2014–2016 Outlook: Low for long

Genevieve Signoret

We’ve updated our Quarterly Outlook for the global economy and asset markets, which now goes through the second quarter of 2016. You can consult full forecast tables here and scenario assumptions here. The full report is available here. A Spanish version of this report will be distributed later this week.

We’ve dubbed our central forecast scenario for the next eight quarters Low for Long because, in it, only two major central banks—the Fed and the Bank of England (BoE)—begin normalizing their monetary policy stance by resuming the use of interest rates to conduct monetary policy and starting to raise rates, and neither one adopts a tight stance. Rather, they move slowly and keep rates low. Meanwhile, the Bank of Japan (BoJ) keeps up its asset purchase (quantitative easing) program, and the European Central Bank (ECB) launches a second round of quantitative easing, this one targeting public debt securities as well as private ones. This central bank conduct sends the market a clear message that global rates will remain low for a long time.

We built this scenario assuming that neither the Fed nor the ECB makes a fatal mistake; Chinese authorities avert an outright financial crisis; international trade flows are only slightly depressed by geopolitical conflict; and commodity supplies are ample. For Mexico, we assume that investors judge the regulatory framework built to fully implement reforms to be good enough that a burst of fixed investment demand is unleashed.

Our scenario is not all rosy. BoE and Fed hikes in the UK and USA cause fear and confusion at first, causing volatility of the worst kind to break out. But, once investors grasp that rates will be low for long, risk assets rebound. The bull market continues.

Although global growth does accelerate in this scenario, it remains slow. In the USA, real GDP growth remains almost unchanged at 2.1% in 2014 and accelerates to 2.8% in 2015. In Mexico, external and investment demand push growth rates up to 2.5% in 2014 and a strong 4.4% in 2015.

Though improved, these growth rates prove insufficient to use up all the slack still plaguing the world economy. Also, we assume ample commodity supplies even amid heightened geopolitical tension. Inflation, therefore, remains low. Last year, inflation was 1.5% in the USA and 4.0% in Mexico. Under Low for Long assumptions, we forecast inflation rates to pick up in the USA to 2.0% in 2014 and 2015, and to fall in Mexico to 3.7% in 2014 and 3.2% in 2015.

The Fed ends its asset purchase program in October as scheduled and, starting in the summer of 2015, raises rates over six months to 1.00%. Banxico, however, betting that the reforms will boost potential GDP enough to keep inflation pressure down, stays on pause at 3.00%.

We assign to Low for Long a subjective probability of 70%.

We also develop two risk scenarios, to which we assign equal probabilities of 15%. Our downside risk scenario, Unanchored, has two versions. In both, geopolitical tensions skyrocket and a severe El Niño episode occurs. Commodity supplies are disrupted. Japan and the euro area fail to reform their product and labor markets. And China is hit with an outright financial crisis.

In the deflation version, the ECB loosens too slowly, while the Fed tightens too fast. The global economy spins down into deflation. Investment grade bond valuations remain high but equity performs miserably.

In the inflation version of Unanchored, the Fed tightens too slowly. Inflation takes off. Markets take a dive.

In our upside risk scenario, Pickup, geopolitical tensions ease. Also, the planet is spared an El Niño event. Commodity supplies are ample. Chinese authorities deflate their country’s credit bubble and reform its financial system so skillfully that financial tensions abate. Japan and the euro area pass bold reforms that promise to boost future potential GDP. Inflation and interest rates are the same as in Low for Long, but growth is stronger. The bull market continues.