US growth rates signal the risk of overheating in the years ahead. Emerging markets and the Euro area economies closely watch the developments in the US.

The COVID-19 pandemic triggered a global economic recession. 2020 will remain in history as the year when the world “shut down”, as the only solution to the advance of the virus was isolation and lockdowns.

But science came to the rescue. Vaccines do work as the results show, and now economic activity is picking up better than many expected. The quick economic recovery poses challenges for central bankers too, who must find a way to unwind the accommodative measures and avoid unwanted recessions further down the road.

For instance, it is estimated that if the United States economy is overheating (i.e. grows above the sustainable growth rate), the danger of an economic recession in 2024 is real. As such, the federal funds rate should rise to such a level to temper the upcoming growth.

An overheating economy leads to higher inflation and global spillovers. Inflation fears are already here, as the April CPI data showed the biggest monthly increase since 1981. Therefore, policymakers must find a way to cope with higher inflation and higher growth in such a way to avoid overheating in the years ahead.

Regional Challenges in the Period Ahead

The United States economy delivered an upside surprise in the first quarter of the year. While the news was positive, it triggered upside revisions for the upcoming quarters. Some investment houses forecasted growth of 2.1% for 2021 and were forced to revise the forecast much higher, above 3.5% based on the Q1 2021 data.

The problem comes from the Fed’s accommodative stance. The Fed signaled that it intends to keep the asset-purchases in place for a while now and the federal funds rate at the lower boundary. As such, stronger than expected economic growth coupled with continued monetary accommodation may lead to the US economy overheating.

How about the Eurozone economy? The risk of overheating is not that acute here, as the fiscal policy in the Euro area was not as expansionary as it was in the United States. Moreover, the Euro area GDP is expected to reach pre-pandemic levels only in 2022, much later than the US GDP.

Emerging markets are in a sensitive spot. Their central banks should raise the interest rates before the Fed does, otherwise, they will have a hard time absorbing the impact of policy tightening in the United States. But slow global growth weighs on emerging markets’ economies, as vaccination rates are sluggish outside developed economies.

All in all, while the pandemic triggered unprecedented challenges, the economic recovery needs to be carefully addressed. Otherwise, the risk of an overheating US economy is real, with global spillover effects.