Overview of the economic chapters
25 June 2017
Over the past year, the global economy has strengthened further. Growth has approached long-term averages, unemployment rates have fallen towards pre-crisis levels and inflation rates have edged closer to central bank objectives. With nearterm prospects the best in a long time, this year's Annual Report examines four risks that could threaten the sustainability of the expansion in the medium term: a rise in inflation; financial stress as financial cycles mature; weaker consumption and investment, mainly under the weight of debt; and a rise in protectionism. To a large extent, these risks are rooted in the "risky trinity" highlighted in last year's Annual Report: unusually low productivity growth, unusually high debt levels, and unusually limited room for policy manoeuvre. Thus, the most promising policy strategy is to take advantage of the prevailing tailwinds to build greater economic resilience, nationally and globally. Raising the economy's growth potential is critical. At the national level, this means rebalancing policy towards structural reforms, relieving an overburdened monetary policy, and implementing holistic frameworks that tackle the financial cycle more systematically. At the global level, it means reinforcing the multilateral approach to policy - the only one capable of addressing the common challenges the world is facing.
Financial markets were confronted by a changing political environment as the economic background brightened. Political events surprised market participants, who quickly needed to take views on the shifting policy direction and its economic implications. Attention shifted away from monetary policy, and political events took centre stage. A natural consequence of this reorientation was a change to longestablished patterns of correlation and risk. Instead of broad-based swings between "risk-on" and "risk-off" positions, investors began to differentiate more across sectors and countries. Bond yields diverged across the major economies, with knock-on effects on foreign exchange markets. At the same time, a gap opened up between surging measures of policy uncertainty and record-low financial market volatility, while a number of indicators pointed to increased tail risks. Pricing anomalies that emerged in the aftermath of the Great Financial Crisis (GFC) retreated but did not disappear, suggesting that such anomalies may have become a more permanent feature of markets.
The global cyclical upswing strengthened considerably during the year under review, with virtually all major economies expanding by early 2017. Consumption was a key factor driving aggregate demand, but business investment also showed signs of a rebound. At the same time, shrinking measures of economic slack suggested that the expansion was maturing. Financial cycles were in the expansion phase in many countries, supporting the economic upswing. In part related to the financial cycle, there are a number of medium-term risks to a sustainable economic expansion. Leading indicators of financial distress signal risks from high private debt and house prices in several economies that were not at the epicentre of the GFC. High household debt might become a drag on demand in some countries, especially if rising interest rates were to boost debt service burdens. Elevated corporate debt, coupled with weak productivity growth, could weigh on investment. And rising protectionist sentiment could hurt economic prospects. Yet the cyclical tailwinds open a window of opportunity to pursue policies that enhance resilience and reduce risks to sustainable growth.
Monetary policy remained generally highly accommodative, with nominal and real interest rates kept very low and central bank balance sheets remaining large or growing further. Against the backdrop of strengthening growth, inflation developments took centre stage in central bank decisions. While inflation rates for the most part became better aligned with central bank price stability mandates, the significant reduction in labour market slack raised questions about upside inflation risks. That said, an evaluation of those risks based on historical labour market developments suggests that they are unlikely to be the primary risk to the global expansion under way. Policy normalisation presents unprecedented challenges, given the current high debt levels and unusual uncertainty. A strategy of gradualism and transparency has clear benefits but is no panacea, as it may also encourage further risk-taking and slow down the build-up of policymakers' room for manoeuvre.
The financial sector faces an improving but still challenging environment. The nearterm economic outlook has brightened substantially. At the same time, intermediation margins remain compressed across the major economies and the sector is grappling with structural forces such as technological innovation and consolidation pressures. With the main chapters of regulatory reform about to be closed, space is opening up for banks and other financial institutions to further increase resilience. One area of attention is global US dollar funding markets, which are likely to remain a key pressure point during episodes of market stress. Banks' continued heavy reliance on short-term US dollar funding, paired with a high degree of market concentration and interconnectedness, underscores the importance of supervisory cooperation and effective backstops. The ultimate aim is a stronger financial system that helps support the resilience of the global economy.
Economic globalisation has contributed to a substantial rise in living standards and falling poverty over the past half-century. Tighter trade and financial integration are deeply intertwined: international trade not only relies on, but also generates, financial linkages. Together, international trade and finance have enhanced competition and spread technology, driving efficiency gains and aggregate productivity. Like any other form of far-reaching economic change, globalisation poses challenges. For example, globalisation has coincided with rising withincountry income inequality in some countries, although the evidence indicates that technology has been the main driver. Moreover, financial openness exposes economies to destabilising external influences. Properly designed domestic policies can enhance the gains from globalisation and mitigate the adjustment costs. And international cooperation must supplement such policies in order to address global linkages. Completing international financial reforms is one priority. Global currencies call for international cooperation, effective crisis management and more systematic consideration of cross-border spillovers and spillbacks.