As One Cycle Ends, Another Begins Amid Growing Divergence

IMF Blog, January 17, 2025

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As One Cycle Ends, Another Begins Amid Growing Divergence

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• Authors: Pierre-Olivier Gourinchas
• Published: January 17, 2025

Global outlook and headline projections

• Global growth: 3.3 percent this year and 3.3 percent next year.
• Inflation: 4.2 percent this year and 3.5 percent next year.
• Context: Inflation is declining toward central bank targets, enabling further normalization of monetary policy and helping draw to a close recent global disruptions including the pandemic and Russia’s invasion of Ukraine, which precipitated the largest inflation surge in four decades.

Major country and regional divergences

• United States
  • Growth projection raised by 0.5 percentage point, to 2.7 percent this year.
  • Economy operating above its potential; stronger productivity growth, particularly in the technology sector, linked to a more favorable business environment and deeper capital markets.
  • Policy shifts under the incoming administration could push inflation higher in the near term (see Risks and Scenarios).
  • US dollar: gained around 4 percent since the November election.
• Euro area
  • Growth likely to increase to 1 percent from 0.8 percent in 2024.
  • Headwinds: weak momentum (especially in manufacturing), low consumer confidence, and 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.
  • Risk of monetary and fiscal policy simultaneously running out of room if weaker activity pushes interest rates back toward the effective lower bound while insufficient fiscal consolidation raises risk premia.
• Emerging market economies
  • Growth projections broadly unchanged: 4.2 percent this year and 4.3 percent next year.
  • Elevated trade and policy uncertainty contributing to anemic demand in many countries, but activity likely to pick up as uncertainty recedes.
  • China: projected 4.5 percent growth next year, up 0.4 percentage point from the prior forecast; potential growth now more like that of other emerging market economies.
  • Risk in China of a debt-deflation stagnation trap if fiscal and monetary measures prove insufficient; the sharp decline in Chinese government bond yields signals rising investor concern.

Risks, scenarios, and transmission channels

• Near-term constellation of risks that could exacerbate divergences:
  • European slowdown amplified by debt sustainability concerns and simultaneous fiscal and monetary constraints.
  • China: risk of debt-deflation stagnation if policy response is insufficient.
  • United States: near-term policy shifts (looser fiscal policy, deregulation) could stimulate demand and increase inflation; other policies (higher tariffs, immigration curbs) could act as negative supply shocks, reducing output and adding to price pressures.
• Potential macro-financial transmission:
  • A combination of surging demand and shrinking supply in the US would likely reignite price pressures, possibly preventing Federal Reserve rate cuts and even requiring rate hikes, strengthening the dollar and widening US external deficits.
  • Tighter US monetary policy and a stronger dollar would tighten global financial conditions, especially for emerging markets and developing economies.
• Medium-term (about five years) dynamics:
  • Positive effects of a US fiscal shock may dissipate and could reverse if fiscal vulnerabilities increase.
  • Deregulation can boost potential growth if it removes red tape and stimulates innovation, but excessive deregulation could weaken financial safeguards and increase financial vulnerabilities, creating boom-bust risks.
  • Restrictive trade policies and stricter migration limits would heighten medium-term risks to economic output.
• Inflation expectations and monetary-policy implications:
  • Renewed inflation pressures soon after the recent surge could de-anchor inflation expectations; inflation expectations are further away from central bank targets than in 2017–21.
  • Monetary policy may need to be more agile and proactive to prevent expectations from de-anchoring; macro-financial policies must remain vigilant to avoid a buildup of financial risks.
• Emerging market policy trade-offs:
  • Appropriate response typically to let currencies depreciate as needed while adjusting monetary policy to achieve price stability.
  • Where inflation dynamics are unanchored or financial stability risks exist, capital flow management and foreign exchange interventions could help, provided they are not substitutes for necessary macroeconomic adjustments and are consistent with the IMF’s Integrated Policy Framework.

Fiscal policy, debt sustainability, and structural reform priorities

• Urgency of restoring fiscal sustainability:
  • For several countries, fiscal policy efforts have been delayed or insufficient to stabilize debt dynamics.
  • It is urgent to restore fiscal sustainability and build sufficient buffers to address future shocks; additional delays could trigger a spiral of rising borrowing costs and larger adjustment needs.
  • Example: recent strains in Brazil’s financial markets illustrate how funding conditions can deteriorate suddenly, analogous to the reaction to the UK’s September 2022 mini-budget.
• Design of consolidation to preserve growth:
  • Fiscal consolidation should preserve growth where possible by focusing adjustment on reducing untargeted transfers or subsidies rather than government investment spending.
• Structural reforms to address persistent divergences:
  • Renewed focus needed on ambitious structural reforms to better allocate resources, increase government revenues, attract more capital, and foster innovation and competition.
  • These reforms aim to overcome structural differences driving growth divergences and to boost potential growth.

Multilateral cooperation and policy recommendations

• Strengthen and improve multilateral institutions to unlock a richer, more resilient, and sustainable global economy.
• Warning against unilateral distortions of competition:
  • Unilateral policies that distort competition—such as tariffs, nontariff barriers, or subsidies—rarely improve domestic prospects durably, are unlikely to ameliorate external imbalances, may hurt trading partners, spur retaliation, and leave every country worse off.

Source: Pierre-Olivier Gourinchas, January 17, 2025.