Economic outlook: Recoupling and a reframing of risks
The U.S. economy distinguished itself in 2023 and 2024, achieving growth rates of 2.5%–3%, while DM peers largely stagnated at 0%–1%. U.S. productivity has also outpaced DM peers since the pandemic. In our April 2024 Cyclical Outlook, “Diverging Markets, Diversified Portfolios,” we identified two main drivers:
- Fiscal policy: A larger cumulative fiscal stimulus since 2021 has led to greater private wealth accumulation in the U.S., which has taken longer to dissipate.
- Monetary policy: The pass-through of higher interest rates to households has been slower in the U.S., largely due to the existing stock of low-rate, long-term mortgages.
Additionally, the prominence of U.S. private credit markets has likely kept financial conditions more accommodative. An influx of investor capital in lower-quality corporate lending has intensified competition for deals while providing financing for weaker companies that may struggle to access other markets.
The U.S. has also been less affected by international spillovers from Chinese economic weakness. European countries, and Germany in particular, have been hurt by weaker trade with China and greater Chinese import competition. Financial gains and capital accumulation from generative artificial intelligence (AI) have also relatively benefited the U.S.
The U.S. also made more modest progress in 2024 than DM peers in reducing inflation. Core personal consumption expenditures (PCE) inflation, the Fed’s preferred gauge, is expected to finish this year near where it ended 2023, as tough base effects are likely to lift the reported year-over-year rate in the next several months.
In contrast, core inflation in other DMs has likely slowed by 1–1.5 percentage points during that period (see Figure 1). Europe achieved additional inflation progress as weak demand and corporate margin compression offset still-elevated unit labor cost inflation.
Figure 1: Headline inflation continues to normalize toward pre-pandemic levels
The factors that supported U.S. outperformance are fading, suggesting some recoupling with the global economy. Measures of U.S. real wealth balances more closely resemble those of other DMs. The monetary policy shocks that have impeded growth elsewhere are also abating.
European growth is likely to recover to a more normal pace as rates decline and trade conditions improve after the energy price spikes of 2022. This will help offset curtailed government spending and a weak global manufacturing environment. Immigration – which bolstered growth in many DMs, particularly the U.S. – is expected to become a growth headwind as policies implemented in mid-2024 to limit immigration appear to be working.
Despite some cyclical growth recoupling, we believe the U.S. economy maintains some distinct advantages. Notably, robust capital spending and AI investment trends present significant upside growth potential, especially compared with Germany and other EU countries that are more exposed to Chinese competition and more reliant on imported energy sources. Recent economic data revisions that have left the U.S. savings rate within pre-pandemic ranges should moderate concerns of an overextended U.S. consumer.
Monetary policy is normalizing …
More resilient U.S. growth and inflation delayed the Federal Reserve in commencing its rate-cutting cycle relative to other central banks. However, forward-looking inflation indicators suggest that further progress toward the Fed’s 2% inflation target is likely in 2025. Factors supporting this outlook include unit labor cost inflation nearer to 2%, a vacancy-to-unemployed ratio lower than 2019 levels (see Figure 2), and a rising unemployment rate that may risk overshooting the Fed’s comfort zone of around 4.2%.
Figure 2: Labor markets, like inflation levels, look more like they did in 2019
Elsewhere across DM, weaker demand, loosening labor markets, and anchored inflation expectations also point to near-target inflation in 2025. Canada stands out as a DM economy where inflation is most likely to undershoot target levels, while labor market indicators in Australia point to somewhat slower progress there.
Consequently, central banks, especially the Fed, are focused on returning monetary policy rates to estimated neutral levels. We expect DM central banks to cut rates by 175–225 basis points (bps) in 2025.
The Bank of Japan (BOJ), which still has a policy rate below neutral estimates, remains the notable outlier. We expect the BOJ to continue with gradual rate hikes despite recent market volatility and yen strength. Japan has been the one economy where elevated inflation has raised inflation expectations, while wage inflation remains firm.
… But what is normal?
With DM economic conditions now resembling their pre-pandemic baseline more than at any time since 2019, the focus now turns to the question, “What is ‘normal’ monetary policy?”
