By Daleep Singh, Chief Global Economist, Head of Global Macroeconomic Research, PGIM Fixed Income
If central banks’ urgency to return inflation to their respective targets encapsulated an underlying theme of the global economy in 2023, early 2024 starts with assessing the ramifications of their initial success.
It is a fitting time to take stock: after years of collectively fighting a bout of inflation now seen as transitory with the benefit of hindsight, policy paths, economic trajectories, and fiscal roles amongst the world’s largest economies appear set to splinter.
The Federal Reserve and the US economy may be leading the divergence, the Fed’s shift was enabled by its clinical progress against inflation, culminating with the December PCE report. The Fed’s favored inflation measure showed the first monthly decline in prices since April 2020, and our preferred view of inflation on a three-month annualized basis decelerated to 2.9%, which is within the prevailing, pre-pandemic range.
For those keeping tabs on when core inflation may reach the Fed’s 2% target, if the monthly core PCE readings continue to average 0.2%, the target may be reached before midyear 2024. And this is before the full effect of slowing rents emerges in the data.
However, the step of precisely hitting an inflation target is increasingly moot: with the benefit of hindsight, the bout of inflation appears transitory, just not to the brevity many initially anticipated.
While the Fed pivoted at the December FOMC meeting with its median projection for an additional two 25 bps rate cuts in 2024 and 2025, which would bring the Fed funds rate to 4.6% and 3.6% respectively, it maintained a semblance of vigilance against inflation by maintaining its 2026 and long-run rate projections. We continue to expect that the Fed may lift its long-run estimate closer to 3.0%, perhaps at a future Jackson Hole symposium.
As is custom, markets bit down on the Fed’s projected rate cuts, pricing in about 75 bps of policy easing through June 2024 in the immediate aftermath of the healthy December payroll report. Yet, we do not believe the Fed will be as quick to turn its back on inflation, and our expectations largely remain unchanged since mid-2023 as we see three 25 bps rate cuts starting in Q2 2024.
Despite the above, our US economic scenarios remain unchanged from Q4 2023 as we continue to see weakflation as our base case (35%), followed by a 25% chance of a recession. Our scenario assumptions include tight monetary, fiscal, and credit conditions that slow cyclical momentum to below trend growth of about 1.6% vs. an estimated 2.1% in 2023.
We anticipate that fiscal developments will also continue to play a role in China this year as authorities aim to steer the world’s second largest economy between short-term goals to stabilise growth amidst persistent deflation and longer-term objectives to deleverage vulnerable sectors, such as real estate.
China’s November inflation reports showed ongoing deflation at the consumer and producer levels, which is consistent with economic data indicating subdued lending activity to corporations and households. Thus, authorities are targeting stimulus at local jurisdictions, and that effort via debt issuance resulted in five consecutive months of increased total social financing in the latter stages of 2023.
This development also involved the first use of central bank financing, which may expand through the first half of 2024 as authorities seek to revive inflationary momentum. As this stimulus fades, it could be offset by the long-awaited revival of activity in the real estate sector.
When looking ahead, China’s combination of long and short-term dynamics leaves us with three key points to watch. First, it is evident that authorities’ policy mix is doing more to stimulate the supply side than the demand side, hence the country’s falling prices. Second, China’s demand impulse to the global economy will remain marginal (the country is 30% of global manufacturing, which could expand further with additional investment stimulus) and implies headwinds for major exporting regions, such as Europe.
Third, from a structural perspective, China’s economic imbalances remain unresolved – e.g., investment as a share of GDP among large economies remains the highest in the world (far too high to be productive or profitable) – thus, deleveraging, demographics, and de-risking will remain a drag on long-term growth.
As China navigates between its short and long-term challenges, its economic direction will continue to exert significant influence across emerging markets.
This year may also see developments with the Bank of Japan (BoJ) and whether its policy rate finally moves out of negative territory and converges towards those of other major developed market central banks. The BoJ may not lift rates out of negative territory until the second half of 2024, but even in that case, it is unlikely to take rates beyond zero.
These outcomes underscore the newly divergent paths that central banks and economies will find themselves on in 2024. As countries embark on this new phase of the paradigm, they are subject to the previously referenced effects of the shifting, structural anchors under the global economy. Thus, as much as conditions may change in 2024, the role of these secular factors in influencing the long-term performance of the global economy cannot be overlooked.