Macro developments in the biggest three economies remain on different paths (see chart 1). The U.S. continues to outperform with growth above potential despite relatively high policy and market rates. The eurozone economy responded in more typical fashion to higher rates, with a manufacturing recession (centered in Germany); a slow recovery has begun.

Chinese growth continues to struggle, reflecting property market woes. These are holding down confidence and spending, putting the 2024 growth target of 5% in danger. Elsewhere, large domestic economies are doing well, and global trade outside of the booming tech sector is subdued.

Chart 1

The performance of services and manufacturing sectors continues to diverge. This has occurred in most economies despite diverse macro developments. Services spending has been powering economies in recent years as the more interest-rate sensitive manufacturing spending has slowed. While services spending has been driving recent growth, it has not returned to pre-pandemic trends outside of the U.S. Goods spending, which surged early in 2020 as economies closed down, continues above pre-pandemic trends.

Labor markets remain strong. Unemployment rates hover near multi-decade lows despite recently rising somewhat in some countries, most notably the U.S. The softening of the U.S. labor market over the past few months represents a return to pre-pandemic trend.

As we have argued in previous reports, continued robust labor demand is central to our baseline soft-landing scenario. Labor market strength remains concentrated in the service sectors, where demand for labor is relatively inelastic and spending remains strong. High asset prices have helped spending, in particular by raising marginal propensities to consume out-of-housing wealth.

Inflation continues to move gradually toward central bank targets (see chart 2). While headline and core measures measured on a 12-month basis remain above target, sequential measures of inflation look more positive. These sequential measure capture the last three months of data, and are seasonally adjusted and annualized.

Most sequential inflation measures lie below the 12-month rates. Many of these are at, or below, the 2% target set by most central banks. With this development, which took longer to materialize than we expected, central banks are now able to begin unwinding the tightening of 2022 and 2023, when rates rose at the fastest pace in four decades.

Chart 2

Policy rate cuts are now in full swing among the major advanced country central banks (see chart 3). The main event over the past quarter was the U.S. Federal Reserve's surprise 50 basis point cut in mid-September. The Fed is increasingly confident of reaching its 2% inflation target, and has shifted its focus toward its full employment mandate. Elsewhere, the European Central Bank (ECB) lowered its policy rates by 25 basis points in September as expected, following its initial rate cut this cycle in June.

The Bank of Canada has been the most aggressive of the group, cutting three times since mid-year as growth and inflation pressures fall at a relatively fast pace. In contrast, the Bank of England has cut rates just once and held in September as growth and inflation pressures remain elevated.

The Reserve Bank of Australia (RBA) is the outlier. We expect the RBA to be the last major central bank to start its easing cycle, beginning in early 2025. Japan--not shown--is on a different path than other central banks as it seeks to reflate its economy and gradually raise policy rates. Most central banks remain in "data dependent" mode.

Chart 3

Financial market conditions have generally eased over the past quarter. Investors' anticipation of policy-rate cuts shows in bond yields, while continued well-behaved labor markets and the low probability of recessions are reflected in bond spreads. Prices of both financial (equities) and nonfinancial (particularly housing) assets remain elevated. This reflects strong fundamentals, and general expectations for a soft landing, rising real incomes, and easing inflation.

Slower But Still Steady Growth Ahead

Our revised forecasts show modestly slower growth through 2027 (see table 1). We now see global growth at 3.2% this year, dipping to 3.1% next year before rising to 3.3% in 2026 and 2027.

The slowdown stems mainly from Asia-Pacific and emerging markets. In 2024, both GDP growth forecasts for Japan and Mexico were lowered by over half of a percentage point. In 2025, the reduction in China's growth forecasts is the main factor behind our estimate of slower global growth.

The U.K., Spain and Brazil led the upside growth revisions for 2024. The other country providing modest upward pressure on global growth was the U.S., where we raised our forecast for 2024-2026, on higher productivity growth.

Table 1

Our regional narratives and reports are as follows:

United States: Shifting To Neutral

We continue to expect GDP growth to slow from above-trend rates this year, to below-trend in 2025. This will be accompanied by a further rise in the unemployment rate and lower inflation.

The Fed looks set to embark on a steady series of interest-rate cuts--we have penciled in policy rates to reach the terminal rate of 3.00%-3.25% by the end of 2025, with risks in both directions. We view the easing as a preventative measure keeping growth from slipping too far below potential, rather than spurring the real economy.

We keep our probability of a recession starting over the next 12 months unchanged at 25%. With consumption still healthy, for now, near-term recession fears appear overblown.

For details, see "Growth And Rates Start Shifting To Neutral," published on RatingsDirect on Sept. 24, 2024.

Eurozone: Consumer Spending To The Rescue

The eurozone economy is slowly rebounding. We forecast GDP growth of 0.8% this year and 1.3% the next, largely in line with our previous forecasts. However, we now expect stronger growth for Spain and France, and weaker growth for Germany. Consumer spending--and, from next year, investment--should become the main drivers of growth as real income accelerates, consumer perceptions of disinflation improve, and interest rates fall.

Inflation, at 2.2% in August, could edge up toward the end of the year. It is not likely to fall to 2.0% before the second half of 2025 as unit labor costs continue to rise quickly. We continue to see the ECB cutting rates by 25 basis points per quarter until the deposit rate reaches 2.5% in the third quarter of 2025. This means that monetary policy will not be neutral before late 2025.

Several factors cloud our outlook. Labor costs are still rising quickly, especially in industry, making a more pronounced downturn in the labor market possible. Fiscal policy could be more restrictive next year, while foreign trade could be less supportive of growth. Geopolitical factors could erode confidence as well.

For details, see "Consumer Spending To The Rescue," published on RatingsDirect on Sept. 24, 2024.

