The Economy of the Future
By Ciáran Heelan, Shahan Khan, Sanah Suresh, Peredur Morgan, Timothy Doherty and Annie Wang
Following our article “The Future of the Economy”, a year on the Monetary Policy Division outlines their new predictions for the next few years using the information that they have learnt from Part 1 (the role of central banks) and Part 2 (analysing monetary policy reports) of the Monetary Policy Research Programme. They examine how the pandemic has affected the economy, changed macroeconomic trends and impacted monetary policy both in a general sense and specifically in emerging economies.
How hopeful are you regarding the future of the economy?
- I predict higher inflation and output over the next five years due to changes in central bank optimisation preferences.
- I also predict lower productivity as the world economy transitions from globalisation to regionalisation.
Firstly, policy-makers will be less hawkish regarding inflation than in recent years. Prior to the pandemic, populist leaders such as Trump and Johnson ran large budget deficits amidst high output and low unemployment (Economist 2018). Despite this, we did not see any significant rise in inflation until the onset of the pandemic (World Bank 2022). This was followed by even greater deficits in even more countries during the pandemic, and although there has been a rise in inflation, it is unclear whether deficits are the cause of this inflation, or whether these are the result of temporary shocks in supply chains (Markovitz 2021). Hence, some policy-makers may conclude that they and their predecessors were too hawkish about the amount of slack in the economy prior to 2016, hampering growth unnecessarily. Eager to avoid the problems associated with this, they may conduct more dovish policy, and all the macroeconomic effects that entails.
Secondly, the pandemic will accelerate a trend towards public and private actors investing in their own region as opposed to exploiting truly global supply chains (EIU 2020, Wang & Sun 2021). This reflects a shift in the preferences of economic actors from pure efficiency to a combination of efficiency, stability, resilience and nationalist pressure (EIU 2020). This trend was already well underway prior to the pandemic but will accelerate due to the perceived risk of being unable to access essential supplies in emergencies (such as vaccines during a pandemic) (Wang & Sun 2021). As efficiency is sacrificed for security reasons however, this will result in lower productivity and hence lower real wages for the average worker. Whether this trend continues in the long-run depends on:
i) whether consumers/voters in major economies are willing to stomach the lower real wage growth that this policy entails in return for more security/stability
ii) the political fortunes of liberal/nationalist politicians in major economies
iii) the diplomatic and power relations between the major powers.
I believe that inflation will increase further in the medium term nearing 6%, primarily due to significant ongoing uncertainty in the labour market and in gas prices (BoE). Since the Bank of England has committed to slowly increasing the bank rate to 1% through 2024, and energy prices will likely stop rising, I think that the inflation rate will be trending comfortably below the mandated 2% rate within the next 3 years (BoE).
Beyond 2025, I believe that UK supply will no longer be curtailed by Covid supply chain disruptions. I think that this will allow for any remaining supply bottlenecks to be broken, and there will no longer be a large excess of global demand (Lea). I think that this combined with tighter monetary policy will lead to a sharp decrease in the growth rate each year from the 2021 level, stabilising around 2025 to pre pandemic rates (BoE).
I think that in the long run recruitment difficulties and job vacancies will decrease as supply chains recover due to more certainty. This will lead to a decrease in the unemployment rate to near-4% levels by 2026 as supply meets demand for labour (PwC).
What are some of the macro trends you see emerging from COVID-19?
Following the Covid-19 pandemic, I think industries will shorten their supply chains to increase resilience. The pandemic has exposed the vulnerability of the global supply chains, for example, Covid related closures of factories in some Asian economies disrupted production across several industries, including motor vehicle manufacturing and computer and electronics [1 and 2].
Additionally, Covid-19 has accelerated technology adoption across industries and in people’s personal lives. The rise in e-commerce, remote working, online working and telemedicine that occurred during the pandemic is likely to continue going forward, as there are convenience and efficiency advantages associated with them .
Consumer behaviour has also changed, as the declining trend in the money spent at home before the pandemic was reversed leading to the “home nesting” (e.g. spending on home gyms) . I think it is likely that this behaviour will partially stick for high-income households, as the convenience from working from home might mean their preferences have changed. Even for lower-income households, their investment into home nesting equipment, means they are likely to continue to use them after the pandemic.
Covid-19 will also affect the way the economy operates as it has exposed the deficiencies in our current system. The pandemic saw a shift from state capitalism toward state socialism (which is a centralised response, prioritising the protection of life) and this shows that in the future operations of the economy are more humane and resilient to future pandemics or crises like climate change .
