Chief Economists Outlook: what bond yields and interest rates tell us about the global economy

This transcript has been generated using speech recognition software and may contain errors. Please check its accuracy against the audio.

Gregory Daco, Chief Economist, EY: The global economy has been affected by several negative supply shocks. Tensions in the Middle East, tensions in Ukraine, a renewed rise in tariffs that the U.S. has imposed on some trading partners - all of those are leading to a higher interest rate environment because they're crystallising into higher inflation.

Robin Pomeroy, host, Radio Davos: Welcome to Radio Davos, the podcast from the World Economic Forum that looks at the biggest challenges and how we might solve them.

This week we're talking about the global economy. As the Forum publishes its latest Chief Economists Outlook, one chief economist tells us where we should be paying attention. Why, for example, are we hearing so much about rising bond yields?

Gregory Daco: I think there are a few factors that are behind this upward pressure on long-term government bond yields in the U.S.

The first one is, of course, the immediate catalysts from the Middle East. The tensions in the Middle east and the renewed tensions of late have led to higher commodities prices, higher oil prices, which are feeding into higher inflation and leading to expectations of central banks around the world tightening monetary policy to prevent inflation from becoming an anchored phenomenon.

Robin Pomeroy: And what will that mean to the wider economy?

Gregory Daco: Upward pressure in terms of those long-term interest rates tends to lead to a higher cost of capital, which in turn erodes private sector activity and can be a constraint on the global economy.

Robin Pomeroy: I'm Robin Pomeroy at the World Economic Forum, and with this look at the global economy...

Gregory Daco: There is resilience, but there is also polarisation in the face of numerous shocks that the global economy is being affected by.

Robin Pomeroy: This is Radio Davos.

Welcome to Radio Davos. This week we're looking at the global economy. The World Economic Forum has just released its latest Chief Economist Outlook. That's a regular check of the pulse of the global economy. And to help us look at that we'll be hearing from a chief economist.

And first we'll hear from my colleague who writes a lot of analysis on the subject of the economy on the World Economic Forum's website, John Letzing. Hi John, how are you?

John Letzing, Lead Editor, Economics, World Economic Forum: I'm very good. Thank you, Robin.

Robin Pomeroy: It's great to have you again. You've done this the last couple of iterations of the Chief Economist's outlook. Just remind us what it is.

John Letzing: So the outlook is essentially a survey that's administered to a group of chief economists every four months, and it gives us a very good read into what's happening in the global economy and what they think is going to be happening in the year ahead.

Robin Pomeroy: Right, and so these are chief economists at banks and other big companies...

John Letzing: International organisations, all manner of chief economist here but these are these are big thinkers on the global economy

Robin Pomeroy: Right, this comes out every three or four months, and we usually do a radio Davos episode, which involves us talking to a chief economist. You've done the interview this time. We'll introduce that in a moment, but before we get into that interview, can you give us some of the headlines from this Chief Economists Outlook? As we say, it's a pulse check. So, you know, is the patient healthy? What is it telling us about the global economy?

John Letzing: Yeah, so context is very important this time around. So this time around, the percentage of chief economists that are expecting conditions to weaken for the global economy is actually way down. But if you recall, four months ago when the last survey was administered, we had a brand new war in the Middle East. We had a major trade route through which we usually get a lot of our energy that was gonna be impeded for a while. Things were looking bad, so it's not entirely shocking that that percentage expecting a weakening outlook would go down, which it has, pretty dramatically, we went from about nine and 10 down to a little less than half.

Robin Pomeroy: They're saying there's fewer people with a very gloomy outlook, is that right?

John Letzing: Stabilising is the word they use, a lot of people seem to be seeing stabilising in the economy.

Robin Pomeroy: Is that because the world is just getting used to because the Strait of Hormuz, as we record this, is still pretty much closed and there's also threats to the strait on the Red Sea? It doesn't look like things are getting better. Is it just there's a new normal now?

