slow down as well as a surge in inflationary pressures, a situation typically termed as stagflation. Also, there is no clear idea when the current supply chain bottlenecks will ease. Global financial markets are also at the same time facing turbulence, further adding to the climate of economic uncertainty.

The US economy grew at a 2 per cent rate in the third quarter this year, the slowest growth since the pandemic era economic recovery. The problem has been further compounded by labour shortage. A combination of strong demand and limited supply is pushing up prices.

Europe and China are also experiencing growth problems on the back of supply chain disruptions. China reported that its third quarter GDP grew at a disappointing rate of 4.9 per cent from the previous quarter as industrial activity slowed down. Germany is also hit by supply bottlenecks affecting its export oriented manufacturing sector. Manufacturing output in Germany was 10 per cent below pre-pandemic period during the third quarter.

The Japanese economy grew by 3 per cent in the third quarter on an annualised basis. Thailand a major developing economy in Asia recorded a negative growth rate of 0.3 per cent during the same quarter.

The annual inflation rate for the US is 5.4 per cent for 12 months ending September, 2021 with little sign of abating. Rising consumer demand is fueling inflation which is running 30 years high in the US. The Bank of England has already predicted that inflation would reach 5 per cent next year in the UK and also inflation is surging in the Euro zone.

Despite central banks and government authorities’ response to the initial surge in inflation was that higher prices would be “transitory”, it is unlikely to be so, rather increasingly becoming persistent. Some economic observers believe that if inflation continues to accelerate, it will be very expansive and very costly to get things under control.

In a recent press conference US Federal Reserve Chair Jerome Powell said it was “very, very difficult to forecast and not easy to set policy”. The Governor of the Bank of England, Andrew Bailey, last month told that the central bank would “have to act” if inflation proved to be stubbornly high, then decided not to do so.

European Central Bank President Christine Lagarde has signaled that the European Central Bank (ECB) would tolerate a short term spike in inflation and said that a rate rise in 2022 was “off the chart”. In fact, Eurozone annual inflation surged to 4.1 per cent in October. Such a price spike has not been seen since 2008, i.e. the highest inflationary surge in 13 years.

But that position could become untenable if inflation in the Eurozone continues to rise as inflationary pressures show very few signs abating in the US. Norway, though not a member of Eurozone or the EU, is the first developed country that has already hiked interest rates.

Such statements are indicative of central banks ability to provide “forward guidance” has become very limited, thus significantly compromised their ability to deal with crucial aspects of monetary policy. This in turn has created turbulence in bond markets.

Forward guidance about the future direction of monetary policy plays a very crucial role for investors decision making. Its two aspects help shape the view of investors – the path of policy rates and the strategy about asset purchases.

The path of short term interest rates generally appears to be well understood but the central bank like the Federal Reserve must provide a clear signal as to the pace of future asset purchases to avoid unnecessary volatility in financial markets.

Central banks set monetary policy in response to not only the business cycle but also to underlying structural shifts in prevailing “normal” level of interest rates that are appropriate for their economies over the medium term. Over a longer span, all central banks are being affected by structural factors that are putting upward pressure on interest rates.

Now all these mixed massaging and rising inflation have caused an upward pressure in bond yields and a fall in bond prices – bond yields and prices are inversely related. The upward trend in bond yields reflect not only policy uncertainty but also reflect overall longer term structural trends globally which are largely seen as an increased spending prompted by the post-pandemic reopening and supply bottlenecks pushing price levels up.

Fuel and food prices are soaring worldwide combined with supply chain disruptions, further pushing up prices. The price of oil is likely to go up further which can spur an economic crisis. In emerging and low income economies rising fuel and food prices could stall economic recovery from the pandemic induced 2020 recession.

The rising inflationary pressures is pushing central banks to tighten interest rates. Rising interest rates lead to higher financing costs for banks and consequently to higher lending rates. This in turn leads to a slowdown in consumption and investments. This can have negative effect on the price of financial and real assets because present value of future returns from these assets decrease.

Also, when central banks manipulate interest rates to encourage or discourage borrowing and spending, they are knowingly distorting prices and behaviour in the financial markets.

In the current circumstances tapering to avert inflationary pressures require central banks to have a clear understanding where they stand in the cycle. Therefore, plans to reduce bond purchase or raise interest rates or both at the same time may prove to be a risky proposition under the current economic climate.

If central banks are forced to take more aggressive action to contain inflation, it will have detrimental effects on aggregate demand, thus lowering growth. Lower economic growth with high levels of debt in developed countries will cause major economic and financial turbulence and even a crisis.

The combination of slowing growth and persistent inflation remains the major challenge. Now fiscal policy support is set to slowdown into 2022 after governments around the world, especially developed countries, ran up the biggest debt since 1970s. That makes it even more difficult to work out the trajectory of global growth.

The Wall Street Journal a couple weeks ago in an article pointed out that central banks were trying to chart a path that would curb inflation but not choke off growth as they “navigate the process of weaning economies off the extraordinary measures – including rock – bottom interest rates and enormous bond – buying programs deployed to support their economies”.

Larry Summers who was treasury secretary to President Clinton and director of the National Economic Council for President Obama in an interview with Judy Woodruff of PBS also told that monetary policy needs to focus on stopping inflation. To achieve that objective he suggested that the Federal Reserve to accelerate taper i.e. to stop buying large quantities of bonds and push up interest rates off the zero floor.

As the global economy is entering the final quarter of 2021 with enormous head winds, policy makers in major industrialised economies are faced with the daunting task of supporting growth while keeping inflation under control at a time when these economies are also hit by domestic and external supply disruptions.

All these problems coupled with the recent turbulence in bond markets are an indication that crisis experienced a year and a half ago may resurface again. Therefore, that will require economic policymakers to develop very carefully crafted policy mix to respond to the complex situation they face now keeping in view that full recovery may take years, not quarters.
Source: Financial Express

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