The Effects Of Higher Rates In 2023 Have Spread Almost Everywhere

Growth slowed dramatically across the major economies in 2023 (see chart 1). The major exceptions were the U.S. and Japan. This reflected tighter financial conditions as the effects of policy rate hikes transmitted through lending and asset price channels. It also reflected negative fiscal impulses as primary fiscal deficits declined (excluding in the U.S., see below and chart 2), further crimping demand. Compared with 2022, GDP growth fell more than two percentage points across the advanced economies. The U.S. was a clear outlier, where GDP rose last year.

Chart 1

U.S. outperformance reflects a combination of resilience, lags, and luck. (see "The U.S. Economy Bucks the Global Trend," published Feb. 28, 2024). The ongoing investment renaissance has been driven by the Inflation Reduction Act (IRA) and the CHIPS Act—both of which have led to public investment crowding in private investment—and robust business formation. In addition, there was a sharp pickup in labor productivity in recent quarters, boosting potential growth and holding labor costs in check. A relatively slow monetary policy transmission, reflecting a prevalence of fixed interest rates, particularly for household mortgages and commercial real estate (CRE) has also helped to boost U.S. growth. This suggests that the U.S. may need to hold rates higher for longer. Finally, the U.S.' benefits from its geographical position far from various conflicts, with smaller spillovers to activity, prices, and confidence compared with Europe.

Higher rates had differing impact on services versus manufacturing. Service spending resilience has been a positive surprise over the past few years. This has been fueled by a strong labor market, pent-up demand from the height of pandemic, fiscal transfers, wealth effects, and, in some cases like the U.S., lower real debt service payments due to a higher prevalence of longer-term fixed borrowing rates. Manufacturing did not fare as well. Output growth has fallen sharply owing to higher borrowing and operating costs and weaker demand because of the more discretionary nature of goods. In recent months, manufacturing appears to have bottomed in Europe while services have softened, so the gap may be narrowing.

Labor markets have remained resilient and are key to our relatively upbeat macro narrative. As argued in previous quarterly reports, labor market strength (with low unemployment and strong wage growth) underpin our baseline soft landing scenario. Despite large GDP growth differentials across our sample of countries, unemployment rates remain near multidecade lows. This reflects a combination of strong services demand (services being relatively labor intensive) and some labor hoarding as firms hold on to workers following the difficult labor market matching as economies rebounded from the depths of the COVID-19 pandemic.

An important divergence in productivity has emerged. In the U.S., labor productivity picked up in the second half of 2023 and is effectively offsetting higher wages and keeping unit labor costs flat. In contrast, Eurozone labor productivity has been flat, resulting in unit labor costs moving in line with nominal wages. These differences spill over to profits and ultimately, labor demand.

Fiscal policy has also been a driver of relative growth differentials across the advanced economies. While the U.S. has been running the largest primary deficit in the group (along with Japan), it also saw the largest fiscal impulse last year (see chart 2). Much of this related to the IRA and other spending on energy-transition-related items. As such, it is working more on the supply side of the economy than the demand side, potentially raising future growth. This year, the U.S. primary fiscal impulse will be more in line with its peer group so this driver of outperformance will disappear.

Chart 2

Inflation continues to decline toward central bank policy targets but remains sticky. After falling steadily from a cyclical peak in early 2023, core inflation has moved sideways in recent months. This has particularly been true for services inflation, because of ongoing strong labor demand and weak productivity growth (outside the U.S.).

In contrast, core manufacturing inflation fell below the overall central bank targets, reflecting the higher sensitivity to interest rate increases and tighter financial conditions. Sticky inflation has fueled debates that the "last mile" of the inflation battle—getting rates to 2% from around 3% at present—will be particularly challenging.

