Rate Hikes Have Been Synchronized, Macro Outcomes Have Not

The rate hike cycle may be in sync, but global performance is not. Major central banks (excluding Japan) have raised policy rates by about 400 to 500 basis points (bps) since the first half of 2022 to slow inflation, which has surged to a four-decade high. The effort to curb inflation appears to be succeeding, but macro performance has varied widely. This reflects differing speeds of monetary transmission, differing fiscal impulses, and differing external conditions and dependencies.

Chart 1

Our macro summary for the major regions and groups is as follows (details and links appear below):

• The U.S. economy continues to outperform, posting nearly 5% annualized growth in the third quarter, led by strong consumer spending and an inventory rebuild. Fourth quarter GDP is tracking close to potential growth of 2%.
• Europe activity has flatlined. Services-based economies (Spain) have done better than manufacturing-based economies (Germany). Monetary transmission works faster than it does in the U.S.
• China's growth has stabilized, reflecting targeted government stimulus. But household confidence remains weak, and the property sector remains under stress. High inflation has not been an issue.
• Emerging markets have proven resilient overall, led by domestic-driven economies (India, Indonesia), or those linked to the U.S. (Mexico). Policy rates cuts are in part currently constrained by the U.S. Federal Reserve.

Strong labor markets are a bright spot almost everywhere. This despite diverging growth outcomes. Low unemployment rates stem from strong spending on services, which are generally labor intensive. They also reflect labor hoarding, as firms are loath to repeat the matching problems experienced in the COVID period. Higher frequency indicators do show signs of slower labor demand, including payroll additions, quits, and hours worked. Ongoing robust fiscal spending helps in many economies as well. As we have noted in previous updates, labor market resilience is key to our soft-landing narrative.

Chart 2

Both headline and core inflation continue to decline following their peaks of late 2022. Headline inflation rose to higher rates than core and is now generally lower, reflecting the recent declines in food and fuel prices. However, core inflation remains stubbornly high--near 5% in several major advanced economies--and well above central bank targets, typically 2% over the medium term.

This stickiness reflects strong labor markets and spending on services and other non-tradable goods. By extension, sticky inflation also implies that demand growth is too strong and that the pace of activity needs to fall to bring inflation lower. Indeed, inflation is coming down faster in economies where growth and demand have fallen below trend growth. This group includes the eurozone and Canada.

Chart 3

Major central banks are signaling that they will need keep rates near current levels for a sufficiently long time, interpreted by markets as until the middle of 2024. There are two reasons for this. Core inflation remains high and sticky. This stems from strong labor markets, which are driving services spending. Also, having been surprised by the jump in inflation in 2021 and responded too late, central banks are wary of getting burned again and are therefore leaning higher. Some emerging market central banks, particularly in Latin America, have begun to cut policy rates, but they are proceeding cautiously due to risks around currency values and capital outflows.

Markets have bought the higher-for-longer view for the most part. First, futures pricing implies that major central banks will keep rates at or near current levels into mid-2024. This broadly aligns with guidance given by central banks themselves. The consensus view sees rate cuts beginning in the second half of the year and ranging from 50 to 100 bps in 2024. Second, loan officer surveys report slowing demand for credit on the back of higher rates. Finally, benchmark long-term yields have moved higher as well (see chart 4), although they have retraced over the past month or so as markets conclude that the hiking cycle is done.

Chart 4

Financial conditions have tightened for most of the year but show recent signs of easing. This is unwelcome from the perspective of keeping conditions tight to bring down inflation further. Ten-year U.S. treasury yields have fallen by about 50 bps from their mid-October peak of just under 5%. And the U.S. dollar index has fallen by 3% to 4% over the same period. Similarly, 10-year German bond yields are down 30 bps since their peak of almost 3% in mid-October. Since financial conditions--not policy rates--are the key to driving demand and (core) inflation, weak conditions open the possibility that policy rates need to stay elevated. Thus, market-driven easing of conditions puts central banks in a tough spot.

Latest Forecasts And Regional Narratives

Our updated GDP growth forecasts for the advanced economies are broadly unchanged for the U.S. and eurozone as a whole (see table 1). Our global growth forecast is 0.2% higher this year and is unchanged over 2024-2026. The main revisions were in the big emerging markets: China and India.

We have nudged Spain, France, and the U.K. higher, and Italy lower with all of these moves less than 30 bps, mainly due to carryovers from revisions to 2022 GDP. The emerging markets had somewhat larger revisions for key countries.

U.S.

