The Macro Script Has Flipped

The script for the economic recovery from COVID-19 has flipped from damage control to driving toward the endgame. In the early stage of the pandemic, controlling the spread of the virus through lockdowns and track-and-trace led to superior economic outcomes. East Asian economies generally outperformed as reductions in mobility and restrictions on social distancing were lighter and shorter lived.

However, with the development of effective vaccines, the storyline has changed. The objective is now getting jabs in arms and dropping social distancing restrictions on a permanent basis, which unlocks key pandemic-affected sectors. Here, the U.S. and U.K. have been in the lead among major economies, which has led to an acceleration of growth and economic outperformance. In response to this changed dynamic, Europe has picked up its pace of vaccination, and, more recently, China has begun to quickly close the gap. Developments in emerging markets are very mixed, but generally lag those in developed markets.

Chart 1

The combination of vaccines (leading to opening up) and better management of the economic impact of the virus (where there are no vaccines yet) has led to stronger-than-expected performance so far this year. Growth was almost universally better than anticipated in the first quarter across both advanced and developing economies. The main reason was services--especially in the U.S., but more prevalent in advanced economies--while tech and commodity exports provided support elsewhere, primarily in emerging economies.

As vaccinations have accelerated and COVID-19 cases have dropped, the opening of key service sectors--food and beverage, hospitality, and travel and tourism--leading to higher confidence and spending is happening across many of the advanced economies, and some emerging markets. (The constraint to further progress in vaccinations appears to be on the demand side (hesitancy) in the more advanced economies and on the supply side (access to vaccines and logistics) in the emerging economies.) This dynamic has played out faster than we expected. Herd immunity seems less of a binding constraint as hospitalizations and fatalities from COVID-19 have begun to diverge from overall caseloads.

Surprisingly, the pickup in growth has led to much higher inflation across a number of metrics and put the fear of inflation on the macro radar for the first time in decades. Part of this fast rise relates to supply and demand mismatches as the latter outruns the former, at least for now, including energy, lumber, air travel, and used cars. The Consumer Price Index (CPI) weights of the items in this group are relatively small, but the percentage increases have grabbed headlines.

The rise in inflation has been particularly pronounced in the U.S. There, the quick rise in incomes, wealth effects, and generous government transfers are fueling demand, while supply is constrained by labor shortages in some sectors and low supply responses as companies ran down capacity and inventories during the worst of the pandemic. Most inflation measures in the U.S., including the Fed's preferred Personal Consumption Expenditures (PCE) index, have surged well past the 2% threshold and look likely to stay well above target for several quarters. We explore U.S. inflation further in the risk section below--for now, it suffices to say that base effects are not a convincing explanation given the large seasonally adjusted month-over-month prints for the last three periods.

Macro and prudential policies remain very accommodative and are now providing strong tailwinds to the recovery. Fiscal support in the form of direct transfers continues in the U.S. (sometimes overly generous), and most of Europe is seeing payments to businesses contingent on keeping workers on the payroll. Monetary support remains extraordinary, with most major central banks keeping policy rates near the effective lower bound, continuing to purchase government bonds to hold down yields, and, in some cases, intervening in corporate credit markets to ensure liquidity and manage spreads. Macroprudential policies include debt moratoriums, payment deferrals, and other forms of forbearance that either cancel or spread out payments of companies affected by pandemic restrictions. Very few of these have been unwound so far.

Our Updated Forecasts

Given the developments above, our 2021 GDP forecasts are generally higher than in our previous Credit Conditions Committee round. Specifically, we have marked up global GDP growth to 5.9% from 5.5% on the back of widespread higher growth, with the U.K. and Brazil leading the way among major economies. We have lowered our forecast for India because of its struggles in containing a recent wave of the virus, although we expect much of the lost output to simply be pushed to the next (fiscal) year.

This relatively benign baseline scenario rests on the assumption of orderly reflation (see "Orderly Global Reflation Will Support The Recovery From COVID-19," March 22, 2021). On the real side, this means that economies recover smoothly in terms of closing output gaps and attaining full employment, and that policy stimulus is gradually withdrawn. On the market side, it means that the transition to the post-COVID-19 steady state is free of bouts of volatility and large shifts in risk appetite that would cause sharp price and spread adjustments and major disruptions in access to funding. It also assumes continued improvement on the pandemic front. Risks to this baseline are discussed below.

U.S.

As the U.S. heads into the summer, the economy is sizzling. A better vaccination outlook, a faster reopening schedule, and $2.8 trillion from two stimulus packages have turbo-charged the U.S. economic recovery this year and the next, with supply constraints (businesses unable to make products fast enough to meet surging demand) preventing the economy from swelling at an even faster pace. Our forecasts of real GDP growth for 2021 and 2022 are now 6.7% and 3.7%, respectively, up from 6.5% and 3.1% previously. Of note, our 2021 GDP growth forecast would be the highest reading since 1984.

