Firm recovery needs many puzzle pieces to fall into place

Judging from the latest surveys, the consensus of economists seems to be discounting that vaccines will prove effective in limiting hospitalisation, allowing those economies with high vaccine roll-out rates to avoid the setback of new tough lockdowns and closures. A closer look, however, suggests that this is just one piece of a much bigger puzzle that needs to fall into place for the consensus to be realised.

Zooming in on the United States and the euro area, consensus is that 2022 real GDP levels will stand at around 6% and 2%, respectively, above pre-crisis. A first element central to this view is that governments smoothly manage the lifting of temporary policy measures, designed to protect businesses and households from the economic fallout of tough social distancing measures, while at the same time ensuring sufficient support for a firm recovery to take root and limit potential scarring to balance sheets and jobs.

Public investment is a key feature of the recovery plans on both sides of the Atlantic, with climate transition and digitalisation centre stage. These plans make sense at many levels; using recovery spending to boost longer term growth potential and getting to grips with the urgently needed spending on the climate transition. Moreover, with many of the advanced economies engaging in such measures simultaneously, we should in principle see positive spillover effects further boost the short-term impact.

As noted by the IMF in its Fiscal Monitor of October 2020, however, new infrastructure plans often come with long lead times, with the preparation phase typically taking 3 to 8 years and the implementation phase 3 to 7 years. Upgrading existing infra-structure is quicker and it is no surprise that this is part of the plan. Even then, governments may face challenges on sourcing the necessary materials and labour. The near synchronised global sudden stop when the pandemic first struck and fast restarts as economies reopened have already placed substantial strain on global supply chains, as evidenced in supplier delivery time and prices. And, procuring qualified labour is already proving a challenge for many industries.

Central banks are assuming that these frictions in supply chains and labour markets will prove transitory. So too is consensus, reflected in the view that come next spring, inflation spikes will have faded. In turn, this underpins the further key assumption that central banks will adopt a very gradual reduction only of policy support.

One of the most puzzling features of the present market configuration is the stubbornly low level of real interest rates on both sides of the Atlantic. Standing in contrast to the more upbeat view on the economic outlook, 10-year real yields remain deep in negative territory, with recent weeks seeing new historic lows. Fitting this brick into the recovery puzzle is quite a challenge, and not least given burgeoning public debt.

One explanation is that financial markets take a dimmer view than the consensus of economists on the economic outlook. This, however, does not square with dynamic risky asset prices. An alternative narrative is that central banks will continue to compress government bond yields and use selective macroprudential tools to tighten any excess in private credit markets. While such a pathway is possible, it seems optimistic to assume that such a scenario can be managed smoothly, without creating unintended side effects of pockets of market excess or seeing more productively private investment crowded out.

At the same time, central banks are mindful that any sharp repricing of interest rate expectations could trigger a sharp and potentially disorderly repricing of risky assets. As the Federal Reserve and the European Central Bank hold their annual meetings in mostly virtual Jackson Hole and Sintra, there will be much to discuss.

Building confidence of both households and businesses is key to recovery. The view implicit to consensus is that consumers will be willing to reduce savings level and spend some of the savings “forced” by pandemic. One concern here is that such savings are concentrated on wealthier income groups with lower marginal propensities to consume. A still uncertain environment may, moreover, see “forced” savings turn “precautionary”.

Hope is that recovery in the advanced economies will trickle down to emerging economies, but many of these economies face a still very challenging health situation. A further headwind relates to trade and geopolitical tensions. Moreover, it seems likely that those economies heavily reliant on tourism still face a long wait for recovery.

Like any puzzle, the pieces that build recovery interlink, and fitting them together could well prove more challenging that the consensus and markets presently discount.

Michala Marcussen, Societe Generale’s group Chief Economist