U.S. & Europe: The U.S. Fed Lags The ECB In Cutting Rates

U.S. growth is easing, the eurozone's is picking up.  U.S. GDP growth slowed in the first quarter. We expect annualized GDP growth of around 2% in the last three quarters of 2024 and in 2025. Following flat GDP in 2023, the eurozone resumed sequential grow in the first quarter. We expect quarterly growth in the eurozone to be broadly the same as in the U.S. in 2024, and somewhat slower in 2025.

Amid sticky U.S. inflation, the first U.S. Federal Reserve rate cut won't likely come until end-2024.  We see the policy rate reaching its "terminal" level of 2.75% to 3% in the second half of 2026. The ECB is more confident about inflation's downward trend. It started cutting its policy rate in early June.

China Should Grow Close To 5% But Demand Remains Soft

Momentum has slowed after relatively brisk 5.3% year-on-year GDP growth in the first quarter.  This has happened amid the relentless property downturn, with housing sales and starts still down around 20% in May on a year ago, and weak domestic confidence and spending.

In the first two months of the second quarter, growth of retail sales, investment and industrial production fell, both compared with a year ago and with the same month in 2019 (which we look at to adjust for the bumpy data of recent years) (see charts 1 and 2).

While the housing sector should bottom out this year, its recovery will be shallow.  That is because confidence among potential homebuyers remains muted and policy support modest. Policymakers have recently cut mortgage interest and minimum deposits rates and announced a scheme to encourage public entities to purchase unsold homes. However, government support to ensure presold housing deliveries remains timid, with little financial commitment from the central government.

Chart 1

Chart 2

We raised our 2024 GDP growth forecast to 4.8%, from 4.6%, but expect a sequential slowdown in the second quarter.  The forecast revision reflects the expectations-beating first quarter growth. Our projection factors in only modest fiscal and monetary policy support. Indeed, overall fiscal spending through April has remained restrained and, with U.S. rates higher for longer, we don't anymore anticipate the People's Bank of China will cut its policy rate this year.

Still, we expect imports--of key importance internationally--to continue to recover this year and next.  China's goods import volumes (as in, corrected for price changes) have recovered gradually since troughing in 2022 amid the depth of the COVID downturn, tracking with a lag the reopening of the economy (see chart 3). The recovery in outbound tourism spending has been more recent and fast (see chart 4).

Chart 3

Chart 4

The combination of subdued consumption and robust manufacturing investment is weighing on prices and profit margins.  In our view, problematic consumer deflation is unlikely, as services inflation remains significant. But the combination of soft consumption and robust manufacturing investment has led to excess capacity in several goods markets. In this setting, nominal year-on-year GDP growth fell to 4.1% in the first quarter, the lowest rate since records began barring the first quarter of 2020, an anomalous period due to the outbreak of COVID at that time.

There are domestic and external risks.  The key domestic risk to growth is major weakness in real estate. The main external risk is accelerated supply chain adjustment and large barriers to trade and investment by major trading partners. Both the U.S. and the EU recently announced increases on imports from China, and this is likely to encourage other countries to follow suit. The U.S. restrictions are on a range of goods, while the EU's focus is on electric vehicles.

Asia-Pacific Growth Is Holding Up, With Emerging Markets Leading

An export recovery and increasingly biting impact from elevated interest rates and/or inflation have affected growth in opposite ways.  Across economies, whether economic momentum has accelerated or slowed depends on which of these two forces has dominated.

In strongly trade-dependent economies, the export recovery has supported GDP growth in early 2024.  This has especially been the case in Hong Kong, Malaysia, South Korea, and Thailand.

In developed economies that are largely domestic demand-led , the negative impact of higher interest rates and/or inflation on household spending power has mattered more.  In Japan, household consumption has been weak as inflation dragged down real incomes. In Australia and New Zealand, elevated interest rates and inflation have weighed on consumption and investment.

In Asian EMs, tighter monetary policy hasn't materially affected solid domestic demand growth  (see charts 5 and 6). This is largely because monetary policy transmission mechanisms are different and weaker in these economies. Indeed, Asian EMs have seen solid credit growth in recent months.

India's economic growth continues to surprise on the upside. GDP growth for fiscal 2024 was revised up to 8.2%.

Chart 5

Chart 6

The export recovery, which initially was especially visible in northeast Asian semi-conductor shipments, has broadened out to other sectors and economies.  Export volumes are on the rise, sequentially, in China and several Southeast Asian countries (see charts 7 and 8). We expect global demand growth to increase materially this year, in part because of an end to destocking in major economies.

