Inflation has been a key concern for the global economy in recent years, particularly after the COVID-19 pandemic caused disruptions in supply chains and sent prices for goods and services soaring. However, there are several reasons for investors to be optimistic about the world economy in terms of inflation.
First, in the United States, inflation is declining, which raises hopes of a “soft landing”. This term refers to a situation where price growth slows down without causing a recession. The Federal Reserve has been closely monitoring inflation and has expressed its intention to maintain a 2% target for inflation, which it considers to be consistent with its mandate to promote maximum employment and stable prices.
In Europe, the falling energy prices have helped to bring down inflation. The mild winter has resulted in lower demand for heating, which in turn has led to a drop in energy prices. This has contributed to the overall easing of inflation in the region.
Another factor contributing to the easing of inflation is the end of China's "zero-covid" policy. This policy was designed to combat the spread of the COVID-19 pandemic, but it also had the effect of disrupting supply chains and contributing to inflation. Now that the policy has ended, China's economy is poised for a rebound, which could help to stabilize prices for goods and services.
Despite these positive developments, there are still challenges ahead for the world economy. One of the biggest challenges is the slowdown in GDP growth. As prices fall, so too does the growth in the overall economy. This can be seen in the decline in retail sales and industrial production in the United States, as well as in the decrease in leading indicators of output. When these indicators drop significantly, it often signals that a recession is imminent.
Another concern is the fast pace of growth in the labor market. The news of massive lay-offs by big-tech companies is making it to the headlines all over the globe. However, despite that the National Bureau of Economic Research working paper shows that the unemployment rate has been significantly low at 3.5% in the United States, combined with low new claims for unemployment benefits, suggests that the labor market is healthy. This rapid demand for workers also presents challenges for the Federal Reserve. It makes it more difficult for the Fed to determine that inflation has been brought under control because under the conditions of inflation there is an increase in the aggregate demand that raises employment in, at least monetary terms. In other words, the low unemployment rate shows that the demand is high in the labour market which suggests towards a wage growth and, rapid wage growth is another factor contributing to inflation. Despite some measures showing a decline in annual wage growth, it remains around 5%. This fast pace of wage growth, combined with slow growth in workers' productivity which stood at 0.8% and 1.4% in the second and third quarters respectively (as per the data by the U.S. Bureau of Labour Statistics, Labour Department), could lead to higher prices for goods and services. Some policymakers hope that companies, whose profits surged in 2021, will be able to absorb the fast wage growth without having to raise prices further. However, this is not guaranteed as the Wall Street is expecting disappointing earnings for the fourth quarter of 2022. According to data from Credit Suisse, the estimated earnings per share has dipped below zero. Forecasts for the S&P 500 index has been revised several times by analysts and corrected by 6.5% for the fourth quarter earnings.
The markets expect the Fed to start cutting interest rates within a year as growth slows. However, if the Fed wants to reduce inflation to 2% and maintain it at that level, it may need to keep interest rates high until wage growth slows, even if this leads to a recession.
Another challenge facing the world economy is the situation in Europe. Despite the falling energy prices, the euro zone still has an underlying inflation problem, which is evident in the increasing wage growth. The head of the European Central Bank, Christine Lagarde, has warned that interest rates will have to rise significantly, which is contrary to the expectations of investors. A stronger dollar, which is likely if the Fed keeps raising interest rates and investors become concerned, would increase imported inflation and make it even more difficult for the ECB to bring inflation under control.
The end of China's "zero-covid" policy has reduced the risk of supply chain disruptions, but its rebound may not be entirely good news for the rest of the world. The extra imports from China may add to the overheated economies, exacerbating the inflation problem. Europe's gas storage is high due to reduced demand for LNG from China in 2022. Now, demand is expected to recover, potentially causing price spikes next winter. The world economy will not fully recover until it overcomes the challenges of overheated labour markets and the energy crisis.