Brigitte Granville: Prospect of higher inflation and interest rates could sow the seeds of an economic downturn in 2021

Brigitte Granville, Professor of International Economics and Economic Policy at the Queen Mary College, University of London, is taking part in the Gaidar Forum organized by the Russian Presidential Academy of National Economy and Public Administration in Moscow. Invest Foresight, a strategic media partner of the Forum, asked Professor Granville to share her views of the foreseeable economic future.

The consensus expects a modest acceleration in global economic growth in 2020. This consensus view appears to be based on macroeconomic indicators stabilizing during the second half of 2019 following the downturn that began in 2018. Another positive driver is the recently announced truce in the US-China trade war (the so-called ‘Phase One’ deal) that is due to be signed by President Trump in Washington this week.

At the same time, the economic growth outlook remains mediocre. The main obstacles to the world economy growing more rapidly are (I) China’s reluctance to repeat the strong stimulus seen in the past decade and (II) the strength of the US dollar, and resulting deflationary effect on the global economy because of the dominance of the dollar in global trade and the rapid increase during the past decade in US dollar-denominated debt – especially in emerging markets (though Russia represents a very healthy exception to this rule, as Russian borrowers have been reducing debt since 2014 and reducing the share of foreign currency-denominated debt in their overall indebtedness).

Against that background, the main challenge that I see in 2020 (especially in the second half of the year) is a pick-up in inflation, and a resulting reaction in both the banking system and capital markets in the form of an increase in interest rates/yields.

As a monetary economist, I have been writing about inflation risks for a long time. My book Remembering Inflation was published by Princeton University Press back in 2012. It is true that inflation has not been quick to respond to falling unemployment (especially in the US). To a considerable extent, this absence of the classic “Phillips Curve” effect must be due to the success of Central Banks in reducing inflation expectations – another theme covered in my book.

But the problem now is that companies’ profit margins will be squeezed by the combination of upward wage pressures and mediocre global demand. At the same time, companies are highly indebted. They will try to raise prices to improve their profits. But pricing power is limited. Weak corporate profitability will be a concern to bank lenders and capital market finance providers. This, in turn, will produce tighter financial conditions. Companies and governments (especially in Europe) are extremely vulnerable to any rise in interest rates. It is worth mentioning here that central banks will be happy to see inflation rise, and that market interest rates could therefore rise faster than central bank policy rates. This prospect of higher inflation and interest rates could sow the seeds of an economic downturn in 2021.

The best answer to this challenge will be business investment that raises productivity. Higher productivity will moderate inflation pressures in general – but, more importantly, help the companies that make those investments improve their profitability and thereby insulate themselves from any general inflation pressure and tougher financial conditions. In general, the easing of US-China trade tensions might unleash business investment plans that have been kept on hold for the past year or more owing to ‘trade war’ uncertainties. Specifically as regards Russia, productivity enhancing business investment is, of course, a core goal of Russia’s present economic strategy.

This last point underlines the prospect of Russia contributing in 2020 to the overall acceleration in global economic growth. Other leading regions will include South-East Asia, again largely thanks to the easing of US-China tensions.

As regards industry trends, the main negative trends during in 2019 were in the automotive and tech sectors. This was due, respectively, to restricted Chinese credit plus tougher German emissions regulation, and the saturation of the global smartphone and microprocessor markets. Both these negative trends should stabilize, if not reverse, in 2020. However, the point that I would like to stress is linked to my previous remark about productive investment. The most important trend for global economic development in 2020 could turn out to be the application in mass markets of major breakthroughs in Artificial Intelligence. One example is driverless cars; and here in Russia, Yandex is among the global leaders.

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