John Letzing: Yeah, I think so. I think people are looking at the resilience that the economy has demonstrated and they are, maybe there's maybe a little bit of optimism in there as well, I think. Context is important, right? If you recall, I mean, the last time around, things were popping off. They were pretty crazy. And so I think what people are seeing is that despite all that, we're still here. Economies are still moving forward more So, so here we are.

Robin Pomeroy: The focus of your interview today, a lot of it is talking about inflation and also interest rates. Tell us why interest rates have been in the headlines a lot at the moment.

John Letzing: Yeah, so that is a big through-line in this outlook is the cost of living. These chief economists, it's a little bit confusing because their overall expectation for inflation over the year ahead has come down a little, again, context is important. But the basics of the cost-of-living, things like food, electricity, the way you can get around in transportation, that's all expected to increase. So what's happening is that central banks are on the spot. That they need to manage this somehow. Well, they're supposed to manage it somehow, so we are now looking at a probable interest rate increase in the US, probably in the UK as well. Essentially, what central bankers are going to be trying to do through that is to get their arms around inflation to tamp things down, tighten the money supply a little bit and get things back in order. Whether or not it's going to require one rate increase or more is up for debate.

Robin Pomeroy: And I should note that we're recording this last Wednesday, the 16th of September, which is the day the Federal Reserve is meeting or its rate decision people will make that decision. So you'll already know that the UK Central Bank is meeting tomorrow as we record this. So by the time you're listening to this, they will have made those decisions, we'll know. But even a decision made if those banks have decided to raise interest rates a tiny bit. That's not taking further interest rates off the table, is it? This is a kind of a medium term pressure on those banks to look like they're ready to raise rates to combat inflation.

John Letzing: Sure it's not going away anytime soon.

Robin Pomeroy: You also talk about bond yields. This has also hit the headlines recently. Remind us what a bond yield is and why, again, that's in the headlines right now.

John Letzing: Yeah, that's the biggest part of our conversation because that's sort of the big backdrop to everything that's happening in the global economy right now.

It's a question of trust, really. How much do investors trust in what governments are doing to manage their economies at the moment?

So a bond yield is a great measure of trust and essentially, if a government bond yield is increasing, that means the market is feeling a little less confident about what that particular country is doing to manage its economy.

We've seen yields increase. We've had what has been described as chaos in the government bond market recently. And in particular, US bonds are in focus because US bonds are this sort of global benchmark for where the world puts its money and expects returns. And actually, as we were doing this interview or shortly after, one particular yield on the US 10-year Treasury actually hit the five percent mark and that is a very important mark psychologically speaking and we get into that in the interview a bit.

Robin Pomeroy: And your interviewee, who we'll introduce in a moment, gives a very concise kind of list of things that have caused that. And probably the main thing is, as you mentioned, John, these concerns about whether a central bank can control inflation. But there's also other things, including...

John Letzing: Debt. Debt. If investors see debts going in a direction they see as out of control, they will let you know. Right.

Robin Pomeroy: And other things as well - there's only a certain amount of money floating around in financial markets a lot of it is flowing at the moment into artificial intelligence and so perhaps money that would have gone into government bonds and supported those prices is actually going elsewhere.

John Letzing: Yes, indeed, they have options these days.

Robin Pomeroy: Great, just remind us the relationship between bond prices and bond yields.

John Letzing: Yes, very important. So essentially if a country issues a bond and the bond is worth $5, let's say, on the market and it pays $1 an interest a year, that's all well and good. But if the bond trades down and the bonds becomes less valuable, it becomes worth, let say $4, you're still, as the issuer, paying that $1 a year. So that spread between the value of the bond and interest paid is the yield. It essentially pays more to investors, but those investors understand that their investment is a little bit more risky.

Robin Pomeroy: Central banks raise rates to tamp down the economy and to tamp down inflation, but actually, just raising rates in themselves, people are going to be paying more for their, for their loans, more for that mortgages, whatever. It's not pretty.

John Letzing: It's not a pretty process, I think.

Robin Pomeroy: I think he makes that point. There is this kind of conjunction of unfortunate things coming together. So tell us who it is you're interviewing for this episode.

John Letzing: So this episode we had Greg Daco, the chief economist at EY.

