All eyes on central banks

Broadening global growth, resurgent inflation define outlook

Six months ago, the consensus outlook for the global economy in late 2024 featured steadily falling inflation amid a slide toward recession that would trigger aggressive central bank rate cuts. The best outcome would be a “soft landing” slowdown that dodged a recession thanks to central bank action. Investor hopes for this scenario led to simultaneous rallies in equities, high‑quality government bonds, and bonds with credit risk.

What a difference a few months make: Consensus now expects continued expansion, resurgent inflation pressures, and limited easing from central banks. We’re not quite as sanguine on growth as this “no landing” scenario, but it looks like recession is off the table for at least the next six months.

Broadening of global growth

The consensus also still involves U.S. exceptionalism, with U.S. expansion easily outpacing anemic growth in other developed markets. But U.S. first‑quarter growth disappointed. With leading indicators in the eurozone moving smartly higher, we could easily see an overall broadening of global growth, undercutting the U.S. exceptionalism narrative.

“...recession is off the table for at least the next six months.”
Nikolaj Schmidt, Chief Global Economist

The European Central Bank at its June meeting became the first major developed market central bank to cut interest rates. The Bank of England (BoE) looks poised to be the next to ease ahead of the UK general election on July 4, followed by the Federal Reserve. Because of the weaker starting point for the eurozone economy, we think the ECB will cut the most in 2024, with sticky inflation keeping the Fed to only one or possibly two rate reductions of 25 basis points each.

Which way for monetary policy in 2025?

The overarching question is: Where will this bring monetary policy in 2025? Even modest rate cuts this year could easily lead to reaccelerating growth—and inflation that would force the Fed to raise rates next year, with other major central banks following close behind. This could mean that central banks will be tightening policy as the labor market weakens going into the next recession.

In this unusual scenario, we would expect more divergence in returns as investors sort through the implications for sectors and individual securities. Active portfolio management, with a focus on fundamental analysis and relative value, would be vital in this environment.

Murky environment to challenge Fed policymakers

Investors have steadily ratcheted back their expectations for Federal Reserve rate cuts in 2024. In most previous economic cycles, the Fed has been the first to ease, but the ECB was the first mover this time. We still see a slight possibility of a Fed cut this summer followed by the central bank cutting 25 basis points at its December policy meeting, after the November elections are out of the way.

Fed policymakers seem eager to implement an “insurance cut” or two in 2024 to preempt a slowdown—assuming that inflation moderates. The Fed believes that monetary policy is tight, so it would only take modest softening in the labor market to convince the central bank to cut.

The Fed wants to avoid any sign that it is influenced or motivated by politics, so will not act at the September or November Federal Open Market Committee (FOMC) meetings. In fact, a July rate reduction might be earlier than the Fed would act if it were not an election year.

Elevated potential for Fed surprises

The potential for surprises from the Fed is much greater than in a typical late‑business‑cycle environment. There’s an increasing chance that a lack of progress on getting annual core inflation to 2% will prompt the Fed to keep rates steady for an extended period. Stepping back for a broader view, we are more likely to see the Fed surprise with fewer cuts than with more. Preempting the question on whether it is possible that resurgent inflation could prompt the Fed to raise rates later this year, we place less than 20% odds on that outcome.

The outlook for Fed easing in 2025 is even murkier. Two to three cuts in 2025 are priced in now, which appears too dovish. One or two rate reductions next year seems more realistic. And there is a risk that “insurance cuts” by the Fed could allow inflation to fester and raise the chances of the Fed moving back to a hiking bias in 2025.

Key takeaway

The Fed is more likely to surprise with fewer cuts than with more.

ECB and BoE to cut as BoJ remains an outlier

For all developed market central banks (excluding the Bank of Japan (BoJ), which is an outlier), monetary policy is quite tight. They will want to avoid tipping their economies into recession. Consequently, these central banks can cut while preserving a tight monetary policy stance. In fact, they will probably ease proactively if inflation allows—if they wait until economic activity craters before cutting, they will be far behind the curve because it will be a long way back to neutral.¹

Fears of labor market cracks lead ECB to act

Eurozone inflation has fallen to the extent that the ECB was able to cut rates in June. ECB policymakers think that eurozone employers have been hoarding labor over the past 12 months. This makes the region’s economy susceptible to an abrupt labor market downturn if corporate profit margins come under pressure amid softer final demand.

“The BoE may not feel it needs to rush in cutting rates....”
Ken Orchard, Head of International Fixed Income

The big questions are: When will the ECB ease after June, and how large will the cuts be? The number of expected cuts has been steadily dropping, but we believe the ECB will likely cut twice before the end of 2024—however, it could be as few as once or as many as three times.

BoE likely to follow in the third quarter

There have been hopes that the BoE would follow fast on the heels of the ECB by cutting rates later in June, but we believe it may be a little later than that. With tentative signs that the UK economy is recovering, the BoE may not feel it needs to rush in cutting rates and is likely to wait until the autumn before doing so.

Gradual tightening from the BoJ

Japan has also struggled with inflation—but the lack of it rather than prices rising too quickly. After finally moving away from its subzero rates policy earlier in 2024, we expect the BoJ to continue gradually tightening while sounding dovish enough that the market doesn’t undo its work in boosting inflation. By tightening policy, the BoJ would also support the yen, which has plumbed multi‑decade lows against other major currencies in 2024.

Reaccelerating inflation to make central banks walk tightrope

Inflation is notoriously difficult to predict, and it has continued to baffle most forecasters since the onset of the pandemic in 2020. However, it’s becoming clear that inflation isn’t going away, and we see a meaningful risk that it will reaccelerate as U.S. exceptionalism moderates and global growth broadens.

Several factors drive risk of reaccelerating inflation

The big decrease in global inflation from 2022 to 2023 was due to goods disinflation, which is the easy part of taming inflation. Now services inflation, which is sticky, needs to fall. But for this to happen, the labor market must have space to adjust—wage pressures drive services inflation, and higher unemployment is required to control wage pressures. Artificial intelligence (AI) is one countervailing force that could help tame services sector wage growth, but AI will take time (and expense) to implement, making it a longer‑term factor.

Fiscal spending in an election year will also put upward pressure on inflation, and energy prices—which have been a headline inflation tailwind since surging in 2022 following Russia’s invasion of Ukraine—are a wild card that could easily spike again if conflict in the Middle East escalates or other geopolitical hot spots erupt.

These factors would, of course, make central banks’ difficult balancing act between supporting growth and restraining inflation that much harder.

Because we see renewed upward pressure on inflation, investors may benefit from exposure to real assets such as commodities—including gold and silver—and real estate or to inflation protected government bonds. Real assets tend to hold up well in inflationary environments, while inflation‑protected government debt has principal and interest payments that adjust based on inflation data.

Key takeaway

The big decrease in global inflation from 2022 to 2023 was due to goods disinflation, which is the easy part of taming inflation. Now services inflation, which is sticky, needs to fall.