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The International Monetary Fund is good at getting the headlines. This week is its annual spring meetings in Washington DC, and it has had three big hits, two about the world economy, one specific to the UK.
The first, from the forecasts in its new World Economic Outlook, was that the world was “entering a perilous phase”. The risk of a recession across the developed world had risen sharply, and the banking problems showed that there were increased risks to global financial stability.
The second was longer term: that once the current burst of inflation had receded, interest rates in the developed world, including the UK, will return to pre-pandemic levels, and remain very low for the foreseeable future.
And the third was that the UK would have the lowest growth this year among the major economies – indeed no growth at all, for the economy is projected to shrink by 0.3 per cent. That certainly hit the headlines here, though the results it published for 2022 were less widely reported. Last year it estimated that the UK had four per cent growth, the highest of the G7.
The pessimistic view
Come back to the UK in a moment. What should we make of the warning of peril for the world economy? If indeed the outlook is so perilous, why is the most important index of US shares, the S&P500, up eight per cent this year? Why is the FTSE100 index here in the UK up nearly four per cent and pretty close to the all-time high it reached in February?
The best explanation is that there are two quite different views about what will happen. The pessimistic view, reflected by the IMF, is the central banks are focusing too much on fighting inflation and will increase interest rates too much. (They can’t quite say that, but this is implicit in their argument.) Higher rates will put more pressure on borrowers, force consumers to cut back, undermine housing markets still further, and push some businesses into bankruptcy. That is the peril and of course it is possible they may be right.
The optimistic view
The other view, reflected in share prices, is that interest rates are already high enough to curb inflation, which will come back to the target level of around two per cent by the end of this year. This will enable growth to get going again, supporting company earnings. As far as the US is concerned, maybe there will be one more increase in interest rates but the top of this cycle is in sight. Much the same argument applies to the UK, and in both cases, interest rates will be heading down by the end of this year, or early in 2024.
For what it is worth, the latest inflation data for the US, out today, showed a rise of only five per cent, the lowest annual level since May last year. This supported the optimistic view that inflation was being beaten and shares rose on both sides of the Atlantic. But of course one month’s figures are only one month’s figures and the uncertainties remain.
Personal finance impact
There are even greater uncertainties about the longer-term path of interest rates. It is a seductive prospect for home-buyers to think that if they can hang on through the current surge in rates, mortgages will soon be back to those ultra-low rates of a couple of years ago. It is a less attractive one for anyone trying to get a decent return for their savings, knowing that they will probably get less than the rate of inflation if they keep their money in a bank. We also have seen how a long period of very low interest rates widens wealth differentials, because it boosts asset prices. Those with the most assets, the wealthy, benefit the most. Anyone trying to save to buy their first home, on the other hand, is clobbered.
So is the IMF right? Its argument, stripped down, is that the world faces an excess of savings. As countries’ populations age, people save more and spend less, and there are fewer opportunities for investment. This excess of savings pushes down the return of those savings – so interest rates go down, as they have in Japan, the oldest society on earth.
But will the world really become more like Japan? Or will it become more like the US? One of the characteristics of Americans, and indeed of Britons, is that if they have money they spend it. Private consumption in Japan is 53 per cent of GDP, whereas in the US it is 68 per cent. (In the UK it is 61 per cent.) Both the US and UK have rising populations and need massive investment in infrastructure and housing, and arguably much more in commercial activities too. Japan, by contrast, has a declining population.
Outcomes, not forecasts
In any case, we have seen how damaging it is socially to have such low interest rates and how eventually they lead to higher current inflation. Anyway in practical terms, I cannot see the central banks making the same mistake again, at least for a generation. That would suggest that on this the IMF is plain wrong.
And wrong about the UK? Well, if they are right it will be politically damaging for this Government. But as has been noted the IMF has form on this matter of underrating the UK. In 2014 its managing director, Christine Lagarde, famously asked “Do I have to go on my knees?” when she admitted on The Andrew Marr Show that the Fund’s criticisms of UK policy had been wrong and its performance had surprised them.
It is worth pointing out too that the IMF’s forecasts of a year ago substantially underrated the UK’s prospects in 2022, while overrating those of the US, Germany and France. What matters are not forecasts but outcomes, and I expect a year from now there is a good chance that the Fund will have underrated the UK again. Actually, I don’t think the prospects for the world economy are so perilous either. But we will see.
Need to know
Stepping back from the headlines, it is interesting that the IMF should be so gloomy about the UK, and this raises a wider question: what has gone wrong with forecasting, not just by the IMF, but by most official bodies? After all, the central banks failed to see the surge in inflation, with the Fed labelling it “transient” – leading to a huge policy error.
There is a slightly unsatisfactory explanation, which is that the economic models can only capture how the different countries’ economies have performed in the past. So when something new comes along that is outside past experience, an external shock such as the pandemic or war in Ukraine, they cannot cope and throw out wrong answers.
I think that is right, but since we have to rely on economic models to do the forecasting, it is not very helpful. And even before those two shocks, the models gave some dodgy forecasts. For example, when QE was first introduced, I remember going to a really interesting background briefing at the Bank of England as to how it would work. By pumping money into the system that would cut long-term interest rates, which in turn would increase investment and asset prices. That would initially lead to higher growth and then eventually to higher inflation.
Well, the early stages did indeed work out more or less as planned in that long yields did fall, and that increased the price of gilts. But investment was sluggish, and growth OK but uneven. The one thing that did not happen was a rise in current inflation. Eventually, that came through with a vengeance but the Bank of England, along with the other main central banks, was lulled into complacency. The European Central Bank even used negative interest rates to try to boost corporate lending and hence investment.
No way of predicting
While we don’t yet have the full explanation I expect that what will eventually emerge is that the lags between excess money creation and its impact on inflation were much longer than anyone expected. And since there had never in human history been negative interest rates there was no way of predicting how they would work.
So what do you do? My own, admittedly unsatisfactory, response is to say that you use intuition and common sense. Do the modelling because that gives a base to start from, but then ask whether the outcomes square with one’s intuitive feel for the economy, how people (and businesses) behave, and if the numbers don’t feel right, change them. In the case of the UK at the moment I think the models underplay the resilience of the British consumer, which in turn makes the economy more able to cope with shocks than the models predict. That resilience has been underpinned by the cash pile of the so-called excess savings that people built up over the pandemic. Now those savings are being spent and that is enabling many people (sadly not all) to cope with the higher prices.
Anyway, let’s see whether the IMF is right after all. My instinct is that it is wrong on all those three big “calls” referred to at the start of this article. But I would be the first to admit that all economists get things wrong, including this one.
My book on the future of the world economy, The World in 2050, is available here
This is Armchair Economics with Hamish McRae, a subscriber-only newsletter from i. If you’d like to get this direct to your inbox, every single week, you can sign up here.
