Firing on all cylinders?

What a difference a year makes. Last year the annual International Monetary Fund (IMF) meetings in Washington were characterised by doubts over the outlook for the global economy. This year, as we discuss in the video above, the IMF forecasts for the world economy were revised up and the theme was "seeking sustainable growth".

Leading indicators suggest that growth will remain robust, largely owing to the synchronised nature of the current upswing with the US, Europe and Japan all performing strongly.

Loose monetary policy has certainly played a role, but so too has the recovery in commodity prices and a resilient performance from China.

We have also seen a revival in investment intentions, particularly in the US. Although this has been one of the longest expansions on record, it has been one of the weakest for US capital spending (capex), particularly for business capex.

Explanations for this focus on the changing mix of growth in the US (more growth in labour intensive services, less capital intensive manufacturing) and the difficulty of measuring the cost of technology.

Inflation continues to puzzle: should we give up on the Phillips curve?

The upturn in global growth has lifted sentiment and markets, but investors and central bankers remain puzzled by the behaviour of inflation. Given the tightening of labour markets, most would have expected wages and inflation to be accelerating by now. Instead, we have a "Goldilocks" recovery where growth is not "hot" enough to push up prices.

At the heart of this lies the Phillips curve. It describes the relationship between unemployment and wage growth, such that lower unemployment leads to higher wage growth and vice versa. The problem is that it has not worked during this cycle and as some have argued, has not worked for at least a couple of decades¹.

This has created something of an intellectual crisis in central banks as the Phillips curve has been seen as a compass for guiding monetary policy.

An enhanced compass would be useful

Essentially economists come out on two sides of the debate as to the usefulness of the Phillips curve today. The first group argue that central banks should simply recognise that the relationship does not work and find something else to guide policy. The second say we should keep the framework, but work harder to understand the drivers. It's a choice between trying to make the compass work better, and throwing it away.

In our view central banks should not give up on the Phillips curve. Apart from the issue of what to replace it with, there is plenty of scope to enhance the current framework.

For example, adjusting unemployment for factors such as part-time working or temporary contracts could provide a better guide to wage and inflationary pressures. Using global rather than local output gaps is also likely to prove more fruitful.

The coming months could provide a key test as the signs of strength in the world economy discussed above are likely to bring further labour market tightening. An enhanced compass will prove useful.

^{1. See "Through the looking glass", Claudio Borio, Bank for International settlements, OMFIF City lecture, 22 September 2017 here↩}