Asia-Pacific: China Property Still A Drag, Central Banks Remain Wary

For China, we have reduced our 2024 GDP growth forecast to 4.6% from 4.8%. This reflects the country's sluggish property sector, weak domestic demand, and reluctance among policymakers to ease fiscal policy. This leaves the economy vulnerable to downward pressure on prices and profit margins. We project 4.3% growth in 2025.

Growth elsewhere in Asia-Pacific is largely tracking our expectations. We continue to see mostly solid expansion, particularly in the emerging markets. We anticipate 4.4% GDP growth in Asia-Pacific, this year and next, slightly down on three months ago. Central banks will only gradually reduce policy rates, in our view. Interest rates are low compared with the U.S., and currencies cheap. In certain economies, rising house prices and household debt contribute to a cautious approach to rate cuts.

For details, see "Central Banks To Remain Cautious Despite U.S. Rate Relief," published on RatingsDirect on Sept. 24, 2024.

Emerging Markets: While Lower Interest Rates Help, Risks Are Rising

Our macroeconomic baseline for emerging markets is unchanged for most economies since the previous quarter. Monetary policy normalization by the U.S. Federal Reserve, as long as it is accompanied by an orderly slowing of the U.S. economy, is positive for emerging markets. This is particularly true for those economies with strong economic fundamentals, such as in Southeast Asia.

In several major emerging markets, particularly in Latin America, a high degree of policy uncertainty could keep risk premia elevated. This, in turn, could reduce the magnitude of capital flows those economies receive relative to past Fed easing cycles.

In several cases downside policy-related risks have risen. The implications of the U.S. election on trade and fiscal policy, a more rapid-than-expected slowdown in the U.S., ongoing economic weakness in China, a further escalation of the Middle East conflict, and persistent uncertainty over domestic policies in several emerging markets, are key downside risks for our outlook.

For details, see "Lower Interest Rates Help As Pockets Of Risk Rise," published on RatingsDirect on Sept. 24, 2024.

Risks To Our Baseline

Macro factors, markets and geopolitics tilt the risks to our baseline to the downside.

The top risk to our baseline is a sharp weakening of services spending and labor demand. Resilience has been the mantra of our forecasts in recent quarters. Despite fast policy and market interest rate increases, labor demand has remained reasonably strong. Should services spending and labor demand fall off sharply, we are likely to move into a hard landing/recession scenario.

Here, output would drop more quickly than in our baseline (we could not rule out a technical recession) and central banks would likely cut rates aggressively. In this scenario, policy rates would likely undershoot our terminal rate assumption and unemployment would likely overshoot its equilibrium rate. Both would ultimately return to their long-run values.

A bond market selloff and an associated spike in yields and volatility is also a risk to our baseline. Bond yields and spreads have been well behaved--and declining--throughout most of the post-pandemic period despite market concerns about rising debt, particularly for U.S. Treasuries (see chart 4).

A bond market sell-off, triggered by perhaps by an external event or a return of the so-called "bond market vigilantes" would not only cause yields to spike, but would also raise volatility and blow out spreads. This financial market turbulence could spill over to the real economy and hit spending, employment and growth.

Chart 4

Geopolitical events continue to pose a downside risk to our baseline. The macro impact of two land wars and a reconfiguration of some shipping flows and energy supply chains has been lower than we expected, at least so far.

This favorable outcome is not guaranteed to persist. An escalation of a current conflict or the appearance of a new one runs the risk of shattering consumer confidence and spending, and generating a sell-off and flight to quality in financial markets.

Again, the result is likely to be a sharp drop in activity and labor demand, generating an aggressive policy response, including sharp rate cuts. We also need to get through the rest of the election cycle in a very busy year, including in the U.S.

We Haven't Landed Yet: The Search For Neutral

With the policy rate cutting cycle underway, the question becomes how fast and for how long. In our soft landing baseline reductions in policy rates are gradual, but the issue of the terminal rates remains a point of uncertainty.

Given the fixed nature of inflation targets, the ultimate determinant of this neutral rate is the equilibrium real interest rate: the most well-known unobservable variable r*. The neutral rate has almost surely risen over the past half decade: the key unknown now is by how much.

Economies were whipsawed during the pandemic. First, supply was disrupted as workers stayed home, spending patterns shifted to durables and businesses were shuttered to combat the spread of the virus. This led to goods shortages and an initial spike in inflation. Governments responded by stimulating their economies, and pent-up demand (mostly for services) came through as life returned to normal. This resulted in a surge in inflation not seen in four decades.

Central banks responded, belatedly, as it became clear that inflation was more persistent than many thought. Policy rates were raised at the fastest pace in decades and to levels not seen in decades. The surprise over the past year has been the resilience of the demand for services amid these higher rates. With inflation moving close to target, most central banks have now started to lower policy rates.

Where will rates settle at the end of this cycle? The best guess is that r* has risen from close to zero to between one-half and one percent in recent years on the back of higher investment demand and higher debt. This would put the terminal rate at 2.5%-3% for a central bank targeting 2% inflation.

Starting from their current restrictive stance policymakers will be trying to discover their neutral rates in the coming year or two. This is akin to crossing the river by feeling the stones.

The process will be made easier to the extent that the macro economy and labor market remain well behaved. It will be complicated to the extent that policy operates with long and variable lags. Either way, getting the terminal rates correct will be essential.

Related Research

• Growth And Rates Start Shifting To Neutral, Sept. 24, 2024
• Lower Interest Rates Help As Pockets Of Risk Rise, Sept. 24, 2024
• Consumer Spending To The Rescue, Sept. 24, 2024
• Central Banks To Remain Cautious Despite U.S. Rate Relief, Sept. 24, 2024