Robin Pomeroy: Well, Greg's got a lot of interesting things to say, particularly on that issue of inflation and of bonds and of interest rates. Let's hear. This is you, John, speaking to EY's Greg Daco.

John Letzing: Greg, thanks very much for joining us.

Gregory Daco: My pleasure, thanks for having me.

John Letzing: The latest outlook, the keyword seems to be stabilising. That seems to the overriding sentiment out there anyway, but I'm wondering, is that a good word to describe what you're seeing when you're looking at the global economy at the moment?

Gregory Daco: I think if you look at the latest survey from the chief economists, they indicate that more than half expect the economic outlook to remain unchanged and I think that's really on par with our own forecast for the global economy, which is one in which there is resilience, but there is also polarisation in the face of numerous shocks that the global economy is being affected by, including tensions on the geopolitical front, including tariffs and trade tensions. And of course, this AI led tech revolution, all affecting economic activity in different ways and pushing different economies in different directions.

John Letzing: Indeed. And we should note that the context for the last Chief Economist Outlook four months ago, that was a very fraught moment. We just had a brand new war in the Middle East kick off. It became clear that a vital trade route through which a big chunk of the world's energy comes through normally was going to be impeded. So that probably explains why about nine and 10 chief economists at that point saw the outlook weakening.

In terms of positives, you did mention AI, I guess in some ways that is cited as a positive in the outlook in terms of increased adoption. However, there is another interesting tidbit in the outlook about 79% of the chief economists seeing some likely pushback to data centre expansion from local communities. And that sort of feeds into the broader sort of tension that you mentioned around AI. And I'm wondering if you think. There is a real risk there from this pushback that we might potentially miss out on some of the economic benefits that we'd otherwise get from AI.

Gregory Daco: I think in general, AI is likely to deliver upon its promises of stronger productivity growth and stronger business investment to support that technology. But in the initial phase, there are going to be some disruptions that are going affect the labour market, that are gonna affect the energy market, and that are likely to see some pushbacks in some segments of the global economy.

So I think we have to be conscious of both the potential upside from AI and this technological revolution to lift economic output and offset some of the negative supply shocks, but at the same time be conscious that this is just not going to be everybody wins all the time. There are going to be some segments of the economy that are affected in a negative way because of potential energy tensions, because of potentially energy risks, because labour market displacements.

So it's not necessarily going to be all good or all bad. There are going to be nuances there. And I think that's where there is a great opportunity for the government and the private sector to collaborate in order to ensure that the negative externalities are counted for and that the technology delivers the most potential in terms of its boost to growth, limiting the negative effects in terms of population, in terms of energy and in terms of potential downside risks from asset market overappreciation.

John Letzing: Yeah, indeed. And these, these things, I suppose they can ebb and flow. Do you see this pushback that we're seeing? Do you see that as maybe something that, that will recede at least to some extent, or is it just going to have to be more proactively managed?

Gregory Daco: I think it will have to be proactively managed.

What we are currently seeing is the first phase of any technological revolution. And that first phase is very intensive in capital investment, infrastructure investment. We've seen that throughout the ages, from the industrial revolution to the electricity revolution to computer age.

There is a first phase that requires a lot of capex investment, a lot infrastructure investment, and that tends to strain resources, which leads in some cases to pushback, but also leads to inflationary pressures.

That is something that people don't always understand that in the first phase of a technological revolution, there are inflationary pressures. And only once you start to see the gains in terms of productivity that come from skills development, that come greater diffusion, then you start see the productivity effects that lead to a disinflationary impulse.

And that is the natural evolution of a technological revolution.

But we have to be very careful that there can be excesses in the case of this latest technological revolution with AI.

John Letzing: In terms of positives, another positive I think we can cite in the outlook is the inflation outlook. It seems that the percentage of chief economists that are expecting inflation to increase over the coming year has declined decidedly compared to four months ago.

I guess as we are recording this, we are anticipating a potential interest rate hike in the US. I'm wondering what your take is on the outlook for inflation. And do you see us getting to a point where It is effectively being tamped down by central banks.