Central bank policy rates have plateaued. Policy rates have been on hold since mid-2023 with the exception of the Reserve Bank of Australia, which enacted at 25-basis-point (bp) hike in November and the Bank of Japan, which raised rates in March 2024. With inflation declining steadily, real interest rates have been rising, tightening financial conditions through this channel. However, financial conditions have fluctuated as evidenced by longer-term bond yields.

Central bankers have been resolute in announcing that they plan to return to their inflation targets, and that progress is being made. Yet they have held off cutting rates and are waiting for more sustained evidence that inflation is moving toward their respective targets. On a related issue, policy rates and remuneration of bank reserves have led to sizeable central bank losses. While these losses have gained some press attention, they are operationally irrelevant and do not affect the ability of banks to fully undertake their desired policy actions.

Chart 3

Our Updated Forecasts

The largest changes to our GDP growth forecasts this round are for the U.S. and India (see table 1). Compared with previous rounds, the revisions are more balanced as we did not have an across-the-board rise in the current year growth forecast.

We have raised our U.S. growth forecast by a full percentage point (which we announced in our earlier report, "A Sturdy Job Market Keeps Growth Going," published Feb. 21, 2024). The higher forecast mostly reflects the strong finish to 2023, which continued into the first part of 2024, lifting the path of output for the rest of the year. Importantly, we did not change our forecast of a slowdown to below trend growth in the final three quarters of the year. Also, higher U.S. activity spilled over to Mexico, for which we also revised our growth forecast higher in 2024.

The other strong upward revision to growth was India. Here, we increased our forecast for GDP growth in fiscal 2024 (ending in March 2024) 1.2 percentage points to 7.6%. We now expect fiscal 2025 growth will increase 40 bps relative to our previous forecast to 6.8%. These revisions reflect ongoing strong private sector investment, productivity gains from the digital transition and higher confidence (PMIs). Agriculture and private consumption are growing slower than overall GDP. The combination of higher U.S. and India growth lifts our forecasted global GDP growth by 40 bps to 3.2%.

Table 1

Regional economic outlooks

U.S.

We expect U.S. real GDP to grow 2.5% in 2024 as the labor market remains sturdy. We continue to expect the economy will transition to slightly below-potential growth in the next couple of years. Inflation will likely remain above (but approaching) the Fed's target of 2% through 2024, reflecting persistently higher service price inflation, even as goods prices ease modestly. Above-target inflation will limit the Fed's ability to ease rates this year. We continue to pencil in 75 bps of rate cuts in 2024, with the first cut likely coming in the summer. In our base-case, we incorporate a sharper, 125-bp cut in 2025, though there is a risk that the pace could slow down. A recession in the next 12 months appears less likely now than it did in the spring of last year. However, factors that supported rising demand through 2023--especially consumer spending and direct government outlays--are likely to fade.

For details, see "Heading For An Encore," published on RatingsDirect on March 26, 2024.

Europe

The European economy remains on track for activity to improve and employment growth to moderate. However, uncertainty over productivity trends and slow implementation of the Next Generation EU recovery package may cause the rebound in growth to be weaker than we expected. We have revised our 2025 GDP growth forecast down to 1.3% from 1.5%. Record high labor costs are limiting the scope for disinflation. We have slightly increased our inflation forecasts to 2.1% in 2025 and 1.9% in 2026, reflecting prolonged high wage growth against a backdrop of sluggish productivity. We expect the European Central Bank to cut rates three times in 2024, starting in June. The potential for further rate cuts in 2025 seems more limited than we thought. The deposit facility rate could bottom out at 2.5% in 2025 instead of the 2.0% we considered previously.

For details, see "Labor Costs Hinder Disinflation As Rate Cuts Loom," published on RatingsDirect on March 26, 2024.