Big events accelerate, but do not cause developments.
The rise of populism, and its anti-globalism (e.g., Brexit, China trade war), in the past decade has started a trend towards shortening supply chains in Western economies. The pandemic has accelerated this: globalised supply chains’ weaknesses have been exposed, e.g., disruptions in Asian ports — an inflationary development.
This is compounded by a looser monetary policy — a trend prevalent before the pandemic but has since accelerated. Though policymakers in developed economies will become more hawkish as inflation rises, it is unlikely we’ll see Volcker-esque moves in the short- to medium- term.
Higher inflation will accelerate the trend towards digital currencies — and hence developments in this area could counter inflation. Other deflationary forces from technological developments include DNA sequencing (lowering health costs), robotics (lowering manufacturing costs), energy storage (lowering energy costs), and artificial intelligence (increasing productivity).
How hopeful are you regarding the future state of monetary policy?
The United Kingdom is facing some of the highest rates of inflation it has seen in 30 years. This has prompted speculation among some of a return to the 1970s, as monetary authorities’ lose credibility, inflation expectations become unanchored and wage-price spirals follow. On top of this, economic support packages passed in response to the COVID-19 pandemic have caused public sector debt to rise to the highest level in half a century. This has raised concerns about fiscal dominance, a situation in which the fiscal authority’s desire for low interest rates trumps an independent central bank’s target for price stability. Whilst quantitative easing has mitigated this problem by replacing expensive, long-dated gilts with far cheaper central bank reserves, it has also made public finances more exposed to short-term interest rate hikes. For example, whilst in December 2020 the UK government paid £2.7bn to service its debt, in December 2021 this figure had risen to a record £8.1 billion pound.
Despite these challenges, I remain cautiously optimistic. Central banks have overcome far greater challenges in the past and these experiences have equipped us with a better understanding of how to deal with the present. While inflation expectations for the year ahead have risen considerably above target, at about 4.8% as of the last YouGov CitiGroup poll, these are in fact less than the 7% that the Bank of England is itself forecasting for Spring 2022. Just as inflation did not spiral out of control when CPI rose by nearly 6% in 2011, I do not expect wage-price spirals to happen today. If anything, inflation can be expected to return to normal as supply chain problems fade out and economic agents tighten their belts in response to higher interest payments and energy costs. This last point is partly why I believe fiscal dominance is not likely to happen in the UK; although rising interest payments will inevitably be a challenge for the Treasury, this in itself will have a deflationary effect on the economy. What’s more, given that between a quarter and a third of the UK government’s outstanding debt is index-linked, the gains from a situation would be too small to justify the costs. It is for these reasons that I cannot imagine this kind of situation will happen any time soon.
So, to summarise, while rising inflation and interest rate costs do present a challenge, I am confident that they are far from unsolvable for the Bank of England.
How do you expect monetary policy to be in emerging economies in a post-Covid world?
Emerging economies have deployed unconventional monetary policy during the pandemic, as shown in Fig 1, the number of emerging economies adopting Asset Purchase Programs increased significantly during the pandemic . However, unconventional monetary policy tools such as negative interest rates and Quantitative Easing have been adopted less,due to there still being room to cut policy rates . Previously, policy makers feared that easing monetary policy by cutting rates and undertaking asset purchase programmes extensively in emerging economies would lead to capital outflow and currency depreciation, which would have a negative impact on trade.
However, recent monetary policy easing has shown to be quite successful in controlling inflation due to reasons including better central bank credibility and structural reforms. Furthermore, interest rates in advanced economies are likely to remain at low levels due to the need for monetary policy to remain expansionary to sustain economic recovery, leading to a lower risk of capital outflow. Therefore, most central banks in emerging economies are likely to consider and undertake unconventional monetary policy tools in the future. However, there are certain risks that should be taken into account, this includes the risk of increasing inequality due to the increase in Quantitative Easing, and simply due to the fact that inflation, caused by the easing of monetary policy, is a regressive tax, disproportionately affecting lower income households.
These are our opinions, comment below to let us know yours!
This article is written by: Ciáran Heelan (Head of Europe Monetary Policy Research), Shahan Khan (Research Associate, UK Monetary Policy Research), Sanah Suresh (Research Associate, UK Monetary Policy Research), Peredur Morgan (Research Associate, Europe Monetary Policy Research), Timothy Doherty (Research Associate, US Monetary Policy Research) and Annie Wang (Research Associate, Europe Monetary Policy Research).
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