EuroFinance

Global inflation has brought complex economic questions to the forefront. These questions touch on the causes and implications of inflation, the role of fiscal and monetary policy, and the path forward for both advanced and emerging economies.  At the EuroFinance International Treasury Management 2024 in Copenhagen, Thomas Harr, Chief economist and head of economics and monetary policy at Danmarks Nationalbank, and Jeromin Zettelmeyer, Director at Bruegel AISBL, engaged in a discussion with Daniel Franklin, executive editor and senior editor, United States, at The Economist. They shared valuable insights on this multifaceted economic issue, exploring the dynamics of inflation, interest rate trends, geopolitical uncertainties, and the unique economic landscapes across various regions.

A tale of two inflation experiences

Based on his new book on the global inflation crisis of the 2020s, Harr pointed out that the inflation burst primarily impacted advanced economies, while Asia was more insulated, with the exception of Japan. Harr attributed this to different shocks, where the war in Ukraine impacted Europe and, to a lesser extent, the U.S., much more than the rest of the world. Additionally, the economic stimulus was much larger in the West than it was in the East.” This difference, he suggested, helped keep inflation in Asia from reaching the unprecedented levels seen in the U.S. and Europe.

In advanced economies, growth in the U.S. is strong at 2.8% this year. For advanced European economies, a modest growth rebound is expected next year, with output returning to its long-term trend. The growth outlook for emerging markets and developing economies is relatively stable, projected at around 4.2% for both this year and next, supported by continued strong performance in emerging Asia, according to the IMF.

Harr suggested that advanced economies are now largely “very far” along the path to reducing inflation rates to their target levels of around 2%. However, he noted that certain sectors, such as services, remain impacted due to “high wage growth in many economies, both in the U.S. and Europe,” which contributes to lingering service price inflation. Denmark, as an example, has moved even further, with inflation now under 2%, though wage growth remains elevated, Harr noted. As such, Harr expects that service price inflation in Denmark should also eventually ease as labour markets adjust and wage pressures diminish.

Searching for the “Goldilocks” rate

One of the key concerns for central banks worldwide is finding the natural level of interest rates that would allow economies to grow steadily without overheating or cooling too much—a balance Harr described as “the Goldilocks rate.” He acknowledged that the exact level of this “natural interest rate” remains uncertain. While some factors, such as higher debt levels, might push interest rates higher, other influences continue to apply downward pressure. He described this rate as crucial for a balanced economy, noting, “The honest answer is… we don’t know,” though he emphasised the possibility of a slight increase compared to the years before the pandemic. Financial markets, anticipating slower economic growth and moderating inflation, have priced in a gradual decrease in interest rates by 2026, with U.S. rates expected to fall close to 3% and euro-area rates below 2%, according to Harr.

Despite uncertainties, Harr views this as a reasonable outlook, pointing out that “it’s a very natural interpretation” of the economic data, indicating that market sentiment aligns with expectations for more stable inflation levels.

Harr noted U.S. impressive economic growth, partly supported by a very expansionary fiscal policy during the pandemic, where the total sum of fiscal packages amounted to 28% of GDP. This stimulus fueled a surge in private consumption throughout 2021 and 2022. While the U.S. economy is now decelerating as stimulus wanes and interest rates rise, Harr observed that the slowdown is moderate, with the labour market showing only slight softening. As such, he anticipates a gradual decrease in U.S. interest rates, aligned with market expectations, without a dramatic economic downturn. 

Geoeconomic fragmentation and the risk of supply shocks

Geopolitical risks, including the Russia-Ukraine conflict and the Israel-Hamas war, threaten financial stability by disrupting energy security, global supply chains, and inflation. In the Asia-Pacific region, tensions in the South China Sea are expected to rise, though the Taiwan Strait and Korean Peninsula are less likely to see military escalation. These complex conflicts highlight the interconnectedness of global affairs, requiring careful and strategic responses, S&P Global said in a report.

As the world faces increasing geopolitical tensions, Harr raised the concern of “geoeconomic fragmentation,” a phenomenon where countries are less inclined to trade freely, leading to lower growth and higher prices. “It may also lead to higher inflation, ,” Harr said, explaining that these developments often produce supply shocks, such as the impact of the Russia-Ukraine conflict on energy prices.

According to economic wisdom, central banks should typically “see through” supply shocks, as monetary policy only affects the economy after a delay. However, Harr explained, persistent supply shocks compel central banks to react more assertively, as was the case in 2022.

