Long-term Forecasts: DM Policy Easing

The Continuum Economics research team has spent much of the last month researching, reviewing and debating our long-term GDP, CPI inflation and central bank policy rate forecasts for 2025-30. Alongside a reassessment of long-term factors such as productivity and demographics, we have examined the lasting impact of three major themes for this decade: the switch to climate change-friendly energy; the digital revolution (5G, Internet of Things, AI, and cloud computing) and scarring from monetary tightening. While some of our economists will write on their own economies, we wanted to highlight some key issues and differences across countries. This is a complement to our one- and two-year ahead views highlighted in the September Outlook (here).

Figure 1: DM Official Rate Forecasts 2023-28 (%)

Source: Continuum Economics.

GDP: Long-Term Trends

We reviewed and discussed a number of competing forces for the 2025-30 growth outlook for the 23 economies that we follow closely. Some of the key issues and differences are:

Demographic Headwinds / Tailwinds:

Economists' growth model (the neoclassical) suggests that labor, capital, and Total Factor Productivity (TFP) drive long-term economic growth. Following this standard framework, demographic changes – including aging population, lower mortality rates, and reduced fertility rates – will be key determinants of economic growth in the next decade. This is not just about lower absolute consumption for older people, but also less people in the 15-64yr age group inhibiting housebuilding/consumption and tax revenue growth. Our view is that those countries with declining populations could be negatively affected by the change, and political reasons might hinder the implementation of solutions to counteract decreasing labor force (e.g. large scale immigration). On the other hand, countries with an increasing population would benefit from the change only if they adopt the necessary policies to leverage the demographic dividend or increase productivity growth.

The latest projections from the United Nations indicate that populations have already begun to decline or are expected to start declining in the coming years in certain European countries/Japan and China. For instance, China's population is projected to start declining in 2025 (here), while Germany's populations are set on this trajectory from 2023. Furthermore, we believe that this demographic shift will likely result in a slower growth of the labor force as early as this decade, acting as a drag on income and consumption. Possible solutions to counter the declining labor force in these countries include expanding female labor participation, facilitating more immigration, and increasing retirement age. In this context, the IMF estimates (here) that EMs could boost GDP by 8% over the next decade if the rate of female labor force participation increases by 5.9 percentage points. Similarly, the Fund shows (here) that a 1 percentage point increase in the inflow of immigrants relative to total employment expands output by almost 1% by the 5^th year in DM countries. Finally, Professors Michael Kuhn and Klaus Prettner conclude (here) that a rise in the retirement age leads to faster long-run economic growth in DM by expanding the workforce and reducing savings via consumption. However, we argue (here) that political tensions arising from voters' opposition to these measures can impede the execution of these policies.

However, India, Nigeria, and the U.S. stand in contrast as examples of countries poised for continued population growth in the next decade and likely to reap benefits from this demographic trend. While population growth is deemed a necessary condition, it alone does not ensure long-term economic growth. Take India, for example—the South Asian nation is well-positioned to harness its demographic dividend. Should India aspire to emerge as the world's leading manufacturing hub and fortify its services sector, it must implement policies aimed at bolstering female employment, elevating workers' skill levels, and fostering investment in its population's health.

Figure 2: Population Growth in Select Countries (%)

Source: UN, Continuum Economics

DM and EM fiscal policy investment vs. consolidation:

The fiscal buffers of DM countries have been diminished by the dual impact of the COVID pandemic and the energy crisis. Consequently, sustained efforts are required for some countries to navigate a course toward fiscal consolidation, though avoiding too quick a pace and hurting growth. Within the EZ, countries are making progress in this direction, as the EU next generation funds help to provide domestic infrastructure investment without a strain on national governments. However, the progress in France and Spain is slow, while Italy's high government debt/GDP (Figure 3) means little room for adverse fiscal surprises – see risks below. EZ pensions are also on the rise as population aging kicks in more fully. In the United States, we anticipate loose fiscal policy in the coming years, irrespective of the outcome of the presidential election in November 2024, given Congress is reluctant to raise taxes or cut expenditure.2025 could see U.S. fiscal tensions. Moreover, policies related to climate change and geopolitical issues such as Ukraine could be subject to change if Trump is victorious. The trajectory of government bond yield and policy rates in North America will also be pivotal, given their influence on interest costs for the federal debt, which have recently reached record highs.

