Confronting the Crisis - OECD Economic Outlook November 2022

OECD’s global outlook

Muge Adalet McGOWAN:
The outlook is dominated by the third major shock hitting the world economy in the past 50 years, the largest since the 1970s energy crisis. Energy expenditures have risen sharply in OECD economies to around 18% of GDP, which has not been seen since the late 1970s or early 1980s. When energy prices increase, energy expenditures tend to increase, cutting off other kinds of spending, which creates the risk of recessions across all OECD countries.

The share of items in the inflation basket with price increases above 6% is two to three times higher than last year in most large OECD countries. However, the situation in Japan is relatively good from an international perspective. In addition, higher prices are bad for the economy because they weigh on purchasing power and confidence. Now, OECD average confidence levels are lower than what they were in 2008 and 2020. However, at the same time, labor markets have continued to remain tight across the OECD. It is especially tight in the US where vacancies per unemployed is around two. Such worker shortages increase the risk of large wage rises which can fuel inflation further. Even though labor markets are remaining tight, nominal wage increases have not kept up with the unanticipated, large increases in inflation, and real wages have fallen in almost all the OECD countries with a lot of cross-country variation. Such a large decline in purchasing power can affect consumption and growth.

Global growth projections

We project global growth to be 3.1% in 2022. It will slow to 2.2% in 2023 before going back to a relatively modest level of 2.7% in 2024. We expect global growth to be driven by Asia; emerging Asia will be the main engine of growth in 2023 and 2024, accounting for close to three-fourths of global GDP growth in 2023. Europe is particularly affected by the impact of Russia's war against Ukraine.

The OECD revised downward its real GDP growth projections for 2023 for almost all G20 countries because uncertainty is very high. Downside risks have intensified, resulting in these downward revisions. Additionally, we expect inflation to remain high this year and next year, given the impact of the war on energy and food markets, and moderate in 2024 as tighter monetary policy takes effect, demand pressures decrease, and transport costs and delivery times normalize.

Risks and energy prices

The most important risk in the outlook is the gas supply shortages in Europe this winter and next winter, and higher global energy prices. Energy prices paid by households and firms may increase further. European households are paying more than before for their electricity and natural gas, even as governments are providing a lot of fiscal support to shield consumers from the energy crisis. The risk is that there might be further short-term pressures in energy-related retail inflation. The rise in retail energy prices is only a fraction of that in the wholesale markets. An important risk is further pass-through from wholesale to retail prices.

Other risks are supply chain bottlenecks, which have been easing but have not disappeared. There is also monetary policy tightening in response to the high inflation. This higher inflation also puts households, firms, and countries under pressure. Households with variable rate mortgages are facing rising interest payments. Firms are facing tighter credit conditions. Also, many low-income countries are at a high risk of debt distress. Past experience shows that when advanced economies tighten their monetary policy rate, there can be significant negative spillovers to emerging market economies. Given the impact on food prices, food insecurity is also a key vulnerability. Pre-war Ukraine supplied a significant share of wheat imports, and energy price hikes are increasing the price of fertilizers, pushing food costs up.

What can we do?

Monetary policy should continue to tighten in countries where inflation remains high and broad-based. Fighting inflation has to be the top priority. Central banks around the world are increasing interest rates to slow demand growth and increasing prices. In addition, fiscal policy should work together with monetary policy so as to not contradict each other. Fiscal stimulus can raise demand pressures that monetary policy is trying to address, resulting in even higher interest rates needed to control inflation, which would add to financial vulnerabilities. Fiscal policies to shield households and firms from the energy shock must be targeted and temporary so as not to add to the inflationary pressures and increase public debt burdens. However, this support is mostly untargeted across the OECD. Price caps, price and income subsidies, and reduced taxes are being used by almost all OECD countries. However, as energy prices are likely to remain high and volatile for some time on targeted measures, keeping prices down will likely become increasingly difficult to fund and can discourage energy savings.

Moreover, macroeconomic policies are important. OECD is known for structural policies. Therefore, we want to consider structural policies that address the current shock. For Europe to manage the energy crisis and encourage energy security, it would require a combination of policies to replace the Russian pipeline gas supply through diversifying its sources and increase energy savings. Diversifying supply also means boosting reliable and low emission generation. This is the key to reducing vulnerability to unreliable fossil fuel exporters; therefore, increasing energy security. A huge investment in clean energy is essential to reduce the risks of future price hikes and volatility, and get on track for net zero emissions by 2050. Governments should take the lead and provide strategic orientation, but the investment required is too large for public finances. Therefore, the governments also need to provide transparent, clear messages, and investment certainty so that private investors know what to do and can invest as well.

