Could the global economy overheat in 2018 or 2019?

In a welcome change from the past few years, global growth is strong, economic slack is diminishing, and there are early signs that inflation is beginning to rise. In the past month, IHS Markit has revised up world economic growth from 3.2% to 3.3% in 2018 and from 3.1% to 3.2% in 2019, reflecting improved outlooks for the United States, Canada, and China. With robust growth and (gradually) rising inflation, worries about overheating are increasing. If central banks are seen to be “behind the curve” and might have to tighten more aggressively than financial markets expect, then the damage to confidence and the economic expansion could be substantial. Given that inflation is still modest, such a scenario seems at least a year or two away. Meanwhile, the expansion will continue.

United States: A modest boost to growth from tax cuts. The forecast for 2018–20 has been revised up modestly to reflect the inclusion of the Tax Cuts and Jobs Act that, among other things, cuts personal taxes through 2025, allows expensing of equipment through 2026, and reduces the corporate tax rate permanently. Relative to last month, the IHS Markit forecast of real GDP growth is revised up by 0.1 percentage point to 2.7% in 2018, 0.2 point to 2.6% in 2019, and 0.1 point to 2.0% in 2020. Faster growth will result in a lower unemployment rate and a gradual acceleration in wages and prices. We assume the Federal Reserve will respond by advancing a rate hike, so that the federal funds rate will average 25 points higher in 2019–20 than previously projected.

Europe: Continued above-trend growth, despite numerous political uncertainties. IHS Markit estimates that Eurozone real GDP growth will ease slightly from 2.5% in 2017 to 2.3% in 2018. The business climate will remain favorable in 2018–19, and risks are balanced. Labor markets continue to improve, and mild inflation is helping consumer purchasing power. Unfortunately, political uncertainty remains high, including a March election in Italy and the stalemate between Spain and Catalonia. Meanwhile, the UK economy continues to slow in the face of a protracted and indeterminate Brexit process.

China: A little more upside in the near term. China’s economy has shown resilience, ending 2017 with solid growth in retail sales and exports. Yet, three policy initiatives will restrain China’s near-term growth trajectory: 1) supply-side reforms, which aim to remove excesses in industrial capacity, debt, and housing inventory; 2) a regulatory crackdown on the shadow banking sector, which attempts to mitigate systemic risk of a financial crisis; and 3) the antipollution drive, which endeavors to reduce social discontent about living conditions. These policy campaigns have already cooled fixed investment. Real GDP growth is projected to moderate from 6.8% in 2017 to 6.6% this year and 6.3% in 2019.

Other large emerging markets: The tailwinds have become stronger. Stronger global growth and rising commodity prices are boosting export volumes and earnings. The major risk facing these economies (still relatively low) is a sharper-than-anticipated increase in developed-economy interest rates. This would not only renew downward pressure on exchange rates, but would also increase the debt-service payments for some of the most indebted countries.

Bottom line: With growth momentum strong, there is a high probability that the current global expansion will continue through 2018 and into 2019.