Global macro developments continue to pan out in line with our baseline view. GDP growth has moderated in most economies (the U.S. remains an outlier) and recessions have been avoided. Demand pressures have come down, bringing inflation back toward target. Services demand and employment remain robust, moderating the speed of decline, and bolstering the probability of a soft landing.

Up Together But Not Down Together

The start of the long-awaited policy rate cut cycle has captured the global macro spotlight. After a long pause owing to stickier-than-expected core inflation, key central banks have begun lowering policy rates. The European Central Bank (ECB) lowered rates by 25 basis points on June 6, following the Bank of Canada's equally sized cut on June 5. The nexus of demand, inflation and the pace of rate cuts across major economies should dominate the macro narrative for the next one to two years.

Inflation continues to decline, but at an uneven pace across countries (chart 1). Where growth momentum and demand pressures have come down more decisively, as in the eurozone and Canada, inflation momentum has eased and central banks have begun to cut rates. Where growth momentum remains stronger, as in the U.S., progress on inflation has been uneven, and central banks remain on hold for now.

Chart 1

The U.S. economy continues to outperform its advanced-economy peer group. Growth has averaged almost 3% over the past four reporting quarters (chart 2), well above the advanced-country average. The drivers of this strong growth have been, in order, the consumption of services, fixed investment and government spending. But while quarterly growth fell sharply--from 3.4% in the final quarter of 2023 to just 1.3% in the first quarter of this year--the contribution of the two main drivers actually picked up. Moreover, growth in the second quarter of the year is tracking close to 3% so there has been no material slowdown in private demand so far. U.S. outperformance continues.

Chart 2

Labor markets remain tight everywhere, with unemployment rates still near all-time lows. This is notable given the differing cyclical positions of key economies. Low unemployment is to be expected in the United States, where demand (for services and investment in particular) has not slowed appreciably, and the output gap remains positive. But the eurozone labor market also remains tight (perhaps due to labor hoarding) despite just going through a manufacturing recession with overall sequential growth close to zero.

Meanwhile, the Chinese economy continues to be weighed down by the combination of property sector woes and related weak consumer confidence. Growth picked up to 5.3% in the first quarter, but it seems to be slowing again in the second quarter and household spending remains weak. (Real estate is by far the most important asset on household balance sheets.) Government stimulus remains limited and credit growth has slowed. Exports are providing a modest boost to growth and, outside of the property sector, investment momentum is holding up. But the combination of subdued consumption and robust manufacturing investment is weighing on prices and profit margins.

Our Revised Forecasts: Still Evolving As Expected

Our updated GDP growth forecasts appear in table 1. They remain broadly unchanged compared with the previous quarterly update. This includes all major economies. Elsewhere, we have raised the 2024 forecast for Spain, to reflect robust household balance sheets and rapid disinflation, and for the U.K., where the recovery in services in the first quarter has been stronger than expected, as well as for the more open economies in Asia-Pacific, reflecting a pickup in electronics trade. We lowered our forecasts for Mexico and South Africa reflecting growth that was below our expectations in the first quarter, and rising policy uncertainties following recent elections.

Table 1

On policy rates for the advanced economies, we forecast that the descent path will be gradual. This means smaller cuts, paced farther apart. In contrast to the hiking cycle of 2022-2023, when only half of the hikes were 25 basis points, we see only 25 basis point cuts across major central banks in our baseline scenario. Moreover, whereas many of the large hikes were enacted at consecutive central bank meetings on the way up (policymakers realized they were behind the curve), we see smaller rate cuts coming roughly once per quarter on the way down.

Chart 3

Terminal rates for this cycle should be reached in late 2025 and 2026. In a soft landing these terminal rates should be approached from above, and rates throughout the descent should be kept on the restrictive side of neutral. Undershooting should only happen in a harder landing when policymakers would need to move to an accommodative position to stimulate demand.

Our terminal interest rates are also the medium-term neutral or "equilibrium" interest rates. These rates neither stimulate nor support demand. The real interest rate corresponding to the (nominal) terminal rates should be two percentage points lower (or lower by whatever the policy target is).

