Head of Economic Research, Banco Agrario de Colombia
Strong Cycle and Soft Landing: the Post-Pandemic Challenge.
The Austrian school of economics suggests economic cycles of boom and recession are the result of credit expansion-contraction processes. These cycles are pronounced when central banks, artificially, set a key interest rate that has short-term effects on leveraged consumption and gross fixed capital formation. The cycle arises, basically, from a lack of coordination in the intertemporal decisions of households and businesses. Beyond the academic and philosophical discussion, this is the result of macroeconomic policies that countries adopt to influence their economic cycle. This brief theoretical description allows us to analyze the current cycle that the world economy is going through and where we could navigate in the near future, understanding that the primary objective of macroeconomic policy is to guarantee a soft landing of the cycle.
After the unprecedented crisis caused by the COVID-19 pandemic, the world economy recovered faster than anticipated. Lockdown measures adopted to mitigate the contagion spread, and others economic policies that were designed to preserve jobs, generated excess savings that accumulated very quickly.
In response to the crisis, central banks and governments adopted expansionary policies that aggressively expanded the monetary base, cutting benchmark interest rates to historic lows and increasing public spending. Once health measures relaxed, while the vaccination process was advancing successfully, there was a private spending boom (consumption and investment) that allowed to recover activity levels prior to the pandemic shock.
The collateral effect of a rapid recovery in aggregate demand, far exceeding the speed at which the output capacity was opened, was a significant imbalance between demand and aggregate supply that induced a higher inflation. Other inflationary supply pressures have emerged, particularly of a geopolitical nature, which are once again creating constraints on global supply chains and upward pressures on commodity prices.
At this point it is worth remembering what Milton Friedman pointed out when he stated that inflation is always and everywhere a monetary phenomenon. If the economy's money supply grows faster than real output, the unequivocal result will be more inflation. By constitutional mandate, central banks have the obligation to adopt measures that drive inflation towards goals defined within the target inflation schemes framework. Given the current imbalance, policy interest rates increased rapidly to curb inflation around the world.
In advanced economies, programs of monetary base expansion called Quantitative Easing (QE), which were used to inject liquidity into the economy and stimulate consumption and investment during the pandemic, have also reversed. Other programs called Quantitative Tightening (QT) are contracting the monetary base nowadays and short-term interest rates in financial markets have increased further. Governments have also begun a normalization of fiscal policy, although at a slow pace that maintains high deficits and strong pressures on public debt levels, which in turn generates more pressure on the capital cost.
As a result, world economy growth has been slowing from 6.2% in 2021 to 2.7% in 2023, according to various multilateral organizations projections. In the case of advanced economies, the economic growth moderated from 5.4% to 1.3% during the same period.
Risks of a recession are just the natural result of the economic cycle we are going through because of the monetary and fiscal adjustment, especially in emerging markets economies like Latin America where this adjustment has been aggressive. In the case of Colombia, central bank's interest rates increased from 1.75% in 2021 to 13.25% in 2023, while the growth of the economy plummeted from 10.7% in 2021 to 1% in 2023.
Looking ahead to 2024, very good news about global inflation is that it is already declining, largely due to the actions of central banks. This has allowed monetary policy to tackle inflation in 2023, but interest rates are still required at relatively high levels to consolidate the current disinflationary process towards the objectives.
Under the logic of the economic cycle, beyond the fact that interest rates in advanced economies will probably decrease in 2024 and that in other latitudes they will continue to gradually decline, all of this implies that global GDP growth will continue to be subdued at low rates around 2.5%. The bias on this forecast is naturally bearish due to geopolitical risks that could continue to affect production and international trade, and other more structural risks such as the slowdown in China's economic growth. The objective of macroeconomic policy is to guarantee a soft landing after a strong boom cycle.
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