Gregory Daco: What we are seeing is essentially a lot of ebb and flow in the inflation picture, a lot of volatility in the different economies throughout the world.

In the earlier May survey, we saw a lot worries about inflation rising. In the latest September survey, half of the chief economist expected inflation to rise and half expecting inflation to stabilise. So we're in this unknown, uncertain type of environment.

But unfortunately, with the latest developments in the Middle East and the upward pressure on commodities prices and renewed supply chain disruptions, we're likely to see some re-acceleration of inflation throughout the world, and that's likely to put many central banks on watch.

We've already seen a couple of central banks tighten monetary policy in the face of these renewed inflationary pressures. It's likely the Fed will follow suit with some tightening of its monetary policy. And that brings a combo that is little bit difficult to manage from a growth perspective because you have higher inflation, higher cost of inputs, higher consumer prices at the same time as you have higher interest rates and a higher cost capital which is constraining private sector activity.

So that duality is something we have to monitor very closely in the next few months as we navigate into 2027.

John Letzing: Okay. And perhaps another thing that raising rates might help us get our arms around is bond yields. Government bond yields have become very topical recently. One particular U.S. bond especially is making a lot of people nervous for different reasons. And maybe before we dig into this, we could help explain to our audience exactly what is a government bond.

Gregory Daco: Essentially a government bond is what the government is willing to offer in terms of debt but in compensation for people financing that debt, it offers an interest on that debt and that interest is the government bond yield. So essentially the private sector is lending money to the government to finance expenditures and potential tax cuts. And as a result of the government over time reimburses more than the initial loan from the private sector. So that's really what a bond is. And when you have economies that have larger debt loads and incur greater deficits year after year, then the cost of that debt tends to increase and that's when you start to see bond yields rise.

John Letzing: Okay, now the average person might look at something in the market rising bond yields and say, well, that couldn't be bad, but help us understand what does that mean effectively if a bond yield is rising? What does it mean for that country who's issuing that debt?

Gregory Daco: Well, essentially, the bond yield is the cost of debt. You can think of it as an interest payment on your own debt. If you buy a car with a loan, you have an interest payment, so you're not just paying the cost of the car, but you're also paying the interest on that loan, which accumulates over time. The longer you take out that loan for, the greater the interest payment.

Now, in an environment where you are able to reimburse your debts rapidly, then that interest gradually over time fades but in an environment where you're constantly borrowing more as many governments around the world are doing running larger budget deficits that tends to lead to a larger debt load and in turn the interest on that debt tends to increase feeding back into a greater debt burden and as a result the compensation that investors and the private sector is asking for to essentially loan to the government is greater and that is the upward pressure that we see on interest rates and on government bond yields.

John Letzing: Yeah, is it a trust issue in a way is it is it effectively investors saying to governments, We're not sure about you as we were maybe a month ago.

Gregory Daco: Yeah, you can see that across different types of economies, economies that have deep financial markets that have institutional credibility that have the rule of law, that have debt burdens that are not excessively high and run deficits that are either small or in some cases, minor primary budget surpluses, those economies tend to pay less in terms of the interest rates on their debt.

But for smaller economies that have more volatility from a geoeconomic, a geopolitical perspective, that have difficulties reigning in their finances, their government finances, and have rising debt loads. In those cases, you tend to see very high interest rates on the debt. And generally, that is also accompanied by higher inflation, which forces the central banks of these economies to tighten monetary policy in an effort to curb inflation and that also feeds into higher interest rates and a higher cost of debt.

John Letzing: Okay. And there is one government bond in particular that many, many people are focusing on right now, and that is the U.S. 10-year Treasury. And I think, uh, the yield on that has risen to somewhere close to 5% if I'm not wrong and that's captured a lot of attention now. Help us understand what is it about this particular bond, um, that is so important, why is that 5% mark considered so important, psychologically.

Gregory Daco: So before we go into the 5% mark, I think it's very important to understand that US debt is generally believed to be central in terms of international lending and in terms of borrowing in the US market, which is one of the largest markets in the world, if not the largest and the deepest market in terms, of financial market activity.

