Macro: central bank inflation campaign reaches last mile

Inflation nudged up again at the start of this year in many economies. This increase, in part, reflects seasonal distortions and methodological issues. But the strength of wage growth and core services inflation, alongside a sharp rise in maritime freight rates, mean many key central banks are not ready to cut interest rates just yet.

However, year-on-year rates of inflation should fall close to target by mid-year in many economies. Although core services inflation is strong, shelter-price growth should soon moderate in the US, while wage growth is coming down gradually and inflation expectations remain well anchored in almost all developed markets (DM).

Bumpy disinflation is broadly continuing across emerging markets (EM) as well, helped by restrictive monetary policy. But there are clear last-mile risks here too, including from the climate impact of El Niño or geopolitical volatility pushing up food prices.

US soft landing

We think the US economy is heading for a ‘soft landing’ – that is, inflation can be brought under control without a recession. The financial strength of households and firms suggests the peak impact of higher interest rates has passed. Meanwhile, progress on getting inflation down means a recession is not ‘necessary’ to cool price pressures.

Nonetheless, many drivers of US exceptionalism – household savings, fiscal support, rising labour participation rates, a rebound in productivity – should fade in 2024. So, we expect the pace of US growth to shift lower this year.

Elsewhere, the UK and Eurozone should slowly emerge from recession-like conditions in 2024, helped by positive real wage growth. But Germany will continue to struggle from cyclical and structural headwinds to its growth model.

Rate cuts coming

We expect major DM central banks to begin interest-rate cuts around the middle of this year. The Federal Reserve (Fed), European Central Bank (ECB) and Bank of England may each make an initial cut in June.

We expect a cumulative 100 basis points (bps), or 1 percentage point, of fed funds rate cuts this year and a further 125 bps in 2025. Our assessment of the trajectory of equilibrium rates puts the eventual end point of cutting cycles at some 2%-3%.

The Bank of Japan (BoJ) will be a notable outlier. Admittedly, the data paint a mixed picture about the sustainability of Japan’s emergence from low inflation. However, a decent Shunto wage round should be enough for the BoJ to exit both negative interest rates and ‘yield curve control’ this year.

Across EMs, cooling inflation and a high starting point for real rates give room for rate cuts. Monetary policy easing is well underway in Latin America, although cuts in Mexico may wait until after the Fed has moved. Meanwhile, Asian central banks didn’t hike as aggressively and growth is holding up better in much of the region, but rates are still likely to be lowered later this year.

Contrasting fortunes for China and India

Chinese policy continues to ease, with recent intervention aimed at shoring up weak equity markets. However, real estate activity and property prices show a continued slide. The desire to hold the line on de-risking means these headwinds may continue to outweigh stimulus measures.

We forecast 2024 gross domestic product (GDP) growth to be below the 5% target. That said, ‘Japanification’ concerns – fear of a decades-long period of economic stagnation – are overdone, with underlying inflation dynamics less concerning than the deflationary headline numbers.

By contrast, although Indian growth will slow from 2023’s heady rate, it should still be a global growth outperformer thanks to favourable structural tailwinds. Reform momentum and avoiding protectionism after Prime Minister Narendra Modi’s almost-certain re-election this year are key to further boosting the economy.

Scenarios...

The US election is a source of significant uncertainty. Former president Donald Trump’s proposed 10% across-the-board tariff, and 60% tariff on China, would hit global trade and sentiment, push upwards on US inflation, and downwards on growth. Potential fiscal easing could support growth, but also put upwards pressure on interest rates.

In terms of other important macro scenarios, the probability of a ‘hard landing’ in the US is still higher than in a typical year, especially as the tailwinds from high savings and strong supply-side growth fade.

Conversely, the recent strength of US activity may also point to a global ‘no landing’ – growth remains well above trend and inflation reaccelerates. In this scenario, policy would have to remain tighter for longer, and the next interest-rate move could be higher. In the near term the market would price this as reflation, but it could cause a more pronounced downturn further in the future.

A more unambiguously upside scenario would be an improvement in global supply, in which trend growth moves higher. This may be driven by sooner-than-expected productivity gains from artificial intelligence (AI), allowing strong growth to continue without an increase in inflation. In this case, monetary policy would still ease this year, but long-term equilibrium interest rates would move up.

Paul Diggle is chief economist at abrdn.

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