Activity accelerated in the third quarter, with GDP growth at a blockbuster pace of 4.9% annualized. But we see clear signs of moderation ahead. On the consumer side these include the sharp slowdown in real income growth, the low household savings rate, the lifting of the student loan moratorium, and ongoing challenging affordability.

On the firm side, we see a deterioration of capex intentions and lower inventory accumulation. In the labor market, the imbalance between demand and supply is narrowing, with payrolls growth trending lower and wage gains moderating. Inflation continues to fall but remains too elevated for the Fed's comfort; financial conditions remain reasonably tight. We see the Fed on hold into the middle of 2024, with a chance of one more hike in December depending on the near-term data flow. Fiscal policy should remain supportive of growth over our forecast horizon. We see below-trend growth for 2024 and 2025, with unemployment drifting into the mid 4% range in one year's time. We see the risks to be broadly balanced: upside spillovers from government policy, downside strong lags from previous tightening. For details, see "Cooling Off But Not Breaking," published on RatingsDirect on Nov. 27, 2023.

Europe

In contrast to the U.S., activity in the third quarter was flat in both the eurozone and the U.K. Production has suffered from high energy prices and destocking (manufacturing is in recession); fiscal policy is no longer expansionary (although there are differences from country to country); and the passthrough of policy rate hikes has been relatively swift. Spain (tourism) gave the biggest boost to eurozone growth while Ireland (shifting profits) was the largest drag. Importantly, the drivers of the slowdown are changing. Services, the previous bright spot, is showing signs of weakness. Meanwhile, manufacturing appears to be bottoming out, particularly in Germany.

Employment continues to rise for a variety of reasons, but with output flat, this is raising questions about productivity and profits. Disinflation is easing household income constraints and has allowed the European Central Bank and the Bank of England to adopt a "hawkish pause," although markets still see a chance of another hike by the latter. We expect policy rates to be on hold into mid-2024. Our forecast is for below-trend growth in 2024 before a return to trend in 2025. For details, see "Headed For A Soft Landing," Nov. 27, 2023.

Asia-Pacific

Growth in China picked up in the third quarter, rising to 1.3% quarter on quarter (and 4.9% year on year). Fiscal and monetary easing has remained limited, and we don't expect major stimulus, given the focus on containing financial risks. But the measures are starting to add up, especially on the fiscal side and in real estate, although the property sector is still struggling, and consumer confidence remains subdued. Ex-China, the region has shown resilience led by robust domestic demand growth.

Moreover, our estimates suggest that export volumes have bottomed out in Northeast Asia. Inflation pressures mostly remain contained as sequential core price increases have eased in most Asia-Pacific economies and the impact of recent increases in international prices of oil and food has so far remained modest, especially in terms of core inflation momentum.

While policy rates in most economies have been on hold in this setting, we don't expect them to come down significantly soon. And the Bank of Japan will take its time in tightening monetary policy. We see China's GDP growth at 4.6% in 2024 with modest pick-ups elsewhere in the region. For details, see "Emerging Markets Lead the Way," Nov. 27, 2023.

Emerging Markets (EMs)

Across the EMs we cover, growth was mixed in the third quarter, depending largely on trade exposure. Those exposed to the U.S. (Mexico) tended to overperform whereas those exposed to Germany (Poland, Hungary) tended to underperform. Sequential growth in EMs in Europe, Middle East and Africa (EMEA) was stronger in the third quarter than in the second, pointing to a possible bottoming out. Also, domestically driven economies tended to outperform more open ones. Disinflation continues apace, with October readings mostly lower than consensus. Median EM consumer price index inflation is now 4.8% compared with a peak of 8.2% in August 2022, driven by moderating food and energy prices.

Action by central banks is picking up, influenced by swings in Fed expectations. Three EM central banks in Asia-Pacific (Thailand, Philippines, Indonesia) hiked rates, three in Latin America (Brazil, Chile, Peru) cut rates whereas Poland surprised with a hawkish hold. Turkiye continues its aggressive catch-up tightening. Finally, we have seen no clear impact yet on EM spreads from the Israel-Gaza conflict. For our outlook, we expect below-trend real GDP growth in most EMs in 2024. For details, see "Challenging Global Conditions Will Constrain Growth," Nov. 27, 2023.

Risks To The Our Soft-Landing Baseline

We continue to see a material risk that macro developments will turn out better than anticipated. Indeed, this has been the pattern for the past year, and many of the contributing elements remain in place. Labor markets remain tight across a wide swathe of economies even though headline growth numbers are diverging. This reflects labor hoarding by firms, who are loath to repeat the difficulties finding workers in the post-pandemic period. Instead, hours have been reduced and there is some evidence that redundancies have risen.