The prospect of higher-for-longer U.S. policy rates means less monetary policy easing in Asia-Pacific, thus weighing on domestic demand.  With interest rates likely to start falling only late this year, the positive impact of monetary easing on growth won't kick in until 2025, given the lags in the transmission of monetary policy. Having said that, resilience of the U.S. economy is the reason for delays in U.S. rate cuts; and this is in itself a positive for Asia-Pacific exports and growth.

Chart 7

Chart 8

In our view, the export recovery and impact of elevated interest rates and/or inflation will continue to shape growth across the economies sensitive to them.

• Better export growth will lead to higher GDP growth this year in Malaysia, the Philippines, Singapore, South Korea, Taiwan, Thailand, and Vietnam. Other economies should also benefit from stronger exports this year.
• In Japan, we expect GDP growth to slow in 2024 as elevated inflation eats into real incomes and consumption. In Australia, restrictive interest rates are driving GDP growth lower than in 2023. That said, in both countries, a resilient labor market helps ease strains on growth.
• In India, we expect growth to moderate to 6.8% this fiscal year, with high interest rates and lower fiscal spur tempering demand in the non-agricultural sectors.
• In other Asian EMs, solid domestic demand growth and a pick-up in exports should drive robust growth, with the Philippines and Vietnam projected to expand almost 6%, and Indonesia almost 5%.

Overall, we project 5.1% growth in 2024 in the region excluding China and Japan, compared with 5.4% in 2023, and 5.2% in 2025.

Key growth risks include a sharper-than-expected slowdown in the U.S., weaker growth in China, and a pronounced slowdown in domestic consumption.

We expect significant changes, headwinds and risks from the international proliferation of policies to restrict trade and investment.  Supply chain adjustment sometimes leads to the relocation of manufacturing activity from China to other Asian economies. But there will be fewer net winners than often assumed, given the negative impact of such policy action on overall trade and economic activity in the region and the further policy reactions to this kind of relocation by governments such as that of the U.S.

Higher-For-Longer U.S. Rates Challenge Monetary Policy

Inflation pressure has eased in the Asia-Pacific  (see charts 9 and 10). While Indian headline inflation has remained elevated this year, this is solely because of high food inflation--core inflation is significantly lower.

The decline in underlying inflation across the region would, by itself, call for lower interest rates,  although in several economies substantial economic growth reduces the pressure on central banks to cut rates.

Chart 9

Chart 10

But the prospect of later U.S. policy rate cuts is leading Asia-Pacific central banks to delay their policy easing.  This reflects the sensitivity of capital flows and exchange rates in the region to interest differentials with the U.S. and central bank aims to limit currency depreciation. They do that to reduce the impact of higher import prices on domestic inflation, dampen capital outflows and, and prevent financial turbulence.

In addition to delaying interest rate cuts, many central banks have taken other measures to limit foreign exchange market pressure.  In Indonesia and Taiwan they have raised policy interest rates. In China and Malaysia they tightened and enforced capital market regulation and tweaked other elements of the policy settings to dampen depreciation. They intervened verbally, including in Japan, South Korea and Malaysia. And they intervened actually in foreign-exchange markets, including in India, Indonesia, Japan, Thailand, and Vietnam.

Currencies have depreciated on average around 4% against the U.S. dollar so far in 2024. The weakening is the largest in Japan, where the policy interest rate differential with the U.S. is the largest (see chart 11). However, the depreciation has also been large in Indonesia, where the interest rate differential is sizeable in the Asia-Pacific context. In countries such as China and India depreciation has been relatively low, in part because of the exchange rate management noted above.

Asian EMs are generally reasonably well positioned for such external challenges.  Even as exchange rate management has taken place, currencies are much more flexible than in the past. In part as a result, current account balances are not significantly in deficit. Foreign reserve coverage varies but is generally adequate compared with short-term debt (a ratio of 100% is usually considered adequate; see chart 12).

Chart 11

Chart 12

Still, regional EMs could be tested if U.S. rates were to rise further and outflow pressures to intensify.

Meanwhile, in Japan we expect gradual increases in policy rates as price and wage-setting behavior changes.  We think it has become more likely that these changes will be sustained and project medium-term inflation of 1.7%-2% (see "Japan's Long Wait For Sustained Inflation Is Likely Ending," April 16, 2023). Still, amid prospects of modest real growth and sizable financial surpluses, Japan's interest rates should remain significantly lower than in other major advanced economies. The BOJ is also preparing to reduce its asset purchases under its quantitative easing arrangement.

Related Research

• Rated China Carmakers Can Take The Heat From European Tariff Hikes On EVs, June 17, 2023
• Global Economic Update: Policy And Exchange Rate Forecasts Revised On New Fed Funds Rate Expectations, May 2, 2024
• Japan's Long Wait For Sustained Inflation Is Likely Ending, April 16, 2023

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