Horizon 2024: Growth and inflation forecasts for major economies

We have long held the view that the coming decade(s) will be characterised by a new regime of structurally higher and more volatile inflation. Several of the underlying secular drivers of this regime shift were already in place before the pandemic, but their effects have been turbocharged since then by a succession of supply-side shocks and the policy reactions to these shocks, especially in the US. These secular drivers include deglobalisation, demographics, decarbonisation and the dominance of fiscal over monetary policy.

This year, we are taking a closer look at the impact of artificial intelligence on productivity, the so-called neutral interest rate and, ultimately, our estimates for long-term growth. In a nutshell, while we expect Artificial intelligence (AI) to boost potential growth and, eventually, the neutral rate (chart 1), the diffusion process could be bumpy, creating fresh economic, financial and political risks that will need to be addressed. The ‘new normal’ for growth and inflation resulting from the spread of AI should be consistent with a new monetary policy regime that moves away from the zero lower bound and closer to the interest rates that prevailed before the global financial crisis.

In the US, real GDP growth of 2.5% in 2023 smashed expectations. We expect growth to average 2.1% over the 10 years to come, a rate above the Federal Reserve’s estimates of the US ’s long-term potential. Downward pressure on labour force growth due to an ageing population should be partially offset by the recent surge in immigration. After improving meaningfully in the past year, productivity growth is expected to return to trend, with the benefits of remote working and AI possibly counterbalanced by the ageing of workforces and climate change.

Having slowed markedly in 2023, we expect US inflation to fall further in 2024. However, disinflation since 2023 has been largely driven by a one-off normalisation of supply chains and we expect inflation to remain structurally higher – at an annual average of around 2.5% in the next decade, up from the pre-pandemic average of 1.8%. Reconfiguration of supply chains, fractious geopolitics and labour shortages due to ageing populations are likely to result in more supply shocks and higher wage growth, with consumer inflation unlikely to move below 2% on a sustained basis.

We expect the Fed funds rate to start declining in late 2024 and converge toward 3% over the next decade, above the Federal Open Market Committee’s current estimate of the nominal neutral rate and significantly above the 1.6% average in the past decade. Barring a deep recession, we are unlikely to return to the pre-pandemic environment of low interest rates and low interest-rate volatility.

Chart 1
Estimates of US neutral rate of interest

We also expect the Fed to continue to run down its balance sheet through quantitative tightening, albeit at a slower pace going forward. There is great uncertainty regarding the appropriate level of ‘ample reserves’ (the Fed’s preferred regime to avoid any pressures in the funding markets), but we expect the balance sheet to shrink to around 25% of GDP by the end of 2024, down from a peak of 37% in 2021 but still much higher than the 2019 (pre-pandemic) level of 19%.

The outcome of the 2024 US presidential election is likely to influence the macro outlook over the next few years as Republicans and Democrats have different trade, immigration and foreign policies. Although each of the two main candidates would, if elected, probably pursue hawkish policies towards China, Donald Trump would resort more to tariffs while Joe Biden has expressed his preference for further investment and technology restrictions. Trump’s foreign and immigration policies are likely to be sharply different from Biden’s, with a chance that Trump’s approach to these issues have profound implications for inflation. Either way, the fiscal space will only worsen (chart 2) due to high and rising debt, and rising interest payments, with hardly enough political will from either party for material fiscal consolidation.

Chart 2
Meagre fiscal space
Governments’ general balance (% of GDP)

Across the Atlantic, Europe is still trying to move beyond its postpandemic priorities, with Germany in particular finding it hard to adapt its business model to a new economic and geopolitical reality. In addition to its exposure to the war in Ukraine and higher energy costs, we believe that the main reason for Europe’s chronic economic underperformance versus the US in recent years has been a less supportive fiscal stance. Partial and suboptimal reform of European fiscal rules leaves little hope for a quantum leap anytime soon. The European Parliament elections in June 2024 are likely to slow the pace of reforms further as populist parties are set to gain ground. If any progress is made, it may be in the form of increased defence spending in reaction to a more fragmented world and the challenges facing international institutions such as NATO.