So when you think about the US 10-year yield and the US and year Treasury, that is a key asset that is used to price many other assets. And so when you see yields on 10-year government bonds that rise very rapidly, as we've seen, that incurs dynamics that lead to a new cost of capital across the world and across the U.S., because if you think of corporate borrowing rates, or if you points. All of those are priced in some way in either the 10-year bond yield or in a derivative of the 10 year bond yield.

So upward pressure in terms of those long-term interest rates tends to lead to a higher cost of capital, which in turn erodes private sector activity and can be a constraint on the global economy. That is why the 10 years bond yield is so much in focus these days.

Now a 5% 10-year bond yield is the highest we would have seen since before COVID, you have to go back to the great financial crisis of 2007, 2009. And that is a key reference point because if you remember, this was the Great Recession where we had a massive reduction in private sector activity across most economies around the world. And it took quite some time to rebound from that very deep crisis. So that's why this very important gauge is the key point of attention for many investors and many private sector actors.

John Letzing: Okay. Now, what has been happening in this bond market recently has been described as chaos. I'm wondering if that's overstating it a bit or if you think that's a relatively fair description. And I'm also wondering what started this because I mean, governments have been running big deficits for a long time. Inflation has been persistent for a while now. This war in Iran has, well, now it's several months old. So what is it recently that started all of this?

Gregory Daco: I think there are a few factors that are behind this upward pressure on long-term government bond yields in the US.

The first one is of course the immediate catalysts from the Middle East. The tensions in the Middle east and the renewed tensions of late in the Middle East have led to higher commodities prices, higher oil prices which are feeding into higher inflation and leading to expectations of central banks around the world tightening monetary policy to prevent inflation from becoming an anchored phenomenon.

Now that is the cyclical factor, that is really the spark that has led to this upward pressure of late in the 10-year treasury yield.

But I would contend that there are several structural factors that are pressuring up long-term bond yields. One, as you mentioned, the fiscal situation in many economies is concerning. You're seeing many economies post-COVID running larger budget deficits than they were before the pandemic. They're also accumulating more debt. So the cost of that debt is increasing.

Two, you have an environment where it's not just about higher inflation. It's inflation volatility that makes it very hard for investors to price the next central bank move.

Three, you have an environment where AI is pulling a lot of private sector capital in to finance its capex and investment wave. That is deterring some of the investment from going to the public sector.

And three and four, you an environment where what is happening in terms of central bank credibility is central to how investors are pricing the next central bank move and pricing the cost of that debt.

These factors are not going away. They're perhaps not internal, but they are certainly structural in nature, which leads to a higher cost of capital.

Add to that one more phenomenon, which I think is very important to highlight. It's the fact that the Treasury in the US has been intervening in markets, intervening to protect a sell-off of treasuries by supporting the Japanese yen, but also intervening in the form of larger debt buybacks to try to put some downward pressure on government bond yields. Those combinations of interventions are signalling to private sector investments some discomfort from the administration in terms of the higher interest rates, and in a sense, they are exacerbating some of the pressures and the doubts as to these higher interest rates and the potential effects they will have on private sector activity.

John Letzing: Okay. And just, just so I understand how this works in a nuts and bolts kind of way, is it essentially the U S government going out and buying its own debt to essentially elevate the price and reduce the yield?

Gregory Daco: It is in some way that. It is also a means by which the Treasury is swapping some of its debt holdings. Essentially, it's called in some places Operation Twist, whereby you essentially sell some of the short duration debt and you buy some of long duration debt. So essentially, it is some swapping of debt with an effort or an attempt to put downward pressure on long term rates, even if it might put some upward pressure on short term rates. And that is again, because this 10 year government bond yield is central to pricing many assets around the world.

John Letzing: Okay. And the AI aspect that you mentioned is very interesting. Is it effectively the case that investors are seeing so much opportunity to buy debt being issued by these AI companies that it's essentially starving resources that would otherwise be going into U.S. Treasuries into U.S. government debt.