Despite the improved outlook, the labor market still has a long way to go before it recovers the ground lost from COVID-19. The recovery in U.S. jobs growth remains soft, despite recent job gains, and the labor market is 7.6 million jobs short of the pre-pandemic peak. Inflation pressure is rising more than expected on the back of the strong rebound.

Federal Open Market Committee (FOMC) members sharply revised up their median PCE inflation forecasts (4Q/4Q) to 3.4% for this year and 2.1% for the next. Based on that more rosy assessment of the U.S. economic outlook, they also moved up the expected timetable for higher interest rates. FOMC members continued to emphasize that the price run-up so far has been "largely transitory," with which we agree. We expect policy interest rate liftoff to be one hike in first-quarter 2023, with the second rate hike in the third quarter and two more hikes in 2024. Read the full U.S. macro update for more, "Economic Outlook U.S. Q3 2021: Sun, Sun, Sun, Here It Comes."

Europe

The contours of the European economic recovery are changing, from one led by a rebound in industrial activity to a more services-based pickup. A lower incidence of COVID-19 and the broad rollout of vaccines across Europe is enabling governments to lift most restrictions to economic activity, paving the way for a strong restart this summer. We now expect GDP to increase 4.4% this year and 4.5% in 2022, from 4.2% and 4.4% previously. We also have a rosier long-term outlook now that there is more clarity about implementation of the Next Generation EU plan. In our view, the size of the plan will be enough to limit long-term scarring from this crisis as well as close the eurozone output gap by 2024.

The shift to a broad-based recovery is showing up in the labor market, with job postings rebounding even in the most affected sectors, like retail and hospitality. This confirms our view that the recovery will be rich in jobs. We now expect eurozone employment to recover to its pre-COVID-19 levels by the second half of 2022. This is half a year ahead of our previous forecasts. By comparison, it took the eurozone economy almost eight years after the global financial crisis to recover its precrisis level of employment.

In contrast to the situation in the U.S., European employers are likely to struggle less to fill vacancies because they have kept their employees in their jobs through short-time work schemes. This also means that companies will want to restore their profit margins first before raising salaries, to make up for the costs of furlough schemes during lockdowns. As a result, we don't see core inflation reaching 1.6% before the end of 2024. Nonetheless, headline inflationary pressures will be higher this year, linked to the rebound in energy prices last year and one-off effects such as the normalization in German value-added tax (VAT). We do not see the European Central Bank hiking rates until late 2024. Read the full European macro update for more, "Economic Outlook Europe Q3 2021: The Grand Reopening."

Asia-Pacific

Asia-Pacific's recovery is mostly on track. Early stumbles during the vaccine rollout are giving way to redoubled efforts to vaccinate and open up. Exports are contributing to upward revisions to our growth forecasts for some economies in 2021, but as many trading partners reopen and consumers spend more on services, the impulse from exports will wane. Private consumption is exerting a drag, and while we expect an improvement in the next few quarters, much depends on the pace of the vaccine rollout. As result, we have revised our Asia-Pacific growth forecast slightly lower to 7.1% from 7.3% previously, with India and Southeast Asian economies (and Japan) pulling down the region's growth. We nudged China's growth up to 8.3% this year on accelerating vaccinations.

The rise of inflation across the region is, for the most part, transitory. Strong demand for durable goods globally should ease as economies reopen and people are able to spend on services, from hotels to restaurants. The base effect due to plunging commodity prices in early 2020 will also wash out of the annual data later this year.

Passthrough from inflation in producer prices to consumer prices has been weak in Asia-Pacific, and we expect it to remain so. The main reason is that with private consumption and services activities still soft, demand for labor is weak, and companies will not need to hike wages to attract or retain staff. With labor costs accounting for a large share of final consumer prices, this should keep a lid on inflation. There are exceptions where labor markets are tightening much more quickly, such as Australia. Read the full Asia-Pacific macro update for more, "Asia-Pacific's Recovery Regains Its Footing."

Emerging markets

Most emerging markets (EMs) continue to struggle with handling the pandemic. Unlike the advanced economies--the U.S. and U.K. in particular--the vaccination rollout remains slow. This reflects both the demand and the supply side: Vaccine hesitancy remains a challenge as does the supply of vaccines and the logistical difficulties in distributing them. The silver lining is that countries are learning to live with the virus. Specifically, the economic impact of mobility restrictions appears to have fallen appreciably.

We have raised our EM-14 2021 GDP growth forecast by 20 basis points to 4.6% in 2021 since our previous round. This mostly is the result of stronger-than-expected first-quarter performance, but with wide variations across subregions. We revised our growth forecast for Latin America up by more than a full percentage point to 5.7% and for EM EMEA by 0.4% to 4.1%, while we lowered it for EM Asia by 0.3% to 8%. Our forecasts for 2022 and beyond remain broadly unchanged.