While there are reasons to believe that concerns about Europe’s poor productivity gains are exaggerated1, European companies have lagged their US peers in terms of competitiveness and the adoption of new technologies. On the positive side, Next Generation EU funds will continue to support growth in the coming years, to the benefit especially of companies associated with the green transition and digital transformation.

We forecast euro area GDP growth to converge towards 1.5% per annum over the next decade, slightly above pre-pandemic estimates of potential, although Germany and most core countries could continue to underperform the periphery for some time. The resilience of the euro area labour market remains one of the most encouraging developments since the pandemic, suggesting that past reforms have helped reduce structural unemployment, or the non-accelerating inflation rate of unemployment (NAIRU).

Chart 3
Core inflation off peak but not back to pre-pandemic levels

Euro area inflation eased closer to the European Central Bank’s (ECB) 2% target in the early months of 2024, down from the peak it reached at the height of the energy crisis in 2022 (chart 3). While most of the decline in inflation has been driven by the normalisation of supply chains and the easing of core goods inflation from a peak of nearly 7% to below 2% at the start of 2024, demand factors have probably played a role as well. Indeed, a crucial difference with the US has been the faster and more powerful transmission of interest rate hikes to the euro area economy. The ECB raised its bank deposit rate from -0.5% to 4% in just 14 months between July 2022 and September 2023, helping slow the credit cycle and economic growth at large. With wage growth showing early signs of moderation and leading indicators consistent with a further normalisation of underlying inflationary pressures, the ECB should be confident enough to start cutting rates this year. We expect the ECB to cut its deposit rate from 4% to 2% by 2026. This would still leave the deposit rate well above its post-financial crisis average as we expect inflation to hover around the ECB’s 2% target rather than below it. In an environment of structurally higher interest rates, the large public and private debt overhang in Europe should remain a source of concern for the central bank, but we continue to believe that more integrated European institutions have made financial markets less vulnerable to systemic crisis and sudden stops than before the 2010-12 sovereign crisis.

In China, the slump in the property sector has hurt economic growth and become a strong disinflationary force. Despite post-covid reopening and various government support measures, the sector has yet to stabilise. The decline in China’s population growth and the slowdown in the pace of urbanisation suggest that demand for urban housing has probably peaked and may trend downward in the coming decade. Housing-related activities (construction and services) will likely stop being the main growth driver they have been for most of the past two decades and even turn into a drag on China’s economy.

China’s growth potential may also be damaged by the sharp deterioration in the geopolitical environment. Having identified the country as a strategic competitor, the US is taking an increasingly aggressive stance towards China through more stringent technology restrictions. These restrictions will probably have a negative impact on China’s productivity growth going forward. Having already revised down China’s long-term growth potential in the 2023 edition of Horizon, we have decided to lower it further this year, mainly due to our concern that the property slump could have a long-lasting impact.

After more than a decade of relentless policy easing, mainly on the monetary front, the authorities in Japan are finally closing in on their long-held objective of inflation at a sustained rate of 2%, partially thanks to the pandemic. We believe it is likely that the Bank of Japan (BoJ) will gradually head toward policy normalisation in the coming years, raising its main policy rate from the negative level it has been at for years to +0.5%, although the process could be long and bumpy. With the wage-inflation feedback mechanism still nascent and fragile, the BoJ will have to be very careful about how it guides interest rates in the coming years. Our long-term projections for Japanese growth and inflation remain largely unchanged this year. We expect Japan’s real GDP growth to return to an average of about 0.9% per annum over the next 10 years as the post-covid rebound fades. Growth will mainly come from productivity gains.

Chart 4
Our average annual growth and inflation forecasts for the next 10 years

India, the second-largest emerging economy in Asia, looks set to maintain the strong growth momentum that it has enjoyed in recent years (chart 4). Narendra Modi is likely to secure a third term as the Indian prime minister in the 2024 general election, pointing to policy continuity. Some policy initiatives such as increased spending on infrastructure and measures to encourage large-scale manufacturing (like the Production-Linked Incentive scheme) have started to have some impact on the economy. The rising geopolitical tensions between the US and China have also led many multinationals to take India more seriously as an alternative destination for production outsourcing. These tailwinds mean we continue to believe that India’s long-term growth potential is the highest in the region.