Neutral policy rates have gone up across the board in our view. Two prominent examples are the U.S. Federal Reserve and the ECB. With terminal rates at 2.9% and 2.5%, respectively, r* would be 0.9% and 0.5%. These are both higher than pre-pandemic reflecting a combination of higher debt levels, higher investment demand and demographics. We would note the high level of uncertainty surrounding estimates of r* given the multiple shocks to the global economy since 2020.

Our regional forecasts:

United States

Slower headline growth in the first quarter masked relatively strong domestic demand 

Indeed, second-quarter growth momentum is tracking above the (upwardly revised) potential rate of 2.2%. Growth in labor supply primarily drove the increase in estimated potential growth. Headline payroll job gains remains solid but other labor market metrics such as quits and vacancies suggest that we are returning to normal, pre-pandemic conditions. The unemployment rate has been edging higher and now stands at 4.0%. Headline CPI inflation is down to 3.3% on a year-over-year basis; more importantly, month-over-month inflation was flat in May, while core inflation rose 0.2%.

We think it will take several more months until the Fed will feel confident that inflation is sustainably on its path to 2%. We see a first rate cut in December 2024, with the terminal rate of 2.9% reached in the second half of 2026. On fiscal policy, we see no material difference stemming from the upcoming election in November. We are comfortable with our baseline forecast of year-on-year growth easing to 1.8% in the fourth quarter of 2024 from 2.9% in the first quarter of the year.

For details, see "Economic Outlook U.S. Q3 2024: Milder Growth Ahead," published on RatingsDirect on June 25, 2024.

Europe

Macro developments have played out in line with our baseline 

Activity is on the rise, with the May composite purchasing managers' indices firmly above the expansion threshold. The eurozone has exited the recent manufacturing recession, putting it cyclically ahead of the U.S. Meanwhile, the labor market continues to slow although the unemployment rate remains near all-time lows. Southern Europe (Spain and Italy) continues to outperform Northern Europe (Germany) not only due to a prevalence of services, but also a rise in productivity in the case of Spain. Recent slower growth at the eurozone level reflects in part a faster passthrough of monetary policy, which has led to weaker inflation pressures.

As a result, the ECB cut rates in early June (following Switzerland and Sweden), taking its deposit rate to 3.75% from 4.00%. We see the new, higher terminal rate of 2.50% reached in late 2025. Election results for the European Parliament came as no surprise; the far-right gained seats, but the current coalition of center-right, center-left and liberals maintain a comfortable majority. We see eurozone growth trending back toward potential of 1% to 1.5% annually in the coming quarters. The U.K. faces a relatively stickier inflation problem (we forecast a first rate cut in August) with a steeper decline in output and employment, and therefore a longer recovery.

For details, see "Economic Outlook Eurozone Q3 2024: Growth Returns, Rates Fall," June 24, 2024.

Asia-Pacific

Growth is holding up, with emerging markets and open economies leading the way 

We raised our 2024 China GDP growth forecast to 4.8%, from 4.6%, but see a sequential slowdown in the second quarter as the combination of subdued consumption and robust manufacturing investment weighs on prices and profit margins. India remains the strongest story in the region, but we expect growth to moderate to 6.8% this fiscal year, with high interest rates and lower fiscal support tempering demand in the nonagricultural sectors.

In the rest of Asia-Pacific, the export recovery and impact of elevated interest rates and/or inflation will continue to shape growth across the economies sensitive to them. Solid domestic demand growth should help Asian emerging markets to expand robustly. While inflation pressure has eased in the region, the prospect of later U.S. policy rate cuts is leading Asia-Pacific central banks to delay their policy easing and taking other measures to limit foreign exchange market pressures. Asian emerging markets could be tested if U.S. rates were to rise further, intensifying outflows.

For details, see "Economic Outlook Asia-Pacific Q3 2024: Exporters And EMs Are Outperforming," June 24, 2024.

