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Strong economic recovery despite investor concern over the return of inflation

Shamik Dhar
Shamik Dhar7/27/2021 03:55 PM GMT+08  • 3 min read
Strong economic recovery despite investor concern over the return of inflation
Approaching 3Q2021, world economic activity is expected to pick up strongly, despite rising inflationary pressure.
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Approaching the third quarter of 2021, world economic activity is expected to pick up strongly, particularly in those countries that have rolled out vaccinations to a large proportion of the population.

This economic activity will continue to surge in the second half of this year, on the back of enormous pent-up demand and the delayed impact of huge fiscal and monetary stimulus.

Although we are keeping a close eye on rising inflationary pressure this year, we continue to see a strong probability of a ‘good recovery’ from the Covid-19-induced downturn.

In this scenario — which holds a 45% likelihood — a strong supply response to rapid demand growth means we get a very strong recovery in those countries where the vaccine rollout is most advanced, with others following shortly behind.

The good recovery story is a bit patchier in terms of the growth outlook for emerging economies this year, but this is fundamentally a story of recovery delayed, as vaccine rollouts are expected to pick up during 2022.

In our latest outlook, we have two inflation scenarios, distinguished by differing central bank responses to rising inflationary pressure.

The mismatch between strong demand and a more hesitant supply response is the key driver of rising inflationary pressure.

Our first inflationary scenario — ‘overheating’ — gets a probability of 15%, down from 30% last quarter. In this scenario, there is a persistent rise in inflation itself because central banks remain ‘strategically patient’ and fail to tighten policy until recorded inflation rates are well above target and inflation expectations begin to destabilise.

Inflationary surge

This is particularly true of the Fed and the inflationary surge is largest in the US, partly because stimulus is larger than elsewhere and partly because the Fed has made a greater commitment to ‘strategic patience’ than other central banks.

Ultimately, this manifests itself as a ‘policy error’ since the Fed is eventually forced into tightening sharply, generating a big market selloff and sharp economic downturn towards the end of our forecast period.

The ‘overheating’ scenario is closest to American economist Larry Summers’ view of the world.

Our second inflation scenario, which has a probability of 30%, sees a similar rise in inflationary pressure this year, but unlike ‘overheating’, central banks respond much earlier.

Specifically, the Fed signals tightening to come at a lower trailing average rate of inflation and slightly higher level of unemployment than under ‘overheating’. The upshot is an earlier, but ultimately smaller monetary tightening that jolts markets in 2022 but means a smaller and shorter economic slowdown than under ‘overheating’.

Despite the inflation risks, we remain on course in a number of key economies for a strong and vigorous economic recovery in the rest of 2021. We have long argued that this recession was different as it was not prompted by a major imbalance in the economy, such as high embedded inflation or excessive debt.

Rather, it was an ‘exogenous’ shock which — once passed — would allow a sharp bounce back to pre-existing levels of economic activity relatively quickly. But overall, the second half of 2021 looks bright with a positive outlook for markets and broad economic recovery.

Shamik Dhar is chief economist at BNY Mellon Investment Management

Photo: Bloomberg

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