Global industrial output has already recovered half of its loss during the recession. If the rebound were to continue at its recent pace, output would regain its prior peak level by May 2010 – far earlier than expected by the consensus but consistent with the "Zarnowitz rule" that "deep recessions are almost always followed by steep recoveries".
The top line in the first chart shows an index of combined industrial output in the Group of Seven (G7) major economies and seven large emerging economies (henceforth the "E7") – Brazil, Russia, India and China plus Mexico, South Korea and Taiwan. A smoothed path is also plotted, based on fitting log-linear trends to the separate G7 and E7 data since 2000. This path implies a current trend growth rate of global output of 3.5% per annum.
The global output measure peaked in February 2008 and fell by 14% to a trough in February 2009. It had recovered by 7% by September 2009, equivalent to an annualised increase of 13%. If this growth rate were to be sustained, output would regain its 2008 peak level in May 2010 and cross above its trend path in June.
The lower lines show the contributions of G7 and E7 output to the global total, together with associated trends. The outsized impact of emerging economies on global trend growth is immediately apparent. The curvatures of the trends imply annualised output increases of 8.1% in the E7 but only 0.4% in the G7. Put differently, the E7 account for 3.2 percentage points of current global trend growth of 3.5% per annum. If the recent growth differential were to persist, E7 output would surpass that of the G7 by 2014.
In addition to dominating the longer-term trend, emerging economies have been responsible for 5 percentage points of the 7% recovery in global output since the February 2009 trough. E7 output has already moved ahead of its prior peak and is only marginally below its fast-rising trend. If growth were to continue at its recent pace – plausible given current policy settings and functioning banking systems – emerging economies would overheat in the second half of 2010 and 2011.
The recovery in G7 activity, while less dramatic, has still been significantly stronger than forecast by most economists in early 2009. Output fell by 20% between February 2008 and March 2009 but had recovered by 5% by September. Short-term leading indicators signal a further solid gain in late 2009 – second chart.
G7 central bankers argue that their super-loose monetary policies are warranted by domestic "output gaps" that will exert strong downward pressure on prices. These gaps, however, may be smaller and closing more rapidly than they think. The deviation of G7 industrial output from trend has already narrowed from 14% to 10%.
Policy-makers, moreover, are ignoring inflationary risks from emerging-world buoyancy. Continued above-trend E7 output growth is likely to result in further gains in global commodity prices – third chart. If emerging economies overheat, labour cost and margin elements of prices of exports to the G7 will also increase. If E7 central banks tighten to prevent overheating while G7 policies remain lax, currencies should appreciate, with the same result of higher G7 import prices.
This week's UK Inflation Report contained no discussion of such possibilities. The Bank's view – reflected in Governor King's five explanatory letters over 2007-09 – seems to be that any inflation overshoot due to external factors represents an exogenous "shock" that should not affect policy settings based on "output gapology". Given the above-described global trends, this stance implies that actual inflation is much more likely to exceed than fall below the target – as it has in all but three quarters over the last four years.