Emerging Markets

First-quarter GDP data confirmed a recovery across most emerging markets 

This outcome was supported by strong domestic demand; the median growth momentum in our sample of countries was 4%, broadly in line with long-term averages. With a few exceptions, we expect this recovery to continue in the coming quarters. External demand dynamics are also improving, especially in emerging markets that are exposed to the nascent recovery in Europe, or those that are exposed to the improvement in the electronics trade cycle. Unexpected electoral outcomes, particularly in Mexico and South Africa, have increased uncertainty about upcoming policy paths.

Monetary policy normalization expectations continue to be pared back in line with shifting expectations about when the Fed will start cutting. Several central banks have lowered the magnitude of ongoing interest rate cuts (Chile, Brazil, Peru), others have paused (Mexico). For central banks that have not started lowering benchmark interest rates (South Africa and most of emerging Asia), market expectations for cuts have been pushed out.

For details, see "Economic Outlook Emerging Markets Q3 2024: Growth On Track, Policy Risks Rising," June 25, 2024.

Risks to our baseline are both macro and non-macro 

The main risk to our baseline is a sharp decline in service spending and labor demand. Both have remained surprisingly resilient throughout the rate hiking cycle. Pandemic-related imbalances to goods versus services spending as well as household savings have largely unwound. The expectations channel is important here as well. As long as workers have jobs--and expect to continue to have jobs--spending is likely to remain robust and is likely to remain concentrated in labor-intensive services. As an example, an abrupt sell-off of U.S. Treasuries and an associated spike in yields could trigger such a sharp decline in demand.

Sustained U.S. dollar strength is a risk, particularly to some emerging markets. A 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.

The risk here is the mismatch between local-currency receivables and (unhedged) U.S. dollar liabilities. Serving such debt will be more difficult should the dollar remain elevated. 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.

Chart 4

Asset prices could adjust abruptly to higher rates, but this risk is likely to be a slow burn risk. Finance theory tells us that interest rates and asset prices are inversely related. Falling asset prices should produce negative wealth effects on spending, lowering demand and output. However, financial asset prices have continued to rise, with major equity indices at or near all-time highs.

On the nonfinancial asset side, commercial real estate prices are facing downward pressure including due to falling office demand, but these effects will be staggered. Also, residential housing prices remain high as potential sellers hold on to low-interest-rate mortgaged properties, restricting supply. More generally, stretched affordability metrics suggest that lower prices or rates are needed at some point to restore balance.

Geopolitical risks to macroeconomic outcomes remain elevated, although the impact so far has been contained. Exhibit A has been Europe's better-than-expected adjustment to the loss of Russian gas. Ongoing land wars involving Russia-Ukraine and Israel-Hamas have also dented macro and market outcomes less than thought. However, escalation cannot be ruled out and neither can an associated outsized impact on the economy, either through direct or confidence channels.

The beginning of the end-game 

The start of the policy easing cycle signifies the beginning of the cyclical end game. The inflation shock has been more difficult to unwind than initially thought. The market has seen this as a challenge, but in our view it is just the flipside of resilient spending and strong labor market outcomes. The soft landing scenario and the sticky downward (core) inflation scenario are one and the same. A recession with a sharp drop in employment and labor demand would likely produce a faster decline in inflation, but is that what we really want?

We see the beginning of a gradual cutting cycle as a preview to a structurally higher interest rate world. Our terminal policy rates are higher than pre-pandemic neutral rates across the board. This margin ranges 50-100 basis points. The main drivers are demographics, fiscal positions and investment demands around the energy transition. Higher real and nominal rates will benefit savers (and reduce the potentially risky search for yield) and provide more space to policymakers to deal with the inevitable shocks that lie ahead.

Related Research

• Economic Outlook U.S. Q3 2024: Milder Growth Ahead, June 25, 2024
• Economic Outlook Emerging Markets Q3 2024: Growth On Track, Policy Risks Rising, June 25
• Economic Outlook Asia-Pacific Q3 2024: Exporters And EMs Are Outperforming, June 24, 2024
• Economic Outlook Eurozone Q3 2024: Growth Returns, Rates Fall, June 24, 2024