In recent years, a popular narrative about the global economy has been that it is ‘stuck in a low gear’, with central banks unable to tighten policy. As recently as a year ago, there was much talk about the pros and cons of negative interest rates. This year, however, instead of a barrage of media articles on ‘secular stagnation’, the global economy has delivered positive surprises, with some commentators even convinced that the US Federal Reserve (the Fed), despite being the only core economy to be raising interest rates, is now ‘behind the curve’ and not hiking interest rates quickly enough. Even the European Central Bank is sounding more hawkish than before.
The stagnation thesis held that low global GDP growth and falling real interest rates were caused by either of two factors: the first was inadequate global demand, as a consequence of low business investment, high savings rates in Asia and income disparities; the second was inadequate global supply, the result of poor productivity growth and slowing growth in the labour force.
As shown by the chart below, the cyclical peak in the Fed Funds rate (in real and nominal terms) has been falling for decades, and the current cycle should be no exception, thanks to a fall in the equilibrium rate of interest. The size of the Fed’s balance sheet also offers an alternative source of ‘tightening’ this time around, and we expect the nominal Fed Funds rate to peak at roughly 2 per cent in 2018, compared with a previous peak of 5.25 per cent.
Recent evidence suggests that global growth is running at higher levels than anything seen since the temporary rebound after the financial crisis. Nevertheless, supply side concerns remain: there are few signs of improvement in productivity growth, so even though there has been a cyclical improvement in demand, there is as yet no reason to believe that the supply side of the global economy is performing any better than it was. In short, the speed limit for growth in the advanced economies, including the US, is still lower than it was in previous decades, and we therefore think that the Fed’s rate hikes will peak at a lower level than in the last cycle.
The current pace of growth would need to hold for much longer in the face of Fed tightening to counter our base case of a much lower Fed Funds peak. Much depends on how far the equilibrium real interest rate in the US has fallen, and how quickly the Fed hikes interest rates this year.
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