Zettelmeyer echoed these concerns, highlighting the challenge for central banks in distinguishing between transient shocks that don’t significantly disrupt markets and those that do. Central banks, he suggested, must carefully navigate these shocks to manage inflation and prevent destabilisation.

The uncertainty in the current economic environment is palpable, but as Zettelmeyer aptly puts it, understanding the factors driving this uncertainty “helps sort of to clarify why it is so uncertain.”

One key driver, he noted, lies in the persistence of underlying structural factors—demographics and income distribution—linked to the phenomenon previously referred to as secular stagnation. “Those are alive and well,” he explained, suggesting they continue to shape the economic outlook.

Against this backdrop, Zettelmeyer suggests that the current monetary policy tightening is likely a “transitory phenomenon,” implemented to address a unique inflation shock. This shock, he noted, had “unique reasons,” including “very large fiscal expansions during COVID” and “a very exceptional supply shock.”

Fiscal policies and structural challenges in Europe

Turning to Europe, Zettelmeyer discussed the impact of fiscal policies on inflation and economic growth, remarking that Europe’s current trajectory involves significant fiscal adjustment. Many European countries, he noted, are reducing deficits by over 3% of GDP, which may weigh on economic growth.  The impending fiscal tightening will impose a substantial drag on the economy, a development Zettelmeyer finds somewhat ironic. “It’s kind of amusing,” he remarked, “that we have killed inflation—we have dipped below the 2% [target]—just at the time when the big austerity is starting.” He further reflected on the timing, noting, “Central banks have been clamouring for tighter fiscal policy over several years now. They finally got their wish just at the time when they didn’t need it.”

Zettelmeyer was optimistic that, despite these fiscal constraints, central banks retain the flexibility to lower interest rates, thus reducing recession risks. He acknowledged that the “recession risk has not vanished” but expressed confidence that central banks can effectively manage this threat.

The European Central Bank (ECB) cut interest rates by 25 basis points to 3.25% in September, explaining that the decision was based on its updated assessment of the inflation outlook, underlying inflation dynamics, and the effectiveness of monetary policy transmission. In a statement, the ECB noted that the disinflationary process is progressing well, supported by incoming inflation data. However, the inflation outlook has also been influenced by recent unexpected downturns in economic activity indicators. Despite this, the ECB emphasised that financing conditions remain restrictive.

Brazil’s inflation victory and China’s deflationary impact

In assessing the effects of interest rate policies on emerging markets, Harr acknowledged Brazil’s proactive approach, which saw it among the first to raise interest rates in response to rising inflation. This strategy, he noted, helped Brazil bring inflation down and subsequently lower rates. However, he downplayed the impact of European rates on Brazil’s growth, noting that the country’s economic performance is more closely tied to developments in the U.S. and China.

Shifting focus to China, Harr highlighted the significant economic headwinds facing the country, particularly its ageing population and stagnant productivity growth. These structural issues, compounded by a protracted real estate crisis, have dampened sentiment in China. Despite China’s recent policy actions to stimulate its economy, Harr characterised the outlook as mixed, with certain sectors thriving while others struggle. He concluded that “China is likely to be a deflationary force on the world” due to these cyclical pressures, which may counteract some of the inflationary pressures stemming from advanced economies.

Anticipating economic volatility and future challenges

Reflecting on the broader economic landscape, Harr advised caution, stating, “You should assume that global growth would be relatively stable despite… geoeconomic uncertainty, but also relatively moderate.” He warned that supply shocks may become more frequent , particularly as geopolitical tensions intensify, which could spur financial market volatility though recent volatility has been limited. Zettelmeyer concurred, underscoring the end of the “great moderation” and the likelihood of greater economic unpredictability.

Both economists offered insights on how businesses and policymakers might navigate these uncertainties. Zettelmeyer pointed out that understanding the nature of shocks is critical: “The real challenge… is to distinguish between shocks… that actually moves markets and that doesn’t.” For shocks that lead to significant shifts in prices, such as major trade disruptions, market volatility may be unavoidable, and central banks may need to intervene decisively.

In conclusion, Harr and Zettelmeyer highlighted that while the global inflation crisis appears to be under control, many challenges lie ahead. From the delicate balance of interest rates to geopolitical tensions and structural changes in major economies, central banks and policymakers will face complex decisions in a world where economic stability is no longer guaranteed. As both experts suggested, the future economic environment may demand heightened vigilance and adaptability to maintain growth and stability in the face of ongoing and emerging uncertainties.