Gaps, growth and headwinds

Global growth is uninspiring. The global economy plods along with aggregate GDP growth of around 3 per cent to 3.5 per cent and similar levels of inflation. This has been true for the past several years and many expect it to continue for at least the next couple. This is partly because trend growth rates in major economies appear to have slowed from the pre-crisis pace. But slow growth is not just a supply-side condition. A gap between global aggregate demand and supply for goods and services persists, even though global interest rates – nominal and real, short and long maturity – remain at historic lows.

Earlier this year, with oil prices falling, the global economy appeared poised to accelerate. While low oil prices represent a transfer of income from oil exporters to importers, conventional macroeconomic models predict they should boost global aggregate demand as long as the propensity to consume and invest by the importers exceeds the corresponding propensities by the exporters. Moreover, by reducing headline inflation, low oil prices provide central banks with room to ease monetary policy.

This year, no fewer than 40 central banks have taken that opportunity, while among the major economies only three – Brazil, South Africa and the Philippines – have raised rates. In addition, the European Central Bank has embarked on a major quantitative easing programme, while the Bank of Japan has doubled down and greatly expanded the quantitative and qualitative easing programme it launched in 2013.

And yet despite low oil prices, waves of QE and rate reductions by many central banks, world GDP growth in 2015 is expected to come in at a pedestrian 3 per cent, even though one year ago, when little of the stimulus from oil, rates and QE was factored in, the consensus projection for growth was 3.6 per cent. The same is true for the 2016 outlook: a year ago the consensus for 2016 was for 3.8 per cent growth, but now has been marked down to 3.5 per cent. And if history is any guide, it may only be a matter of time before the incoming data for 2016 again disappoint the more optimistic consensus from the prior year.

So why isn’t growth accelerating? The simple answer is that falling oil prices, low interest rates and monetary accommodation are not random windfalls, but are instead responses to an excess of global supply relative to global aggregate demand.

The decline in expectation for future productivity growth is a major source of the “new mediocre” of sluggish global demand falling short of ample global supply. The connection is as follows. Decisions by households and firms to invest or consume today depend in part on expectations for future income or profit growth, which in turn will be tied to future productivity growth. If workers expect modest or no pay increase in the future and firms scale back their views of future profits, they cut back today on consumption and investment.

According to classical economics, the price level, bond yields, stock prices, exchange rates and commodity prices in theory should adjust even in a low productivity growth world to clear global markets at full employment. However, since Keynes, we have understood that the mechanism can break down, and when it does the global economy clears at a level of aggregate demand that falls short of supply. Monetary policy has adjusted to this reality. Monetary accommodation has boosted stock prices despite reduced prospects for productivity growth, while exchange rates reflect divergences – actual and prospective – among these accommodative national monetary policies.

Yet while growth in demand has been disappointing by historical standards, the gap in some countries, including the US, between aggregate demand and supply is closing, in no small part because of the slowdown in potential growth. Understanding this, the Federal Reserve has indicated it expects to commence raising rates, perhaps later this year. As it does so, it will need to remember that the slowdown in potential growth that is closing the output gap is also a “headwind” to demand, which will influence the pace of rate rises as well as the ultimate destination for the average policy rate.