The recovery from the Covid crisis continues, with global activity now exceeding its pre-pandemic peak. However, this rapid rebound has already run into supply constraints in many sectors and economies, leading to a surge in global inflation. Some of these demand- supply imbalances should ease over the coming quarters, helping to cool price growth. But it’s hard to escape the conclusion that Covid has permanently damaged the supply side of the global economy, implying a less favorable trade-off between growth and inflation.

We still believe the global recovery has further to run. But we should also expect even larger divergences in growth, inflation and policy from country to country. Moreover, the risks around our baseline scenario are firmly tilted towards the downside, especially given the emergence of the Omicron Covid variant. This adds another risk to monitor, alongside the threat of further unpleasant news on the inflation front and the need for tighter policy — a painful mix for markets.

Inflation – what’s next?

The big story over recent months has been the surge in global inflation. This was driven by a series of interrelated shocks including:

These shocks have generated severe supply-chain disruptions for durable goods, growing labor shortages and booming house prices. Together, they have created a perfect storm of supply-and-demand imbalances, driving price growth to multi-year highs in many key economies. The impact of each driver varies across countries in terms of magnitude, timing of the inflation peak and degree of persistence.

The good news is that several of these shocks should dissipate over the course of 2022. For example, there are tentative signs that some of the most severe stress in sections of global supply chains are already starting to ease. Similarly, while energy markets remain vulnerable to supply-driven price spikes over the northern winter, favorable base effects should reduce the year-on-year (y/y) contribution from these components well before the summer months in the northern hemisphere.

Nevertheless, intelligence we’ve gathered from our contacts suggests the risks are tilted towards more prolonged disruptions. Also, not all the inflationary pressures will ease independently, especially in economies already pushing up against capacity constraints. This is perhaps most evident in the US labor market, which looks tight across some measures and is delivering strong wage growth. Certainly, it is possible that further normalization in the Covid crisis will ease some of these logjams. But the evidence points to a long-term hit to labor supply, imposing a speed limit on the recovery.

Regional breakdown

The inflation outlook therefore remains uneven and uncertain. US price growth will likely rise further in the short term, before moderating quite quickly over the first half of 2022, albeit to levels that may still be some way above the US Federal Reserve’s (Fed) target.

We expect a similar picture in the UK once the impact of gas-price increases fades, with core inflation falling back to target over the second half of 2022. Inflationary pressures have been less acute in the Eurozone and are likely to fall back to below-target levels over 2022. Meanwhile, underlying inflation is even weaker in Japan, as the country’s economy it remains firmly trapped in its "lowflation" environment.

Inflation drivers and outcomes have been even more varied across emerging markets (EMs), with muted Asia Pacific (APAC) inflation reflecting weaker local demand, less durable heavy consumption patterns and better anchored inflation expectations. There is potential for some convergence ahead, as strong price growth in other EMs fades, and we see some reopening-driven rebounds in inflation across Asian economies. However, a sizable gap will remain.

Central banks tightening

Despite this year’s inflation shock, we remain confident that policymakers will not allow above-target inflation to become entrenched over the medium term. A range of developed market (DM) central banks have signaled an earlier withdrawal of support than was thought likely at the start of the year, and market expectations for interest rates have risen notably.

Market pricing for future policy moves looks broadly justified in the US, with the risks tilted towards even earlier tightening should inflation continue to surprise to the upside. There are also upside risks to market pricing for the terminal Fed Funds Rate, should the Fed need to tighten more forcefully to quell inflationary pressures.

However, elsewhere, expectations for policy tightening appear overdone. The UK is expected to start tightening in December, but we are skeptical that the Bank of England will be able to meet market expectations for further adjustments. Pricing for a deposit rate hike in the Eurozone in 2023 looks very ambitious, with low inflation expected to trap the European Central Bank (ECB) at the lower bound

The policy outlook is most challenging in those Latin America (LatAm) and Europe, Middle East and Africa (EMEA) economies where inflation has increased the most. Many central banks have already lifted rates significantly, with markets generally expecting additional adjustment in 2022. And although expectations have scope to decline, as inflation moderates, a more aggressive, inflation-induced tightening cycle in the US would be a difficult tide to swim against.

Growth to slow

The worsening inflation environment poses a few headwinds for growth. First, via a large hit to consumers’ purchasing power — although there is scope in DM economies at least to draw upon elevated saving rates to cushion this blow. Second, via lower speed limits to growth for those economies where supply constraints are most persistent and acute. Finally, via the tighter monetary and financial conditions implied by quicker policy normalization in some economies.

While these headwinds have forced our growth forecasts lower, we think the recovery will continue, albeit at a lower average speed and with persistent divergences between countries. These will be driven by domestic supply-demand conditions, the local Covid situation, relative policy settings and trends in global goods and services sectors.

Our largest downgrades have come in the US and UK, as this is where the growth-inflation trade off appears to have worsened the most. Chinese growth expectations have also been reined in further. This is partly on account of the country being slower to abandon its "zero-Covid" policy, and also due to disruptions from regulatory action, particularly in the property sector. Some recovery in sequential growth is likely through 2022, as these forces fade. But the amplitude is likely to be muted by historical standards, particularly with the authorities wary of aggravating financial imbalances.

Fortunately, the negative spill-over effects of weaker Chinese demand have been less pronounced in 2021 than we might have expected, partly because lockdowns had their greatest effect on domestic services demand. Looking forward, China’s export partners may remain somewhat shielded from the weaker Chinese growth outlook by an improving global goods production cycle.

And finally

Elsewhere, generally high vaccination rates in DMs, the complementary benefits of antiviral treatment pills and an easing in government stringency should continue to lay the ground for further normalization of activity in 2022. Some degree of catch-up in vaccinations should help certain EM economies, and there is potential for the Asian countries that the Delta variant hit hardest to rebound strongly in 2022.

Overall, our forecasts continue to imply a solid ongoing global recovery from the Covid shock. However, the growth divergences we’ve been flagging are becoming more entrenched, and divergences are set to increasingly show up in inflation and policy too.

Finally, as has been the case for the past 18 months, there are very wide confidence intervals around our central growth and inflation forecasts, our virus and vaccine expectations, and our political and policy projections. Thinking in terms of alternative scenarios and focusing on weighted-mean outcomes across multiple scenarios, are more important than any single-point forecast.

The risks around this baseline do tilt towards an even worse trade-off between growth and inflation. We are less confident in the upside-growth scenarios around the supply side, and more worried about a short- term inflationary breakout, especially if accompanied by a further energy price shock, followed by a more aggressive Fed tightening cycle. A substantial increase in Chinese property and financial stress are also important risks to monitor.

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