The second important structural message is to keep markets open to help restore growth. International trade should continue to flow to strengthen competitive pressures and help alleviate supply constraints. Bottlenecks in global value chains are showing improvement. Shipping costs have declined, but there are still risks.

An OECD simulation, which is a warning against falling into protectionism, shows that the effects on GDP of a significant increase in trade investment could be large. Across the OECD, there are large gaps between female and male employment rates. These gender gaps not only increase inequality, but also decrease labor supply at a time when more labor is needed. Increasing support for childcare and providing flexible work hours can help women with children return to the workforce and boost growth.

The OECD wants to stress the importance of restoring potential growth through investing in skills. During the pandemic, there was a setback in human capital accumulation because young workers could not gain hands-on work experience and children could not go to school. Across the OECD, on average, schools were closed for 13 weeks fully and then an additional 24 weeks partially, which corresponds to almost one whole school year. Japan performed well compared to other OECD countries, but across the OECD, there is a need to reap the losses back. Therefore, extra apprenticeship, training, and investing in skills are needed.

Finally, the OECD wants to stress that we need macroeconomic policies and structural policies to fight the inflation wave that was unleashed on the world economy by Russia’s war in Ukraine.

Japan’s outlook

OGURO Kei:
Japan struggled to recover in 2020 and 2021. The first impact of COVID 19 was weak compared to other OECD countries, and the economic rebound was small. Recovery, especially private consumption investment recovery, was depressed by a series of shocks and step-and-go confinement measures. However, in 2022, Japan balanced sanitary measures and socio-economic activities. Then Japan recorded positive growth continuously. The seventh wave this summer recorded the highest number of infections and deaths, but the government did not introduce any measures. The latest negative growth was mainly the effects of service imports. The Japanese domestic demand growth was firm in the last quarter.

Japan's inflation rate has been led by energy, food, and oil price cap subsidies since early this year. The energy price hike was mainly led by electricity and city gas. Many food and beverage product prices, including dining out services, have increased recently as raw material prices increase and certain measures eased. Communication prices are also a leading factor of inflation. A price hike of mobile phone devices due to yen depreciation also pushed up the index. The travel subsidy resumed in October depressing the headline inflation by around 0.1% to 0.2%. The labor market has been tightening, and wage growth is sluggish. In addition to policy effects, real wage pressure and cost pass-through make Japan's inflation relatively low compared to other advanced economies.

While domestic demand is recovering slowly but steadily, external demand has been volatile. Supply chain disruption resulting from the Russian war and China's zero COVID policy have held back investment exports. Furthermore, widening policy interest rate differentials with other advanced economies have led to the additional yen depreciation, adding upward pressure on prices. Currency depreciation increased export volume and import price in general. With the high energy price, recent currency depreciation increased the trade deficit. It also decreased corporate profits for firms depending on imports, but on the other hand, increased profit for exporting firms.

Assumptions on Japan’s outlook

Labor markets will continue to tighten, and the unemployment rate will continue to fall. Wage growth will lag in the short term but will gain momentum later. In terms of consumer price, global energy prices will continue to rise until early 2023 because of the embargo from Russia and then remain constant. The exchange rate is constant throughout the projection period. The energy subsidy will continue but gradually decline in 2024. As the output gap closes and wage growth gains momentum, inflation is projected to increase to 2%, which is the Bank of Japan's target at the end of 2024.

For fiscal policy, we include a new economic policy package and related supplementary budget of around 30 trillion Japanese yen. However, we assume that R&D and investment subsidies will be implemented across multiple years. Outward revision from the previous outlook comes mainly from the package effects, especially private investment and public consumption. As pandemic-related support is phased out in 2024, government spending will decline, and business investment will normalize. Then domestic demand growth will be moderate in 2024. The OECD assumes that monetary policy will continue to be accommodated when inflation and wage growth meet the Bank of Japan's criteria at the end of 2024. The yield curve control will start to be eased by allowing a steeper slope without changing the short-term rate.

Downside and upside risks

Higher inflation will damage private activities. Weaker external demand and supply chain disruption will negatively affect export, production, and private investment. On the other hand, stronger external demand including inbound tourism will push up economic growth.

The Japanese government reacted to various shocks swiftly and strongly. Even before COVID 19, Japan's gross debt-to-GDP ratio was the highest among OECD countries, so including large scale policy packages, with the assumption that the non-target price subsidy will continue and debt to GDP level will reach unprecedented levels.

OECD recommendations for Japan

At first, accelerating structural reform will be critical to boost productivity and wages. Further fiscal measures to support households and businesses should be temporary and more targeted. Prolonged price caps will damage fiscal sustainability and could reduce incentives to shift to renewables and lower energy demand by distorting market signals. Securing and reallocating employment, global supply chains, and energy sources are high priorities both in the short and longer terms. Continuing work-style reform, expanding social security coverage for non-standard workers, and enhancing vocational training and education could boost labor productivity and supply. Lowering barriers to foreign workers and foreign direct investment would also be beneficial. In addition, progress with data and green transformation is especially needed, which will be supported by the new economic policy package previously mentioned.