The other factor is fiscal policy, which remains expansionary for this part of the cycle. This is also occurring across a wide number of economies, boosting output, labor demand and wages more than would otherwise be the case. In the U.S., households have not yet run down their excess savings balances from COVID-relief policies.

An upside growth scenario also implies that interest rates will need to stay higher for longer. This is relative to our already higher for longer baseline. This will likely cause more pain to households and firms than our baseline since consumer credit (mortgages, autos, credit cards) and company borrowing costs (including rate resets as we approach a large maturity wall) will both rise. There is an unbalanced policy mix element to this story, whereby expansionary fiscal policy is pushing demand and hence prices higher, necessitating a tighter stance by the monetary authorities. The large number of elections next year suggests that these policy imbalances could persist.

Downside risks to our baseline relate mainly to uncertainties around the transmission of higher policy rates to financial conditions and the real economy. These lags vary by economy and the uncertainties appear larger for the U.S., where the lags are longer than in the eurozone. The higher prevalence of fixed rate loans in the U.S. to both households and corporates complicates the picture. Rates will eventually reset, but at a slower pace than most other economies.

Also, given the steep increase in policy and market rates since early 2022, these resets will not be small. To the extent that the reaction to higher rates is not linear, these large rate increases pose larger downside risks. Not surprisingly, this downside is larger where the resets take longer and the rate adjustment is larger.

Non-macro risks are inherently more difficult to quantify but must be recognized. In particular, geopolitical factors are at play, with ongoing conflicts between Russia and Ukraine and Israel and Hamas. So far, the spillovers in both cases have been lower than we expected. But we can't rule out escalations, which could potentially move the macro needle. Tensions around the U.S.-China rivalry have manifested so far in some modest realignment of trade and financial flows, but also remain largely bounded.

Sticking The Landing

The macro focus has shifted from watching inflation to watching the landing. This is progress in a way since the largest inflation shock in four decades now appears to be behind us. The response to higher inflation always had two elements. First, how high would rates need to go--and how quickly--to bring inflation back to target? Second, what would be the collateral damage to higher rates--would a recession ensue? The answer to the first question appears resolved, which is why the focus has shifted to the second.

Most slowdowns are abrupt. Short of a crisis-induced decline, these slowdowns start when the central bank "takes away the punch bowl." Policy rates rise, financial conditions tighten, and demand and growth fall. More often than not, the economy falls into a recession or undershoots its steady state path. Concurrently, unemployment rises beyond its steady state level. This overcorrection eventually is resolved after policy easing, but at the cost of lost output and jobs, at least in a transitory sense. So what does this elusive soft landing look like? Here is our narrative:

• The economy has to land. That is, growth needs to slow below potential in order for excess demand pressures to ease and inflation to fall back to target. A no-landing scenario will not achieve this.
• In a soft-landing scenario the necessary adjustment takes place gradually. The required adjustment is the same since the starting and ending points are the same, but it is spread out: no freebies here.
• Critically, there is little or no undershoot of the level of GDP nor the rate of inflation, and no undershooting of policy rates. The glide path allows for a slower and more calibrated adjustment.
• The labor market is critical. If workers keep their jobs, or expect to keep their jobs, then spending is likely to be maintained. No paradox or thrift here, or a sharp drop in spending.
• Real rates remain positive throughout. This can be seen as the cyclical manifestation of higher for longer. Policy rates will fall, but only after inflation is on a clear downward path. Real rates are likely to remain elevated, and even rise in the coming quarters.
• When landing is achieved--reaching the steady state or sustainable path with full employment of resources including labor--inflation will be at the target of 2% and the policy rate will exceed inflation by r*, the real rate of interest. We think r* has risen globally and could be as high as1%.

Table 2

The soft-landing story mostly hinges on the labor market. And since the transmission of monetary policy works with a lag, the next few quarters will be critical in determining whether we soft land or not.

Related Research

• Challenging Global Conditions Will Constrain Growth, Nov. 27, 2023
• Economic Outlook Eurozone Q1 2024: Headed For A Soft Landing, Nov. 27, 2023
• Economic Outlook U.S. Q1 2024: Cooling Off But Not Breaking, Nov. 27, 2023
• Economic Outlook Asia-Pacific Q1 2024: Emerging Markets Lead the Way, Nov. 27, 2023

The views expressed here are the independent opinions of S&P Global Ratings' economics group, which is separate from but provides forecasts and other input to S&P Global Ratings' analysts. S&P Global Ratings' analysts use these views in determining and assigning credit ratings in ratings committees, which exercise analytical judgment in accordance with S&P Global Ratings' publicly available methodologies.