Gregory Daco: Yes, that's a big part of it. Essentially, you are in an environment where investors have a choice. They can either invest in Treasury bonds or they can invest in AI. Those are two alternatives. There are many others, of course. But when you're thinking about your potential return on this investment, you have a fairly large potential return in terms of investing in AI, so that's driving a lot of investment into the infrastructure buildout the capex buildout to build out data centres and semiconductor facilities all of those investments are going into the private sector and some of that money that would otherwise have gone into the public sector in terms of safe investments in treasuries may not necessarily be doing so at the same time you also have central banks around the world that are cutting back on the size of their balance sheets and that means buying less government debt.

And so that's another factor that's putting downward pressure in terms of purchases and demand for government bonds and pressuring up yields as a result.

John Letzing: In terms of yields rising and yields rising dramatically, help us understand a little bit of historical context here. What are some situations in the past where we've seen in different countries yields rise this sharply? Essentially what needs to be happening usually historically in a country for that to happen.

Gregory Daco: Generally speaking, when a country is running a large fiscal imbalance, when it's running a large deficit, that is when you tend to see upward pressure on government bonds.

Generally, those economies that are running large budget deficits are also seeing higher inflation and, in some cases, a need for central banks to tighten monetary policy more aggressively, i.e. raise short-term rates to try to combat inflation.

And so in these economies that have large budget deficits, elevated inflation, and central banks that are trying to tighten monetary policy, you tend to see significantly higher government bond yields because these longer-term bond yields reflect both the expectation of higher short-term interest rates as well as a higher cost of that debt that keeps rising and rising year after year.

So those are the characteristics that you tend to have in economies that have high government bond yields.

John Letzing: I guess there was a period in the UK a few years ago, I think 2022, where the bond market was essentially credited with pushing out a prime minister at that time. People often talk about bond market vigilantes, this sort of function of bond markets as kind of ultimate reality, a kind of final boss, if you will. Do they really function that way? I mean, are they sort of a final judgement on the way an economy has been managed in a way that is in some ways the last word?

Gregory Daco: In a way, yes, in the sense that bond markets price the cost of debt, and if investors do not trust the government's ability to repay those debts, if they do not trust a central bank to be able to raise short term interest rates in terms of controlling inflation, then they demand a higher compensation to buy that government debt. And that risk premium is what leads to higher interest rates for government bond yields.

You're absolutely right to point to certain risk-off environments that we've had in the UK back a few years ago, but also in the US where you have these sudden surges in government bond yield that lead to a pullback in private sector activity and sometimes are accompanied by a correction in the equity market because the discount factor is that much greater.

So yes, it is true that you tend to see in some cases when economies propose budgets that are not realistic or when they propose different types of spending measures that will lead to a widening of the budget deficit that is when investors demand greater compensation for those bonds and as a result you see upward movement, upward pushes in government bond yields.

John Letzing: Okay, so functions as a sort of reality check, it sounds like.

Gregory Daco: It does function as a reality check for the cost of that debt and it functions as essentially an estimation of the cost that that including the risk of putting your money into government bonds that are generally considered to be safe but can in some cases not be as safe as marketed.

John Letzing: With what's been happening in the bond market, yields rising. It's obviously, it's going to make it more expensive for governments to borrow. But the average person probably has limited to no contact directly with the bond markets. So should they be concerned about what's happening in the market? I mean, what is the possible relation between the price of a bond, let's say, and somebody's grocery bill?

Gregory Daco: So essentially, when you think about government bond yields and you think of the cost of that debt, it's essentially a great reference point for many loans that private sector actors take out.

If you think, about the average household in the US buying a car, the cost of the loan on that car will be anchored to the 10-year government bond yield. So if the 10 year government bond is rising to a 20-year high. There is a very high likelihood that the cost of that auto loan will also rise in sync. You can think of the same when you're buying a house and taking out a mortgage. Mortgages are priced off of the 10-year and the 30-year government bond yield. So if there is upward pressure on that front, that will lead to a higher cost to take out that mortgage.