Higher permanent government expenditure without additional revenue will worsen fiscal sustainability and strengthen sustainable growth. Therefore, the OECD recommends that the government set out a clear roadmap to achieve the fiscal consolidation target by fiscal year 2025 or reconsider the earlier plan and then define a new critical target underpinned by a specific set of measures. It is also important to resume fiscal consolidation efforts on both the expenditure and revenue sides as recovery strengthens.

Further changes in economic conditions might trigger a revision to the monetary policy framework. The Bank of Japan should continue to communicate current and future monetary stances clearly and in a timely manner.

Q&A

Q:
Slide seven shows that the global economic growth rate for 2023 has been revised downwards to 2.2% from the previous outlook in June of 2.6%, which deviates considerably from the 2.7% forecast for 2023 in the IMF’s world economic outlook, which was released last month. How do you explain this difference?

Muge Adalet McGOWAN:
I don't know the exact assumptions of the IMF forecast, but we are living in a very uncertain time, and risks are very high. These kinds of differences in growth projections are expected in these times. Oil prices and exchange rates are changing, which can have large effects. For example, inflation has been surprisingly on the upside for a long time. We have been under-projecting inflation. Therefore, what the OECD and IMF have forecast last month might be different from the current situation. Also, an important factor in this crisis is that during the pandemic, households and firms have increased their savings. The assumptions about the extent to which households and firms are using their savings in this uncertain time makes a big difference in terms of growth projections.

OGURO Kei:
The situation is changing in a volatile way. From our September outlook, we changed a lot of economic assumptions. We can see this even only from looking at the Japanese yen depreciation. Now, the Japanese yen is going back again higher. The main factor of the projection differences is the volatility of the current situation.

Q:
Slide two shows the world is coping with a large energy price shock. In Japan, energy prices are soaring, but we do not view it as seriously as they were before, such as with the Leman shock in 2008. Can we assume that Japan is doing well with this energy crisis?

OGURO Kei:
The situation is totally different from country to country. Also, the dependency on Russian energy is important. Japan heavily relies on the Middle East. The Japanese energy contracts are based on a long-term fixed contract, which works well for relatively unchanged energy prices. The Japanese government is doing well suppressing the energy price hike, and it has an oil price cap which works well. However, the risk is also high in Japan. Increased geopolitical risks and supply chain disruptions will occur in Japan, so it is important for Japan to diversify energy resources and prepare for shocks.

Q:
Japan's government debt is in a critical situation. Are there any OECD countries that have successfully overcome this kind of debt crisis?

In the 1990s, Japan ranked third in GDP per capita behind Luxemburg and Switzerland, but now, it ranks 22nd in the world and is a middle ranking country in the OECD. What do you think is lacking in Japan? How can Japan survive this situation and recover?

Muge Adalet McGOWAN:
In terms of debt, the numbers for Japan are higher than past experiences. A number of European countries in the late 1990s and early 2000s managed to bring their public debt down. They did this through several channels such as fiscal consolidation. Primary balanced surpluses were needed. They were helped by real interest rates and real GDP growth. In today's environment, there will be a need for primary surpluses. If you look at past OECD experiences, one lesson is that expenditure-based consolidations are more durable and growth friendly. Expenditure reforms bring down government consumption. For example, in Belgium in the late 1990s, they transformed their household transfer system so that it became more efficient. Finland, Ireland, and the Netherlands had similar reforms that helped them bring down debt. The last slide in the presentation is advice that we give to many OECD countries because after the pandemic, their debt increased. However, they need a medium-term plan and expenditure rules to contain spending and increase spending efficiency.

OGURO Kei:
20 or 30 years ago, we recognized serious situations in Japan and the challenges in the future, such as population decline and fiscal sustainability. Japan has known about what will happen in the future for a long time. In terms of economic policy, investment was very limited this decade. Now, investments are in tangible and intangible assets, including human capital resources. Japan is now recognizing the difficult situation, so it is good timing to change the deflationary mindset. Also, it is good timing to change to a more agile and flexible policy framework.

When we think about economic policy, recently, Japan only discusses expenditures. However, it is also important to discuss the revenue side. European countries and the United States recently discussed new frameworks for more investment in climate change and to fight inflation. They also discussed windfall tax revenue and tax revenue from highly profitable companies. It is important to discuss constant and various policy mixes. Also, Japan needs to consider mitigating vulnerable household companies. Now is the time to discuss more about the revenue side and various policy mixes to have sustainable growth.