Global Economic Outlook: US leads, others lag, in uneven global economy

United States

AI boom to offset drag from immigration curb

In the first half of this year, investment in computer hardware and software soared and we expect those faster growth rates to be sustained. (See Chart 11.) Spending on data centres should also cushion any drop back in investment in hi-tech manufacturing plants.

One of the key questions for next year is whether that boost to productivity growth helps to offset the weakness in labour force growth stemming from the crackdown on not just unauthorised immigration, but also now legal migration too? We are increasingly confident it will. (See Chart 12.)

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We originally expected Trump’s tariffs to subtract from US GDP, as the dollar strengthened and other countries retaliated. But the trade-weighted dollar has fallen and, as part of the panic to retain favourable access to US markets, other countries appear willing to lower tariffs on exported US goods. As a result, we have pared back how far we think exports and imports will fall. (See Chart 13.)

Tariffs have also had little effect on final consumer prices, in part because the effective tariff rate was still only 9.5% in July, well below the near-20% rate we would have expected based on pre-tariff import shares. (See Chart 14.)

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In addition, importing firms are absorbing the tariffs by reducing margins rather than passing on those higher costs to consumers. Nevertheless, we expect core services inflation to remain elevated, even as housing inflation drops back further. (See Chart 15.) With the latter keeping core PCE inflation well above the 2% target next year, we expect the Fed to cut its policy rate by only 75bp over the next 12 months. (See Chart 16.)

Euro-zone

ECB easing cycle is not over, it’s just on pause

We expect GDP growth to remain subdued. Headline and core inflation are likely to fall below 2% next year, prompting the ECB to cut interest rates.

The front-running of US tariffs gave the economy a boost in Q1 but growth slowed sharply in Q2 and surveys (though quite unreliable recently) point to a similar performance in Q3. (See Chart 17.)

That said, growth should pick up a bit heading into next year. Consistent with our long-held view that US tariffs would have only a very small negative impact on the economy, export orders have actually risen this year. (See Chart 18.)

And looser fiscal policy in Germany should boost aggregate demand. There is also scope for consumption to accelerate if households become less cautious and the saving rate falls from its very high level.

But the big picture is that that economic growth will remain subdued by international standards. And we think that growth in 2027 will be much weaker than the ECB and consensus expect because underlying productivity growth remains weak and the demographic drag will intensify. (See Chart 19.)

Meanwhile, surveys suggest that the labour market is continuing to loosen. Together with past declines in headline inflation, this is feeding through to slower wage growth and we expect it to keep falling. This is the key reason why we expect services inflation to decline further next year, pulling the core rate down below 2%. (See here and Chart 20.)

We also forecast oil and natural gas prices to decline, causing headline inflation to fall closer to 1%. (See Chart 21.)

The ECB could “look through” a period of below-target inflation, particularly if the core rate were not far from 2%. But the risks are skewed towards rate cuts, particularly if policymakers were worried that inflation expectations could once again become stuck at a low level. We’ve pencilled in two rate cuts for next year, which would take the deposit rate to 1.5%. (See Chart 22.)

The shift in the association between bond yields and the exchange rate earlier this year has been sustained. (See Chart 23.) But we don’t think this means that interest rates no longer matter for the euro. Our view that the ECB will cut by more than expected and the Fed by less than expected suggests that the euro won’t rise further against the greenback.

Arguably the biggest risk to the outlook is the high and rising level of public debt in France. By contrast, debt ratios should continue to fall in Spain, Portugal and Greece. (See Chart 24.)

Japan

Japan will continue to shrug off global trade tensions

GDP growth will slow from its current above-trend rate to a more sustainable pace as external demand softens. However, with consumption growth still healthy and underlying inflation set to remain above the Bank of Japan’s 2% target, we expect the Bank to resume its tightening cycle in October.

The 0.3% q/q rise in Q2 GDP was for all the right reasons, with business investment, consumption and exports all rising. However, exports to the US in July were the lowest they’ve been since January and motor vehicle output slumped, too. We expect GDP growth to slow from its current above-trend rate towards a more sustainable pace. (See Chart 25.)

The BoJ is worried that a hit to corporate profits from higher US tariffs will weigh on business investment and wage growth. But while profit margins in manufacturing have weakened, they were around record highs across all industries in Q2. (See Chart 26.)

Encouragingly, firms’ capital spending plans also remained robust in the latest Tankan survey. (See Chart 27.)

The Bank has been arguing that rapid price rises will keep consumer spending “more or less” flat for now. By contrast, we’ve correctly predicted that consumer spending will remain a bright spot this year. After all, real disposable income growth remains healthy. (See Chart 28.) What’s more, the elevated savings rate leaves plenty of scope for consumption to keep rising.

The BoJ has downplayed the slowdown in regular earnings growth in the first half of the year. (See Chart 29.) Policymakers have instead put more emphasis on the continued strength in pay hikes in this year’s spring wage negotiations (Shunto). With consumer price inflation set to average nearly 3% this year, another robust pay hike in the upcoming Shunto appears likely.

