As One Cycle Ends, Another Begins Amid Growing Divergence

This article is published in association with IMF.

Pierre-Olivier Gourinchas

We project global growth will remain steady at 3.3 percent this year and next, broadly aligned with potential growth that has substantially weakened since before the pandemic. Inflation is declining, to 4.2 percent this year and 3.5 percent next year, in a return to central bank targets that will allow further normalization of monetary policy. This will help draw to a close the global disruptions of recent years, including the pandemic and Russia’s invasion of Ukraine, which precipitated the largest inflation surge in four decades.

Though the global growth outlook is broadly unchanged from October, divergences across countries are widening. Among advanced economies, the United States is stronger than previously projected on continued strength in domestic demand. We have raised our growth projection for the US this year by 0.5 percentage point, to 2.7 percent.

Growth in the euro area, by contrast, is likely to increase only modestly, to 1 percent from 0.8 percent in 2024. Headwinds include weak momentum, especially in manufacturing, low consumer confidence, and the persistence of a negative energy price shock. European gas prices remain about five times as high as in the United States, versus twice as high before the pandemic.

In emerging market economies, growth projections are broadly unchanged, at 4.2 percent and 4.3 percent this year and next. Elevated trade and policy uncertainty is contributing to anemic demand in many countries, but economic activity is likely to pick up as this uncertainty recedes. This includes China, where we now project 4.5 percent growth next year, up 0.4 percentage point from our prior forecast.

Some divergence between large economies has been cyclical, with the US economy operating above its potential while Europe and China are below. Under current policies, this cyclical divergence will dissipate. But the divergence between the US and Europe is more due to structural factors, and the disconnect will linger if these are left unaddressed. It reflects persistently stronger US productivity growth, particularly but not exclusively in the technology sector, linked to a more favorable business environment and deeper capital markets. Over time, this translates into higher returns on US investment, increased inbound capital flows, a stronger dollar and US living standards pulling away from those of other advanced economies. For China, it is notable that potential growth is now more like that of other emerging market economies.

Economic policy uncertainty is elevated, with many governments newly elected in 2024. Our projections incorporate recent market developments and the impact of heightened trade policy uncertainty, assumed to be temporary, but refrain from making assumptions about potential policy changes that are currently under public debate.

In the near term, a constellation of risks could further exacerbate these divergences. European economies could slow more than anticipated, especially if investors grow more concerned about public debt sustainability in more vulnerable countries. The main risk is that euro area monetary and fiscal policy could simultaneously run out of room if weaker economic activity pushes interest rates back toward the effective lower bound just as insufficient fiscal consolidation raises risk premia, in turn further constraining fiscal policy. In China, should fiscal and monetary measures prove insufficient to address domestic weakness, the economy is at risk of a debt-deflation stagnation trap, where falling prices raise the real value of debt, undermining activity further. The sharp decline in Chinese government bond yields, seen as haven for local investors, shows rising investor concern. Both in China and Europe, these factors could lower inflation and economic growth.

By contrast, while many of the policy shifts under the incoming US administration are hard to quantify precisely, they are likely to push inflation higher in the near term relative to our baseline. Some indicated policies, such as looser fiscal policy or deregulation efforts, would stimulate aggregate demand and increase inflation in the near term, as spending and investment increase immediately. Other policies, such as higher tariffs or immigration curbs, will play out like negative supply shocks, reducing output and adding to price pressures.

A combination of surging demand and shrinking supply would likely reignite US price pressures, though the effect on economic output in the near term would be ambiguous. Higher inflation would prevent the Federal Reserve from cutting interest rates and could even require rate hikes that would in turn strengthen the dollar and widen US external deficits. The combination of tighter US monetary policy and a stronger dollar would tighten financial conditions, especially for emerging markets and developing economies. Investors already anticipate such an outcome, with the US dollar gaining around 4 percent since the November election.

Overall, these near-term risks could lead to further divergence across economies. In the medium term, about five years, the positive effects of the US fiscal shock may dissipate and could even reverse if fiscal vulnerabilities increase. Deregulation efforts can boost potential growth in the medium term if they remove red tape and stimulate innovation. However, there is a risk that excessive deregulation could also weaken financial safeguards and increase financial vulnerabilities, putting the US economy on a dangerous boom-bust path. Medium-term risks to economic output would be heightened by restrictive trade policies and stricter migration limits.

Renewed inflation pressures, should they arise so soon after the recent surge, could well de-anchor inflation expectations this time around, as people and businesses are now much more vigilant about protecting their real income and profitability. Inflation expectations are further away from central bank targets than in 2017–21, which suggests increased risks of higher inflation. In this environment, monetary policy may need to be more agile and proactive to prevent expectations from de-anchoring, while macro-financial policies will need to remain vigilant to avoid a buildup of financial risks.

The issue is likely to be exacerbated for emerging market economies, given the passthrough of dollar exchange rates to domestic prices and the effects of weaker domestic growth in China. In most cases, the appropriate policy response in emerging market economies will be to let currencies depreciate as needed while adjusting monetary policy to achieve price stability. However, in cases where inflation dynamics have become clearly unanchored or where there are financial stability risks, capital flow management and foreign exchange interventions could help, as long as these are not a substitute for necessary macroeconomic adjustments, in line with the IMF’s Integrated Policy Framework.

For several countries, fiscal policy efforts have been delayed or insufficient to stabilize debt dynamics. It is now urgent to restore fiscal sustainability before it is too late and to build sufficient buffers to address future shocks that could be sizable and recurrent. Additional delays could trigger a worrying spiral where borrowing costs keep rising as markets lose confidence, further increasing adjustment needs. Recent strains in Brazil’s financial markets, like the reaction to the UK’s September 2022 mini-budget, underscore how funding conditions can deteriorate suddenly.

While any sizable fiscal consolidation is bound to weigh on economic activity, countries should take special care to preserve growth as much as possible along the consolidation path, for instance by focusing the adjustment on reducing untargeted transfers or subsidies rather than government investment spending. To achieve this—and help overcome persistent structural differences driving growth divergences—there should be renewed focus on ambitious structural reforms to directly boost growth. These include targeted reforms to better allocate resources, increase government revenues, attract more capital, and foster innovation and competition.

Finally, additional efforts should be made to strengthen and improve our multilateral institutions to help unlock a richer, more resilient, and sustainable global economy. Unilateral policies that distort competition—such as tariffs, nontariff barriers, or subsidies—rarely improve domestic prospects durably. They are unlikely to ameliorate external imbalances and may instead hurt trading partners, spur retaliation, and leave every country worse off.