While macro developments in EMs are looking up, they will lag the advanced economies in the rebound from COVID-19, which creates its own risks. The slower pace of vaccinations both reduces the speed of reopening (including an overhang of uncertainty holding down consumption and investment) and increases the risk of further waves of infection as variants of the virus continue to spread. EMs are also relatively more exposed to spillovers--both positive (demand for commodities) and negative (risk-sensitive financial flows and conditions). Faster vaccination therefore becomes the top priority. Read the full emerging market macro update for more, "Economic Outlook Emerging Markets Q3 2021: Despite Rising Resilience, Vaccinations Are The Key To Recovery."

Shifting Risk Profile (Not A Bad Thing)

The faster and earlier recovery has shifted our risk profile. Inflation and orderly exit-related risks have risen while health- and premature austerity-related risks have declined. For the near term, the balance of risks to our forecast has moved to the upside.

U.S. inflation (rising).  The largest shift in our risk profile since our last report has been the sharp rise in U.S. inflation and its potential impact on macro and credit outcomes, including beyond the U.S. Through May, the headline U.S. CPI has grown 5.0% year over year, the core index has risen 3.6%, and the PCE index--the Fed's preferred measure--has grown 3.9%. Sequential measures of inflation are significantly higher (see chart 2). The Fed is targeting average inflation of 2%.

To be clear, the risk does not relate to the credibility of the U.S. Federal Reserve to achieve its inflation (and employment) objectives over the medium term. It has both the tools and the will to do so. The risk is that inflation will stay higher and last longer than the current forecast and could force the Fed to move earlier than planned, and earlier than what is currently priced by markets. The resulting repricing could cause market volatility, including widening spreads and diminished market access for higher-risk borrowers, and asset price volatility and downward adjustments, with knock-on effects on spending and, ultimately, employment and growth.

Chart 2.

Uneven recovery (stable).   An uneven recovery across sectors and countries remains a key macro credit risk as we exit the pandemic.

• At the sector level, laggards will face the same market conditions as the faster-recovering sectors. This means that as conditions normalize and rates and prices rise, companies in these sectors may find it relatively more expensive--and perhaps slower--to rebuild than if the recovery had been more balanced, with knock-on effects on earnings and profitability. Lagging firms and sectors can also be disadvantaged on the policy front as forbearance and various transfer and subsidy programs expire.
• At the country level, a number of risks face (mainly) emerging markets from a slow recovery, especially relative to the U.S. These include a rising cost of U.S. dollar-denominated debt for borrowing or refinancing, less forthcoming capital flows to the extent that these flows chase relative yields and relative growth rates (and exchange rates), and a widening of spreads as markets reprice a large range of assets amid potential de-risking. A stronger U.S. dollar could lift import costs and raise inflation and result in higher policy rates in emerging markets.

Premature austerity (falling), non-credible exit strategy (rising).  With the recovery arriving sooner than forecast, the policy focus is shifting from crisis control to the sustainability of the post-COVID-19 economy. This applies to both fiscal and monetary policy. On the fiscal side, extraordinary support (including record deficits) was the appropriate response to cushion the blow of the lockdowns and lay the foundations for the recovery. But as we exit the COVID-19 era, governments will need to put their fiscal accounts on credible, sustainable paths, including trend reductions in key debt ratios. On the monetary side, nurturing the recovery through extraordinarily low policy rates and quantitative easing/yield curve control (and their distortions, including on asset prices and risk taking) should be balanced against getting rates and the entire "credit surface" more back to normal.

Pandemic/health (falling).  The pandemic is still with us, but COVID-19-related risks have declined, in our view. While the timeline for attaining herd immunity has not moved appreciably, hospitalizations and fatalities have fallen substantially--especially in the more advanced economies--so the total case numbers may not be the best metric. As countries have learned to manage the economic consequences of the virus better, opening has taken place earlier than previously thought. The main health risk now is that existing vaccines may be less effective against future COVID-19 variants. Thankfully, that has not been the case so far.

From Bad Problems To Better Problems

The faster-than-expected rebound from the depths of COVID-19, while welcome, has merely shifted the set of challenges. We prefer "rebound" to "recovery" since the economic slowdown was not a result of working off excesses in the previous cycle. Rather, it was generated by health restrictions. With the economy now being turned back on, we are close to resuming the pre-COVID-19 cyclical position as health restrictions are removed.

"Bad" problems related to identifying and measuring the effects of lockdowns are fading, while "better" problems relating to a fast opening are rising. Our surveillance focus continues to be on whether the reflation accompanying the rebound is orderly, which we have argued will generate better macro and credit outcomes. The policy challenge as we exit the COVID-19 crisis in the coming quarters will be to withdraw monetary and fiscal stimulus at a pace that provides enough support to maintain adequate velocity while balancing inflation pressures and moving to a post-COVID-19 steady state path. While the outlook is brightening, there is still much work to do.