Asia-Pacific

We expect growth in China's GDP will slow to 4.6% in 2024 from 5.2% in 2023. Our forecast factors in continued property weakness and modest macro policy support. Deflation remains a risk if consumption stays weak and the government responds by further stimulating manufacturing investment. We forecast growth to pick up in trade-dependent developed economies such as South Korea, Taiwan, and Singapore and fall in relatively domestic demand-led ones such as Japan and Australia. For Asian emerging market economies, we generally project robust growth, with India, Indonesia, the Philippines, and Vietnam in the lead. The fall in inflation momentum has so far not been enough to convince Asia-Pacific central banks to start cutting rates. If rates continue to choke demand, the case for lowering will strengthen in the coming months. We expect the Bank of Japan to modestly raise rates in the next four years.

For details, see "Looking Forward To Monetary Policy Normalization," published on RatingsDirect on March 26, 2024.

Emerging Markets

Macroeconomic conditions for emerging markets (EMs) in 2024 have improved marginally since the end of 2023. This is mainly due to continued resilience in global economic growth, especially in the U.S., and a modest improvement in financial conditions as we expect monetary policy to eventually loosen in the U.S. and the eurozone this year. In this context, we expect significant growth divergence across EMs. Growth will moderate for many countries that outperformed in 2023 (Brazil, Mexico, and India) but remain relatively strong. Conversely, some countries that underperformed last year (Colombia, Peru, Thailand, Hungary, Poland, and South Africa) will grow modestly faster in 2024, but in most cases activity will remain subdued. Despite improving conditions, EMs will still face significant obstacles this year that will keep economic paths highly vulnerable. These include the lagging effects of high interest rates and a drag from an eventual slowdown in the U.S., which we expect to occur in the second half of 2024.

For details, see "Growth Divergence Ahead," published on RatingsDirect on March 26, 2024.

Risks To Our Baseline

Interest rates could take longer than expected to decline and may be permanently higher. While policy rate cuts start around mid-2024 in our baseline, they will take time to land as long as labor markets remain strong. Getting back to neutral will likely take a number of years and neutral may not look the same as it did in 2019. We believe the neutral rate of interest (r*) has arguably risen compared with the pre-pandemic period; the question is how much. The answer will depend on the determinants of r*, most notably productivity growth and investment. We currently estimate, broadly in line with consensus, that r* has risen by around half a percentage point in the U.S. and by a full percentage point in the Eurozone. A structurally higher path of global rates is not fully priced into markets and will have implications for borrowing rates, asset prices, and debt sustainability.

A continued strong U.S. dollar poses risks to the "rest of the world." The combination of stronger U.S. growth and higher U.S. interest rates suggests a protracted period of dollar strength. This will be problematic for borrowers in U.S. dollars, especially in emerging markets. The issue here is the mismatch between local currency receivables and (unhedged) U.S. dollar liabilities. Serving such debt will be more difficult. Weak local currencies can result in higher domestic inflation pressures as import costs will be higher in local currency terms. Local interest rates may need to be higher to rein in such pressures, putting a damper on growth. Finally, a higher dollar is also likely to steer financing flows away from some emerging markets, making it more difficult to cover current account deficits, putting additional pressure on exchange rates.

We believe 2024 features an unusual amount of geopolitical risk in the form of elections. Fragmentation of the global order and the end of the Washington Consensus (of private-sector-led growth with free flows of capital and free trade) are part of our new normal. But downsides to this new baseline are still possible. Election results giving political power to "nativist" parties could spur another round of tariffs and investment restrictions, further undermining confidence. This would also unwind the benefits of trade diversification and globalized capital flows, raise the cost of doing business and put a further damper on investment and growth.

Related Research

• Economic Outlook U.S. Q2 2024: Heading For An Encore, March 26, 2024
• Economic Outlook Eurozone Q2 2024: Labor Costs Hinder Disinflation As Rate Cuts Loom, March 26, 2024
• Economic Outlook Asia-Pacific Q2 2024: Looking Forward To Monetary Policy Normalization, March 26, 2024
• Economic Outlook Emerging Markets Q2 2024: Growth Divergence Ahead, March 26, 2024