Resilience, Once Again

Demand remains surprisingly resilient in the U.S. and many other advanced countries (see chart 1). This despite cumulative policy rate increases ranging from 350 to 500 basis points since the first half of 2022, and the associated inversion of yield curves, which typically signals a sharp slowdown. Strength remains concentrated in service sectors reflecting pent-up demand for tourism, entertainment, and leisure resulting from COVID-19-era restrictions. In some cases, generous fiscal spending and savings and wealth buffers have provided tailwinds.

Labor markets are still tight, albeit with some recent easing around the edges. Unemployment rates are at or near multidecade lows in most advanced economies. Again, much of the tightness in labor markets is concentrated in the services sector. Some signs of slackness have begun to appear in the form of lower quit rates, lower vacancies, and higher jobless claims. But overall, the demand for labor has stayed robust, wage growth is relatively high, and markets will need to cool for central banks to achieve their price-stability objectives.

Chart 1

The Next Moves Are Likely Up

Headline inflation is coming down quickly, but core inflation remains stubbornly sticky. The former, driven by declines across fuel, electricity, and gas prices as last year's spike drops out of the data, is good news for households as it increases real wages. In contrast, the latter is bad news for central banks since it implies that demand-driven inflation (which is under their indirect control) remains elevated. Headline inflation is now lower than core in the U.S., a trend we expect to extend to most developed economies by year end.

Central banks have slowed the pace of policy hikes, but the next moves are likely up. Inflation remains well above target and, even allowing for the lagged effects of previous rate hikes to work through the system, more needs to be done to bring inflation convincingly back toward target. Medium-term inflation expectations are moving in that direction, but this is not the case for core inflation momentum (annualized inflation measured over the past three months rather than over the same month of the previous year). We think that central banks will need to see a strong downtrend in core momentum before beginning to lower policy rates.

Chart 2

Markets are increasingly moving to central bank views on policy rates. This is particularly true in the U.S., where traders are now pricing an end-2023 fed funds rate of 5.25%-5.50%. One month ago, the market was pricing 4.50%-4.75% at the end of the year; and following the collapse of Silicon Valley Bank (SVB) in March, market pricing of the U.S. policy rate dipped as low as the mid-3% range. During this cycle, markets have consistently underestimated the willingness of central banks to keep policy rates elevated to help cool inflation. Central bank put options remain out of the money. Interestingly, this is only true for 2023. For end-2024, traders are still pricing much lower rates than Federal Reserve governors are signaling in their dot plots.

Although nominal policy rates are high, real rates remain low by historic standards and financial conditions are not particularly tight. The main drivers of loose financial conditions are equity valuations and volatility, which have moved higher and lower, respectively, over the past few quarters. The fallout from the U.S. banking turbulence in March was a blip that reversed quickly. There has been some tightening of bank-lending standards in the wake of that turbulence, but not enough to move the macro needle. Conditions have now returned to the relatively easy 2021 levels.

Revised Forecasts: Downturns Shallower And Later

The ongoing demand resilience in many economies has led us to push out and temper the necessary growth slowdown. We have generally raised our annual growth forecasts in 2023 and lowered them in 2024. However, this masks the quarterly profile, where the slowdown is deepest in late 2023 into early 2024. Our "out" years of 2025 and 2026 are broadly unchanged (see table 1).

In terms of the numbers, we now see global GDP growth at 2.9% for this year and next before climbing to 3.3% in the out years. We have raised our U.S. growth forecast by a full percentage point this year given the strong first half; we see U.S. growth slowing to below 1% in the second half of the year and avoiding a recession.

The eurozone is a bit of the opposite story, currently experiencing stagflation (low growth but strong employment and wages) but likely to return to modest, positive growth in the second half of the year before slowing more sharply. Spain and Italy are the strong performers. We see the United Kingdom's GDP as flat this year and have marked down 2024 given higher-than-expected rates and tighter monetary conditions.