And for the private sector, for private sector companies, you also have this phenomenon and whereby if a company is looking to take out a corporate bond, that will be priced off the 10-year government bond yield. So a higher 10- year government bond yield will lead to higher cost of borrowing from the private sector and perhaps lead to a pullback in investment intentions and in hiring intentions, which should cut back on private sector activity.

John Letzing: Okay, and can you give us a sense of how long these things usually take to play out within a system? So let's say someone is seeing what we've seen in the bond markets recently, I mean, what would be a reasonable expectation for when that would start showing up tangibly in their day-to-day lives potentially.

Gregory Daco: I mean, in some cases, it's almost immediate if you're trying to buy a house today in the US, then you're going to be paying much more in terms of your mortgage rate than you would have just six months ago because there has been significant upward pressure on both the 10 year and the 30 year government bond deals. So it's near immediate in terms of the cost of that debt.

Now, it is very important to remember that we don't take out loans on a daily basis for the most part. What happens is that a lot of that debt is fixed at a certain point in time. So unless you need to refinance that debt or take out a new loan, you don't always get the one-for-one effect in terms of private sector activity. It affects only the marginal buyer of that that that wants to invest, wants to hire, wants to buy a house. But it's a gradual effect that filters through whenever somebody needs to refinace a loan or to take out new loan for new private sector activities.

John Letzing: Okay. So let's maybe take a step back and imagine that the Iran war ends tomorrow, that central banks around the world take a very firm hand with inflation by raising rates. Does the bond market issue go away or are there longer term issues that need to be addressed for this to sort of settle back to normalcy?

Gregory Daco: I think one thing to realise is that the global economy has been affected by several negative supply shocks, including tensions in the Middle East, including tension in Ukraine, including the recent rise, a renewed rise in tariffs that the US has imposed on some trading partners. And all of those are leading to a higher interest rate environment because they're crystallising into higher inflation.

Now if the Middle East conflict were to end tomorrow and oil flows were to resume rapidly, then what you would see is essentially both a reduction in inflation pressures from reduced energy prices, a reduction in inflation expectations because of that positive resolution to the Middle East conflict, and that will lead central banks to essentially contemplate maintaining their current policy stance.

Overall, those evolutions would essentially lead to lower long-term interest rates. We should not forget that the structural factors that are still putting upward pressure on long-term government bond yields are still going to be present. You're still going to have an environment where government finances are under pressure. You're going to in an environment where there is inflation volatility. You're in an an environment where there's a massive pull for private capital from the AI revolution. And you're also going to be in an environmental where central banks credibility is in doubt. And in some economies there are questions from investors as to how resolute the commitment of a central bank is to control inflation.

John Letzing: And do you see a point coming, maybe relatively soon, where governments really have no choice but to answer to the bond markets and start doing what the bond market are suggesting?

Gregory Daco: I would hope so because we have to have some type of resolution to ever rising government debt loads. It's often the case that you don't know when a crisis is going to occur, but running larger and larger budget deficits year after year after years leads to an accumulation of debt that rises to very high levels. And in turn, the interest on that debt keeps rising which puts upper pressure on interest rates which lead to higher interest payments on that that and you have a snowball effect there that can lead to higher inflation and force central banks to tighten monetary policy.

So I would hope that some of the pressures that we are seeing today in terms of running an environment where we have the 10-year Treasury yield approaching 5% would force policy makers to take action over a long period of time, controlling expenditures on the healthcare front, on the ageing front, ensuring that the tax base is solid enough to generate revenues on an ongoing basis and allow for budget deficits to not be structurally higher, but instead be structually smaller as the global economy continues to grow.

John Letzing: I think we'll leave it there. Greg Daco, thank you very much.

Gregory Daco: Thank you very much.

Robin Pomeroy: Greg Daco chief economist at EY was talking to my colleague John Letzing.

You can read the Chief Economists Outlook on our website there's a link in the show notes to this episode, and you can find all episodes of Radio Davos at wef.ch/podcasts where you'll also find our other two weekly podcasts, Meet the Leader and Agenda Dialogues.

This episode of Radio Davos was written and presented by me with my colleague John Letzing. And we'll be back next week. In the meantime, thanks very much to you for listening and goodbye.