In EM countries, the panorama varies on a country basis, both in terms of deficit and government debt trajectory. China official figures provides a misleading picture and we prefer the IMF measures, which shows a large general government budget deficit and a debt trajectory that is set to exceed 100% by 2027 (Figure 4). India, on the other hand, has the benefit of high nominal GDP growth in the coming years, which should ensure that the government debt/GDP trajectory should stabilize. Of the other big EM, Brazil and South Africa need to do more multi-year fiscal consolidation to ensure that government debt/GDP levels do not get too high and risk fiscal crisis. Finally, the substantial short-term external financing requirements are placing significant strain on the capacity of several weaker emerging market economies (e.g. Egypt) and low-income countries to meet their debt obligations. Their sovereign spreads are persistently high, hindering the access to credit for many economies that heavily depend on short-term borrowing.

Figure 3: Key DM Net Government Debt/GDP (%)

Source: IMF, Continuum Economics (net of financial assets)

Figure 4: BRICS Gross Government Debt/GDP (%)

Source: IMF, Continuum Economics

Climate Investment and Costs:

Developed markets started implementing significant climate change policies in the 2010s to promote investment in this space. During President Biden's administration in the United States, the US Inflation Reduction Act was passed, allocating over USD 370 billion in funding to mitigate climate change. In Europe, initiatives such as the EU's Green Deal, Fit for 55, and RePowerEU have been put into effect. China also launched its mid-century long-term low greenhouse gas emission development strategy (here), which among other strategies, aims to reduce the cost of climate investment and financing while promoting green consumption. Although these policies represent a step in the right direction and offer some net stimulus in terms of economic growth during the second half of the 2020s, we think that political headwinds could potentially slow or even reverse some of the progress achieved. We delve into this issue in depth (here), where we argue that the outcome of the November 2024 U.S. presidential election is crucial for the U.S. and globally.

The International Energy Agency estimates that Emerging Market and Developing Economies (EMDEs), excluding China, will require a seven-fold increase in annual investment by the early 2030s, and this level of investment needs to be sustained until 2050 to align with the goals of the Paris Agreement (here). Given the limited fiscal space that some EMDEs experience, private investment will play a pivotal role in achieving this goal. In this regard, adequate policies to improve macroeconomic fundamentals, enhance governance, strengthen capital markets, and match returns with investors' expectations to position these countries as attractive investment destinations will be required. Our view is for climate investment to have a modest to zero impact on economic growth in EM for the remainder of the decade.

Artificial Intelligence and Digitalization:

A key subject to analyze is the impact of artificial intelligence on growth over the next decade (here). While there is no definite answer to this question, most economists argue that AI will boost growth in the long run. Various explanations have been suggested for this. First, AI is expected to make existing workers more productive by allowing them to complete tasks more efficiently. Second, a new virtual workforce, capable of learning and solving problems autonomously, is expected to emerge. Third, in tandem with the AI revolution and complemented by the diffusion of innovation, new products, services, markets, and industries are anticipated to arise, thereby boosting consumer demand, this being a classic example of Say's Law where supply creates its own demand.

We see the initial effects of AI starting to kick in the late 2020s and gaining traction in the 2030s. It is crucial to highlight that countries will need to navigate through an adoption phase, which includes establishing the regulatory framework and implementing policies in the areas of labor, education, and competition. Similarly, firms will undergo this stage by integrating technologies, adapting processes, and providing training for their workforce. This adoption stage is one of the reasons of why the impact of AI is not realized sooner.Also it is worth remembering that digitalization continues to provide a boost as 5G/Big Data and the Internet of Things enables an improvement in processes and benefits growth (here).