Among the emerging economies, India has taken the mantle of global growth leader from China among the countries that we cover. We see its GDP expansion averaging about 6.5% over our forecast period compared with about 5% for China. Nonetheless, given the Chinese economy's much larger size, it is still the largest contributor to global growth at around 1 percentage point per year. Growth in Brazil and Mexico has been marked up while South Africa has been marked down. Stalled global trade means that domestically driven economies will fare better than export-dependent ones.

Details of our forecasts for the major countries and regions are as follows:

United States: Sticky, longer slowdown  The U.S. economy continues to run too hot despite 500 basis points of official rate hikes in just over a year. Growth is near potential (so the output gap is not closing), the labor market is tight, and inflation is too high. The necessarily slowdown in activity means that policy rates will likely need to go higher and stay there for longer, with a protracted growth slowdown rather than a recession in store. The main risk to our forecast is that demand and growth may be stickier than anticipated, leading to more rate hikes and/or higher rates for longer. This will cause more damage to the interest-rate sensitive sectors and asymmetrically affect credit conditions.

We forecast GDP growth falling only modestly to 1.7% this year, although that masks a slowdown in the second half. We see the pace of activity expanding at less than 1% for the remainder of this year, and staying below trend (1.8%) through 2024. On policy rates, the Fed has at least one more rate hike and will likely hold until the middle of 2024. This should result in higher real rates as inflation gradually resides. 2025-2026 has the economy returning to a sustainable path of trend growth and 2% core inflation.

For further details on the United States macro view, see "Economic Outlook U.S. Q3 2023: A Sticky Slowdown Means Higher For Longer," June 26, 2023.

Eurozone: Medium-term gain?  The eurozone economy is evolving broadly in line with our previous forecast. While output has stalled, the labor market remains tight. Fiscal policy has been supportive of growth in some countries, and inflation remains well above target, although headline is falling supporting real wage growth. The second half of the year should see a temporary return to positive growth, before tighter monetary conditions begin to weigh more heavily on activity, although we do not see a sharp or protracted downturn. Over the medium term, the Next Gen EU plan, spending by the European Commission, and a less restrictive stance of monetary policy should all support growth.

On GDP growth, we forecast 2023 to be slightly higher and 2024 to be slightly lower than in our previous round, but with a largely unchanged narrative. We see one more rate hike from the European Central Bank before a protracted pause into 2024. Headline inflation should fall close to 2% in late 2024, although core will remain above headline well into 2025.

For further details on the eurozone macro view, see "Economic Outlook Eurozone Q3 2023: Short-Term Pain, Medium-Term Gain," June 26, 2023.

Asia-Pacific: Steady demand, inflation relief  The overall economic picture has improved slightly in the last three months. China's recovery should continue but will remain uneven much of this year, with investment and industry lagging. Other Asia-Pacific economies are on track to slow due to the global slowdown and interest rate hikes. Still, service-sector resilience should generally keep growth significant, with economies driven by domestic demand outperforming those driven by net exports. Price pressures remain lower than in the West.

We reduced our 2023 China GDP growth forecast to 5.2%, from 5.5%, but see little appetite for a broad-based package to stimulate growth. For the region overall, with sequential core inflation modest, the need to increase policy rates has receded, barring a few exceptions (Australia, New Zealand). However, cuts will be slow to materialize, in part because of U.S. rates remaining high for longer.

For further details on the Asia-Pacific macro view, see "Economic Outlook Asia-Pacific Q3 2023: Domestic Demand, Inflation Relief Support Asia's Outlook," June 25, 2023.

Emerging markets: Beating expectations, but for how long?  Despite better-than-expected growth performance in the first quarter, we continue to forecast a sharp slowdown in 2023 for most emerging markets (EMs) excluding China. The recent resilience in exports will prove fleeting. Industrial sectors will struggle as global momentum weakens, weighing on GDP growth more generally across EMs. Headline EM inflation has dropped thanks to food and energy but core inflation in EM EMEA and LatAm-excluding Brazil have only recently started to slow, keeping headline inflation above target.