Headline inflation has come off the boil, but inflation excluding fresh food and energy has reached fresh highs in recent months. Amidst concerns that household inflation expectations are on the rise, we expect the BoJ to resume its tightening cycle in October.

If we’re right and energy prices will drop sharply next year, headline inflation will fall below the Bank’s 2% target. (See Chart 30.) But with underlying inflation set to remain above that target, we expect the Bank to lift its policy rate to 1.5% by 2027.

The media narrative is that the recent surge in long-term government bond yields reflects concerns about the sustainability of Japan’s public finances. (See Chart 31.) With the budget deficit shrinking to a 30-year low in 2023 and probably having declined even further since then, that argument seems bizarre. (See Chart 32.) Granted, we do expect the 10-year JGB yield to rise further from 1.63% now to 2.0% by 2030. However, that’s mostly a reflection of our hawkish views on monetary policy.

United Kingdom

The UK won’t be the inflation outcast forever

• More tax hikes in the Budget in November adds to our view that inflation in the UK won’t remain higher than in the euro-zone and that the Bank of England will cut interest rates from 4.00% now to 3.00% next year rather than to 3.50% as investors expect. (See Chart 33.)
• The lingering drags from the previous rises in interest rates, the hikes in business taxes in April and soft overseas activity explain why we think GDP growth will slow from 1.5% this year to 1.2% next year. (See Chart 34.)
• That said, the Budget on 26^th November may dampen growth. To prevent her from breaking the rules and to restore her fiscal headroom of £9.9bn, we estimate the Chancellor will need new policies that raise £28bn in 2029/30. (See Chart 35.) With Labour MPs unwilling to stomach spending cuts and the markets unlikely to tolerate more borrowing, higher taxes, this time for households, may do the heavy lifting. A fiscal tightening of £28bn (0.8% of GDP) would trim GDP growth by 0.2%.
• This would leave the budget deficit on track to fall from 5.1% of GDP in 2024/25 to 2.0% in 2028/29. That’s a much bigger fall than is likely in France (see Chart 36), meaning the chances of a fiscal crisis involving a leap in yields is higher in France. Even so, all the ingredients for a fiscal crisis, bar a trigger, are in place. We are not forecasting a UK crisis, but it’s a risk.
• Some of the possible tax hikes that have been mooted over the past month would boost CPI inflation for a year. But by hitting households’ real incomes, higher taxes would also weigh on inflation further ahead.
• Indeed, they would add to the weakness in employment that was triggered by the rises in National Insurance Contributions for employers in last year’s Budget. Since then, payroll employment has fallen by 0.5% and the somewhat unreliable LFS unemployment rate has risen from 4.3% to 4.7% in July. We expect the unemployment rate will peak at 5.0% in the first half of next year. (See Chart 37.)
• What’s more, our CE Unemployment Proxy suggests the labour market is weaker than the unemployment rate suggests. (See Chart 38.) And the job vacancy rate implies the labour market is looser in the UK than in the euro-zone and the US. (See Chart 39.)
• That loosening should feed through into a more marked easing in wage growth in the UK and a fall in CPI inflation to the 2.0% target by 2027. That would leave it no higher than in the euro-zone. In fact, we are forecasting UK inflation to be below 2.0% in 2027. (See Chart 40.)

United Kingdom Charts

Canada

Weak growth to (eventually) prompt more rate cuts

• We forecast average annual GDP growth of 1.0% next year, with a further rise in the unemployment rate – against a backdrop of near 2% inflation – prompting the Bank of Canada to cut its policy rate to 1.75%.
• With employment falling in the past two months, it is possible that a negative feedback loop will develop and the economy has already succumbed to recession. Our baseline view, however, is that the extent of the weakness in exports and investment in the second quarter (see Chart 41) leaves scope for both to partially rebound now that firms have some certainty about the tariff regime.
• As household income growth is slowing rapidly, we expect consumption growth to likewise slow sharply from recent strong rates, which means that overall GDP growth is set to remain close to 1% annualised for the next few quarters. (See Chart 42.) With the household saving rate still somewhat above its pre-pandemic norm, one upside risk to our forecast is that households will further reduce saving to support spending. (See Chart 43.)
• On the whole, however, the risks seem tilted toward more muted growth. Our forecasts assume that the US, Canada and Mexico reach a deal that keeps the USMCA alive. If the US instead pulls out, that would subject a far greater share of exports to tariffs.
• Fiscal policy may also become a drag on activity. Prime Minister Mark Carney has recently taken a firmer tone on the need for an “austerity budget” that reins in operational spending to support long-run investment, which could involve bringing public sector employment back down. (See Chart 44.)
• The recent strength of housing starts also looks inconsistent with plunging immigration and falling rents. Favourable public financing explains much of the strength but, if demand remains weak, the risk is that this type of construction will freeze up. (See Chart 45.)
• We expect population growth to settle near 0.3% y/y, rather than turn slightly negative as the government pledged. That should ensure that shelter price inflation continues to normalise, but we still see reason to expect rent inflation to remain slightly above pre-pandemic norms (See Chart 46), which will keep core inflation marginally above the Bank of Canada’s 2% inflation target. (See Chart 47.)
• That will somewhat limit the extent to which the Bank provides policy support, but we still expect the Bank to cut its policy rate three more times, to 1.75%.  (See Chart 48.)

