CAMBRIDGE – Recall the start of 2023. Forecasters had overwhelmingly anticipated a difficult year for economic growth, and that this would translate into even more losses for the diversified-portfolio investors who had already suffered one of the worst years on record in 2022. In a now famous October 2022 headline, Bloomberg warned: “Forecast for US Recession Within Year Hits 100% in Blow to Biden.”
The prediction of a 2023 recession proved correct, but only for Germany and the United Kingdom, not the United States. The contrast was stunning. While the first two countries experienced two quarters of negative growth in the second half of the year, the US economy grew at an annualized rate of around 4%. Meanwhile, the worrisome investment losses incurred earlier in the year yielded to handsome gains overall, owing to the dramatic turnaround in October for both stocks and bonds.
Chastened by that experience, most forecasters entered 2024 with quite a rosy outlook, anticipating that America’s growth exceptionalism would continue, as would solid investment returns. Yet the growth data for the first quarter came below the consensus forecast, and inflation has proved stickier than many expected.
The difficulties facing forecasters are complicated by two broader phenomena that could last for years. These can be placed in two categories: transitions and divergences. Many advanced economies have embarked on a transition from a world of deregulation, liberalization, and fiscal prudence to one oriented around industrial policy, renewed regulation, and sustained budget deficits on a scale that would have been unthinkable previously.
Moreover, these economies’ policies are becoming more differentiated, whereas previously they represented common responses to common shocks. Internationally, globalization is giving way to fragmentation. All this is happening at a time when economies around the world will have different sensitivities to transformational innovations in artificial intelligence, life sciences, sustainable energy, and other fields, as well as to geopolitical conflicts and trends. Moreover, some countries are much more flexible than others when it comes to adjusting factors of production and introducing policy measures to enhance productivity in the face of changing circumstances.
In the absence of common policy commitments and external sources of convergence, the world will be subject to a much wider range of outcomes, on top of potentially more frequent and violent shocks. But this is also a world that, if navigated well, could deliver better long-term productivity-driven growth outcomes that are also more inclusive and respectful of planetary limits.
Three issues are key to deciphering what 2024-25 will hold for the US economy, which is now the sole major engine of global growth: the Federal Reserve’s reaction function; the resilience of lower-income consumers; and the balance between productivity-boosting innovations and political/social/geopolitical headwinds.
Sticky inflation combined with slower growth will put the Fed between a rock and a hard place. Faced with growth uncertainties and the new global paradigm of insufficiently flexible aggregate supply, the Fed will need to decide whether to stick with its 2% inflation target or allow for a slightly higher one, at least for now.
The future of American growth exceptionalism also will depend to a considerable degree on lower-income consumers. These households’ balance sheets have been deteriorating as pandemic-era savings and stimulus payments have been drawn down, and as credit-card debt has risen. Given high interest rates and some creditors’ loss of enthusiasm, this cohort’s willingness to consume will hinge on whether the labor market remains tight.
The third factor relates to the tensions between exciting innovations and a fragile political and geopolitical landscape, which makes this the most difficult area in which to offer high-confidence forecasts.
While technological advances promise a new favorable supply shock that could unlock higher growth and drive down inflation, geopolitical developments could do the opposite, as well as limit the scope for macroeconomic policy. Just consider the stagflationary consequences of a geopolitical shock that sends oil above $100 per barrel, or of a further deterioration in China-US relations. It is easy to imagine how today’s “stable disequilibrium” could give way to a more volatile disequilibrium, which would then fuel financial instability.
Sustained US growth is especially important at this juncture because China and Europe have yet to re-establish their own growth momentum, and because “swing countries” like India and Saudi Arabia are not yet in a position to substitute for these alternative global growth engines. (The same goes for Japan, even though its economy and policy mix are in the best place they have been in decades.)
From a sectoral perspective, growth for the next few years will be driven mainly by technological innovations and the economic, social, and political forces they engender. Generative AI, life sciences, and sustainable energy will bring a wide range of reactions at the company level, and sectors such as traditional defense, health care, and cyber security will also be ones to watch.
Despite the many uncertainties, I will stick my neck out and offer some illustrative probabilities: I put the chance of a US soft landing at around 50%; the probability of a (misleadingly named) “no landing” – higher growth with no additional inflationary pressures and genuine financial stability – at around 15%; and the chance of recession and new threats of financial instability at 35%.
Or, for those who prefer images to numbers, picture a bumpy, winding road that could well lead to a desirable destination in the long term. It is being traveled by cars whose engines and drivers vary widely in quality and in their stocks of spare tires; and those drivers must also interact with regulators who are still trying to figure out what the rules of the road should be.
While economic fundamentals, finance, and policymaking obviously will bear on the growth outlook for 2024-25, geopolitics and national politics will have a much bigger impact than in prior years. A world of inherently uncertain transitions and divergences calls for more granular analysis, a proper balance of resilience and agility, and an open mind.