Monetary tightening cycles are at or near the end in most EMs given moderating inflation pressure, weakening growth and declining long-term U.S. bond yields. Still, we don't anticipate most would ease in 2023 before the Fed clearly signals its intent to do so. For the 17 economies we cover in the EM space, we expect growth to fall by 1.7 percentage points to 3.3% this year, before recovering to an average of 4.2% during 2024-2026.

For further details on the Emerging Markets macro view, see "Economic Outlook Emerging Markets Q3 2023: A Slowdown Ahead After Beating Expectations," June 26, 2023.

Risks Center On Sufficient Policy Tightness And The Transition To Higher For Longer

Our main concern is that the current monetary settings may not be tight enough to rein in inflation. Real interest rates have begun to rise as (headline) inflation has fallen, but they are not particularly high by historical standards. Financial conditions indices (see Chicago Fed) are also not particularly tight, especially for the risk and credit components, although the leverage sub-index has become elevated. Similarly, financial stress indicators (see U.S. Treasury) also show looser than average conditions, as the brief spike in March following the collapse of Silicon Valley Bank has largely unwound. This looseness is truer in advanced markets and less so in emerging markets. The idea that tighter bank lending standards might do some of the work for the Fed following SVB's collapse has only partially materialized. Taken together, these factors suggest that more tightening may be needed.

Chart 3

A related risk is around the transition to structurally higher rates. While the hiking cycle is arguably nearing its end, it's less clear where policy rates end up once we return to the steady state or equilibrium macro path. The latest Fed "dot plots" still cluster around a long-term policy rate of 2.5%, unchanged since the onset of COVID-19, the rise in geopolitical tensions and heightened awareness of the energy transition and its investment requirements--all of which would tend to push the real equilibrium rate (r*) higher. r* is currently seen as close to 0.5%, leading to the long-term policy rate of 2.5% (the 2% inflation target plus r*). But, if r* has risen and rates will be structurally higher, then asset values would need to adjust (both downward for discounting reasons but upward for the relevant returns) and rolling refinancing stress is likely to appear as markets are forced to adjust to higher rates. Both of these can potentially drag down growth, at least in the short term.

The Relatively Easy Stuff Is Now Behind Us

While the last year or so has featured the unexpected rise and stickiness of inflation, the solution was clear. At least when the problem was correctly diagnosed. Once supply-side pressures and the associated inflation subsided, economies were found to be running too hot and demand needed to be reined in. Policy rates and financial conditions needed to rise and tighten substantially in order to bring demand and therefore price pressures under control. As of mid-2023, core inflation rates have been stabilized and policy rates look close to their peak in the advanced markets: emerging markets got to their peak rates much faster. Mission (almost) accomplished. But that, unfortunately, was the easy part.

An uncertain path back to macro sustainability lies ahead. This is not so much about the rate of inflation--the path from here is likely to be flat to downward. The real challenge relates to bringing activity back to a sustainable path in the least disruptive way.

More colloquially: what type of landing will we have? If policy is already tight, implying that strong lags of rate hikes to date will shortly come through, then perhaps a harder landing is ahead. At the other extreme, if policy is still too loose (more likely in our view) then inflation will remain unacceptably high and more rate hikes will be required to bring it under control, again risking a harder landing. The challenge is to find the "goldilocks" path of policy rate hikes--and the resulting financial conditions--that brings output back to its sustainable path with the least amount of damage to the economy in general and the labor market in particular. No one said central banking was easy.

Related Research

• Economic Outlook U.S. Q3 2023: A Sticky Slowdown Means Higher For Longer, June 26, 2023
• Economic Outlook Emerging Markets Q3 2023: A Slowdown Ahead After Beating Expectations, June 26, 2023
• Economic Outlook Eurozone Q3 2023: Short-Term Pain, Medium-Term Gain, June 26, 2023
• Economic Outlook Asia-Pacific Q3 2023: Domestic Demand, Inflation Relief Support Asia's Outlook, June 25, 2023