Canada Charts

Australia & New Zealand

A tale of two recoveries

• The Australian economy bounced back strongly in Q2, and it increasingly appears that the recovery has legs. In contrast, the New Zealand economy remains mired in a deep slump, and we believe that it will be some time before growth returns to trend. (See Chart 49.) Against this backdrop, we expect the RBA to shift policy towards a neutral stance, while the RBNZ moves further into expansionary territory.
• Australia’s real GDP grew by a solid 0.6% q/q in Q2, as consumers opened up their wallets. Our GDP Nowcast suggests that the economy will have expanded by a healthy 0.5% q/q in Q3 as well. (See Chart 50.) In contrast, New Zealand’s economy contracted by a whopping 0.9% q/q last quarter. There are tentative signs that the worst is behind us. That said, card transactions data point to only a modest pick-up in activity in Q3. (See Chart 51.)
• A key factor weighing down the recovery in New Zealand is the weak property sector. (See here.) Indeed, house prices fell again in August, leaving them 0.5% below levels from a year earlier. With home sales also edging lower in recent months, we suspect the housing rebound won’t take off until well into next year. (See Chart 52.) Meanwhile, Australia’s housing market has already turned the corner, and we suspect the ongoing rally has further to run.
• Australia’s unemployment rate has drifted up a bit since the start of the year. However, at 4.2% presently, it remains low by historical standards. Moreover, with activity firming up, we don’t expect the labour market to loosen much further. (See Chart 53.) Across the ditch, New Zealand’s jobless rate is also close to peaking, albeit at a nine-year high. We suspect that the path back to pre-pandemic levels will be a drawn out one.
• Wage growth in Australia has remained stubbornly above 3% in recent quarters. However, our composite labour market index points to a slowdown in the coming quarters. (See Chart 54.) Meanwhile, wage growth in New Zealand plunged to a fresh low of 2.2% in Q2 and is likely to fall even further.
• Australia’s trimmed mean inflation fell to 2.7% in Q2. However, with the output gap having all but closed and the recovery starting to firm up, we suspect disinflation has largely run its course. In contrast, core inflation has further to fall in New Zealand and is likely to briefly undershoot the mid-point of the RBNZ’s 1-3% target band next year. (See Chart 55.)
• With the RBA mindful of stoking capacity pressures, we have revised up our forecast for the terminal cash rate from 2.85% to 3.10%. The considerations are decidedly different for the RBNZ, which is increasingly concerned about the weak state of the economy. Accordingly, we now see rates in New Zealand bottoming out at 2.25%, down from 2.5% previously. (See Chart 56.)

Australia & New Zealand Charts

China

Growth weak but stable

• The gap between our China Activity Proxy measure of growth and official GDP is one of the widest on record. (See Chart 57.) While exports will continue to prove resilient in the face of US tariffs, growth is set to remain weak.
• China’s economy is growing at a far slower pace than official figures suggest, but it hasn’t slowed since the start of the year That’s partly because exports have held up well despite US tariffs. But it’s also because services sector growth, which had been weakening steadily for some time, has picked up in recent months on the back of stronger financial sector activity. (See Chart 58.) We’re forecasting further gains in Chinese equities both this year and next. That will help boost financial sector activity and may result in some positive wealth effects.
• The leadership finally appears ready to do more to support households, with several new measures announced recently. This could in time prove a significant turning point. The Finance Minister’s recent comment that “more public services will be brought under the scope of investment support” could also indicate that local governments may soon be able to issue special bonds for social spending. But with the labour market softening, the measures announced so far won’t do more than keep consumption growth stable.
• Indeed, while the fiscal stance will remain accommodative, the tailwind from fiscal easing will fade over the next year. (See Chart 59.) We’re also expecting only modest further monetary easing. (See Chart 60.)
• And the country’s overcapacity issue seems set to persist. The government’s campaign against “involution-style” competition may curb investment in some sectors, but policymakers won’t pursue an abrupt pullback in manufacturing investment while property is still declining and options for effective infrastructure spending are limited. (See Chart 61.) Without a meaningful boost to consumption, China’s capacity glut means that supply will still outstrip demand for some time, keeping the economy in deflation. (See Chart 62.)
• Excess capacity will also continue to drive exports. (See Chart 63.) While tariffs have resulted in a sharp fall in exports to the US, a trade-weighted depreciation of the renminbi (see Chart 64) has helped exporters gain market share elsewhere. We’re forecasting a slight strengthening of the renminbi against the dollar, but the trade-weighted currency will remain weaker than its pre-Liberation Day level.
• And as supply-chains in other countries adjust to US tariffs, we expect trade diversion to pick up further. That said, exports won’t expand as rapidly as they have in recent years. (See Chart 63 again). As a result, exports will provide a still significant but smaller prop to growth.
• In short, while the government is taking some positive steps to support households, the scale of the recent measures is too small to give a significant boost to consumption. China will still rely heavily on investment and external demand to drive growth. We expect growth of just 3% over the rest of this year and into next.