If central banks’ urgency to return inflation to their respective targets encapsulated an underlying theme of the global economy in 2023, early 2024 starts with assessing the ramifications of their initial success. It is a fitting time to take stock: after years of collectively fighting a bout of inflation now seen as transitory with the benefit of hindsight, policy paths, economic trajectories, and fiscal roles amongst the world’s largest economies appear set to splinter.
Although the Federal Reserve and the US economy may be leading this divergence, the Fed’s shift was enabled by its clinical progress against inflation, culminating with the December Personal Consumption Expenditures (PCE) report. The Fed’s favoured inflation measure showed the first monthly decline in prices since April 2020, and our preferred view of inflation on a three-month annualised basis decelerated to 2.9%, which is within the prevailing, pre-pandemic range. For those keeping tabs on when core inflation may reach the Fed’s 2% target, if the monthly core PCE readings continue to average 0.2%, the target may be reached before mid-year 2024. And this is before the full effect of slowing rents emerges in the data.
While the Fed pivoted at the December Federal Open Market Committee meeting with its median projection for an additional two 25 basis points (bps) rate cuts in 2024 and 2025, which would bring the Fed funds rate to 4.6% and 3.6% respectively, it maintained a semblance of vigilance against inflation by maintaining its 2026 and long-run rate projections. We continue to expect that the Fed may lift its long-run estimate closer to 3.0%, perhaps at a future Jackson Hole symposium.
As is custom, markets bit down on the Fed’s projected rate cuts, pricing in about 75 bps of policy easing through June 2024 in the immediate aftermath of the healthy December payroll report. Yet, we do not believe the Fed will be as quick to turn its back on inflation, and our expectations largely remain unchanged since mid-2023 as we see three 25 bps rate cuts starting in Q2 2024.
Despite the above, US economic scenarios remain unchanged from 4Q2023 as we continue to see weakflation as our base case (35%), followed by a 25% chance of a recession. Our scenario assumptions include tight monetary, fiscal, and credit conditions that slow cyclical momentum to below trend growth of about 1.6% vs. an estimated 2.1% in 2023.
The Fed’s projected pivot and its respective implications starkly contrast the European Central Bank’s (ECB) approach to preserve its policy optionality going forward, particularly amidst the expected fragility of European growth this year. Although President Lagarde clearly indicated at the latest policy meeting that it was too soon for the governing council to discuss rate cuts — thus projecting the status quo — the ECB’s announced adjustments to its Pandemic Emergency Purchase Programme ran counter to prior statements.
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The prospect for fiscal stimulus is another point of divergence between the US and Europe. In fact, we see it as a wild card in terms of future growth in the euro area. Indeed, the pending introduction of new European fiscal rules appears set to provide some discretion when it comes to rule implementation, and applying a new set of punitive measures would fall to future governments, rather than those that negotiated the framework.
Considering the ECB’s maintained optionality and the region’s sizeable fiscal role, weakflation also remains our base case for the euro area (unchanged at 40%) as we expect GDP growth of 0.5% in 2024. While our recession scenario for the Euro Area (up from 25% in 4Q2023 to 30%) is not our base case, it includes a sharp deterioration in economic activity that would prompt the ECB to cut rates into the 2% area this year.
China and Japan
We anticipate that fiscal developments will also continue to play a role in China this year as authorities aim to steer its economy between short-term goals to stabilise growth amidst persistent deflation and longer-term objectives to deleverage vulnerable sectors, such as real estate. Indeed, China’s November inflation reports showed ongoing deflation at the consumer and producer levels, which is consistent with economic data indicating subdued lending activity to corporations and households.
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Thus, authorities are targeting stimulus at local jurisdictions, and that effort via debt issuance resulted in five consecutive months of increased total social financing in the latter stages of 2023. This development also involved the first use of central bank financing, which may expand through the first half of 2024 as authorities seek to revive inflationary momentum. As this stimulus fades, it could be offset by the long-awaited revival of activity in the real estate sector.
When looking ahead, there are three key points to watch. First, it is evident that authorities’ policy mix is doing more to stimulate the supply side than the demand side, hence the country’s falling prices. Therefore, and second, China’s demand impulse to the global economy will remain marginal (the country is 30% of global manufacturing, which could expand further with additional investment stimulus) and implies headwinds for major exporting regions, such as Europe. That said, the prospects for increased central bank financing at least offers the prospect of easing global goods deflation. Third, from a structural perspective, China’s economic imbalances remain unresolved — e.g., investment as a share of GDP among large economies remains the highest in the world (far too high to be productive or profitable) — thus, deleveraging, demographics, and de-risking will remain a drag on long-term growth.
As a result, we expect China’s growth to continue slowing to about 4.5% this year from an estimated 5.3% in 2023. Therefore, we continue to see a soft landing/moderation scenario as our base case for China with the probability rising from 45% to 55% at the cost of low-growth scenarios. However, beyond this year, we expect growth to moderate further to an approximate ceiling of 3% over the medium term.
As China navigates between its short and long-term challenges, its economic direction will continue to exert significant influence across emerging markets.
This year may also see developments with the Bank of Japan (BoJ) and whether its policy rate finally moves out of negative territory and converges towards those of other major developed market central banks. In our base case, the BoJ will take a patient approach to policy normalisation until it sees the evidence of inflationary dynamics at 2% baked in the data. Therefore, the BoJ may not lift rates out of negative territory until the second half of 2024, but even in that case, it is unlikely to take rates beyond zero.
These outcomes underscore the newly divergent paths that central banks and economies will find themselves on in 2024. As countries embark on this new phase of the paradigm, they are subject to the previously referenced effects of the shifting, structural anchors under the global economy. Thus, as much as conditions may change in 2024, the role of these secular factors in influencing the long-term performance of the global economy cannot be overlooked.
Daleep Singh is chief global economist, head of global macroeconomic research, PGIM Fixed Income