Factors that could support a somewhat higher neutral rate than a decade ago include higher government debt levels, potentially higher defense spending, generally stronger private sector balance sheets, and increased investment needs associated with secular global transformations, such as realigned trade relationships and the rapid development of AI.
However, given longer-term trends in demographics and wealth disparity, and the uncertain pace and magnitude of investment cycles, we’ve maintained our 0%–1% estimate for the long-run neutral real rate, as we detailed in our latest Secular Outlook, “Yield Advantage.” That suggests a neutral nominal policy rate in the range of 2%–3%. When we published that Secular Outlook in June, we noted how market pricing at the time implied that the neutral policy rate was unlikely to fall below 4%. Since then, market pricing has moved more in line with our expectations.
Given the uncertainty around the level of neutral policy rates, it’s natural for central banks to embark on a series of cuts to see how their economies respond. If growth reaccelerates and upside inflation risks reemerge, central banks can always pause or slow easing. Otherwise, if growth plummets or employment falters, there is capacity to cut more aggressively. Across a range of scenarios, we believe there is room for central banks to cut rates.
Risks and uncertainty
Risks to the global outlook have shifted. Inflation risks have diminished – but not disappeared – as supply/demand in labor markets and beyond have come into better balance. Growth is slowing. While DM economy recessions are not our base case, we believe the risks are somewhat elevated compared with historical average frequency. There are also scenarios where economic growth proves more resilient and inflation could reaccelerate.
In the U.S., the main risk is that slower activity and labor market growth fuel self-stoking cycles, ultimately resulting in a more pronounced downturn. Other DMs appear more stable. Still, their continued low growth makes them susceptible to negative shocks, such as market mishaps or escalating geopolitical situations.
China faces its own challenges. Its growth model, reliant on exports and manufacturing investment, seems to be hitting limits. It faces a significant housing inventory overhang, weak consumer demand, and rising trade tensions. In response, China’s government recently announced measures designed to boost asset prices and mitigate the decline in housing prices.
However, the efficacy of these policies may hinge on a return of confidence and whether the efforts will provide more widespread direct government support to households. Fiscal response is also likely and may help generate momentum for growth in the next one to two quarters.
We expect China’s growth to slow to 4%–4.5% in 2025 from 5% in 2023 and 2024, while the country continues to export deflation globally. Demand for commodities, especially related to construction, may get some support from the recently announced policies but isn’t likely to rise as much as in past cycles, given controls on new housing supply.
Geopolitical risks continue to loom large as a source of uncertainty – from the conflicts in the Middle East and Ukraine to elections across many countries during our cyclical horizon, with implications for broad market sentiment and specific countries and sectors.
The upcoming U.S. election is one such source of uncertainty, with pivotal policy implications:
- U.S. deficits will be the biggest loser no matter which party wins. Tax reform will dominate Washington next year, when the individual provisions of the 2017 Tax Cuts and Jobs Act are set to expire. We do not expect much additional fiscal stimulus, given likely narrow majorities or a divided government and lack of fiscal space. However, fiscal consolidation isn’t expected either. Annual deficits are likely to remain high (6%–7% of GDP) before any additional policy changes, due to lack of political will to curb entitlement spending as well as few offsets to pay for extending most of the 2017 tax cuts. This reinforces our curve steepening view in the U.S.
- The direction of travel of tariffs is also clear regardless of who wins. However, the potential for globally disruptive trade policies appears greater under a second term for former President Donald Trump, while Vice President Kamala Harris seems more likely to continue the current more targeted approach should she prevail. In the short run, higher tariffs would likely be inflationary and drag on growth. Tariffs could make tangible U.S. investments more expensive, hurt U.S. export sectors by making them less competitive, and weigh on demand. Tariffs would likely also be inflationary for close U.S. trade partners – to the extent that their governments retaliate with similar trade barriers – but deflationary elsewhere, as slower global growth from rising trade uncertainty could weigh on commodities, while goods previously supplied to U.S. markets could be redirected. The relative implications of tariffs will create a tough economic environment for the Fed. Monetary policymakers will have to be mindful that higher short-run inflation (as the additional costs of tariffs are passed on to consumers) risks rising inflation expectations, despite the downside risks to growth as real incomes fall.