Despite the arguments presented above that suggest a positive net effect of AI on economic growth, certain considerations need to be emphasized. A divergence in the adoption rate of new technologies is likely to emerge, with DM investing more than EM and thus enjoying the benefits sooner. Similarly, countries with low exposure to AI would naturally benefit the least from new technologies, especially those in which sectors like agriculture and construction drive their economy. Finally, the positive impact might not fully materialize if the digital revolution leads to higher unemployment or if labor income does not benefit from the gains generated by AI. In either case, private consumption could decrease, ultimately impacting fiscal balance sheets.

Economic Scarring:

From a monetary perspective, classical economists adopted the concept, which suggests that in the long run nominal variables such as money supply, interest rates, and price levels affect only nominal variables and not real variables like output and employment. Challenging the validity of this claim plays an important role when forecasting growth and inflation, especially as we approach the end of a monetary policy tightening cycle. For instance, a recent paper by the San Francisco FED (here) concludes that the real effects of monetary shocks last for over a decade[1]; furthermore, it suggests that capital and TFP growth are the main drivers of the result, not hours worked. We provide further insights on monetary scarring in this article (here).

Economic scarring can arise not only from the long-term impacts of monetary policy but also from the question of whether deep contractions, such as those caused by the COVID pandemic and subsequent Russia-Ukraine conflict, can have persistent negative effects. A paper by the European Investment Bank (here) addresses this topic and concludes that, on average, three to seven years after a major economic downturn, growth falls 2% per year short of the rate observed prior to the shock. This limitation hampers the desired effect of fiscal policy, leaving countries with lower output, higher deficits, and increased debt. A similar conclusion regarding the long-term impacts of crises and recessions is reached in an IMF paper (here).

Figure 5: 2023-28 DM GDP Forecasts for Select Countries (%)

Source: Continuum Economics

Figure 6: 2023-28 EM GDP Forecasts for Select Countries (%)

Source: Continuum Economics

Could an economic or political shock cause a different trajectory for GDP? Yes for China in the case of an invasion or blockade of Taiwan and major sanctions from the West, but we regard these as a cumulative 25% probability over the next 5 years (here) with an invasion being 5%. The global shock would be greater than the Ukraine war. Two moderate probability scenarios are worth highlighting.

• China Hard Landing. Our baseline is for growth to slow to 4% in 2024 and 2025, before 3% from 2027 onwards due to population aging/lower productivity caused by the swing to state socialism under President Xi. The slump in residential property construction will likely be L shaped and mean years of adverse effects for GDP. However, we could be underestimating the power of this force, which could in an adverse scenario cause China growth to fall to 1-2%. This would hurt the global economy, but especially EM commodity exporters. More proactive policy easing would likely be seen from China authorities and this is now a 20% risk scenario in the next 5 years.
• DM Rate Cuts Delayed and 2024 Recession. If easing in DM central banks is delayed or some further rate hikes seen due to inflation remaining stickier than our baseline (see below), then this could mean (partly from possible scarring) worsen the EZ and UK recession or mean that the slowdown in the U.S. is greater. It could also be a headwind for 2025 growth forecasts.

Inflation: Long-Term Trends

The forces on multi-year inflation are diverse and include 2^nd round effects from high inflation alongside this decade's themes of population aging; energy transition and digitalization. Additionally, some of these forces (e.g. population aging) have disinflation and inflationary consequences, which makes the influence more mixed (Figure 7). The key forces are:

Figure 7: Long-Term Forces More Mixed Than Growth Impact

Source: Continuum Economics

• Population Aging: The perception is that population aging is disinflationary, as that is Japan's experience and will Europe and China follow this pattern? It is certainly the case that lower aggregate consumption via lower spending in old age, plus less housebuilding, will likely be a disinflationary force in these countries. However, population aging also means that the labor market can tighten and cause imbalances that means some upward pressure on wage inflation. For the EZ and China (here), this is a long-term risk, but enough labor market slack in China case and labor market flexibility in EZ case means that the disinflationary force will likely dominate in the next 5 years. For countries, with a population dividend and strong growth in the labor force (e.g. India), new workers can help cap wage growth by meeting employment demand. For this group of countries however, healthy demand from labor force growth will likely mean inflation pressures at times.
• Climate/Energy Transition and Digitalization: In contrast, the inflation consequences from climate change are clear (here) and will likely be inflationary though the remainder of the 2020's. The energy transition boosts costs of alternative energy sources, while investment is also need in electricity supply infrastructure given the variability of renewable electricity production. Meanwhile, the inflation consequences of AI/digitalization are likely to remain disinflationary in the remainder of the 2020's.Clear evidence exists of this downward force on inflation (here). Though AI will really kick in the late 2020's/early 2030's, the impact of 5G and transformation of business models is ongoing and will likely be a disinflationary force in the coming years.
• Geopolitics and Global Supply Chains: The other influence is a shift to on shoring for certain key industries (after the COVID crisis); a shift to more domestic energy production for energy security (post Ukraine war) and climate change reasons and reshaping of global supply chains. The reshaping of global supply chains not only relates to the two big crisis of recent years, but also fears of what would happen to supply chains if China invades Taiwan. While we feel an invasion of Taiwan is a low probability scenario in the next 5 years (here), risk management means that companies want to ensure resilience in supply chains. China will likely see a structural loss of trade, which is disinflationary as excess production in China tries to undercut alternative countries. Mexico/India/Vietnam/Indonesia and Turkey are potential beneficiaries of shifts in supply chains, which can cause some intermittent inflation tensions if the switching of supply chains become too large.

Overall, the second half of the 2020's will have somewhat more inflation than the post GFC period due to investment in climate change/energy security and separately a desire for resilient in supply chains. This means that inflation will be close to inflation targets rather than undershooting. Climate chain investment and changes to supply chains will likely mean that EZ see a goldilocks outcome of inflation close to 2% (Figure 8). For the U.S., immigration volatility, ill health and a mismatch of skills will likely mean a tight labor market outside of recessions and this will likely mean core PCI inflation close to 2.5%. Japan inflation will also be higher than the 2000-19 period, but population aging and inertia will likely mean inflation falls back to just below 1.5%.

Figure 8: 2023-28 DM CPI Inflation Forecasts for Select Economies (%)

Source: Continuum Economics (average for year)

Inflation in the big EM countries will vary (Figure 9). China will likely struggle with disinflation forces and see inflation stuck between 1.0-1.5% (here), due to population aging and shift of supply chains away from China. Other big EM's will be closer to inflation targets, with intermittent upside risks in India from solid growth but capped by excess labor ensuring that price/wage cycle do not breakout.Indeed, labor market slack is one of the reasons that most big EM countries have had a better inflation performance relative to their inflation targets than DM countries and big EM countries will not significantly struggles outside of Argentina and Turkey (though even these two should see some progress through to the late 2020's).

Figure 9: 2023-28 EM Inflation Forecasts for Select Countries (%)

Source: Continuum Economics (average for year)

Monetary Policy: DM and EM Divide

In terms of the impact on DM monetary policy, a couple of points are worth making.

• Inflation allows a move back towards neutral policy rates. Inflation at or just above target means that a shift of monetary policy can be seen towards more neutral policy rates (Figure 10). Additionally, with inflation getting back towards target, some central banks will likely also reduce real policy rates from current high levels. With the EZ already in recession, we feel that this process will likely start in Q2 2024 and will occur consistently through 2024 and 2025. Additionally, central banks are coming to understand that QT is contractionary and this will encourage central banks to ease policy in 2024/25.
• Divergence towards neutral policy rates. The U.S. is trickier as the Fed will have to accept core PCE averaging around 2.5%, which will likely see them accept more flexible inflation targeting but also that the long-term neutral rate has likely have risen to 2.75%. This will likely mean gradual Fed easing in H2 2024 and 2025 slows in 2026. Nevertheless, if the U.S. were to fall into recession, then the likely policy reaction would be to aggressive cut the Fed Funds rate to the 2.0-2.5% region. The Fed will remain more aggressive than the ECB in this type of scenario. Other DM economies will likely follow the ECB and Fed trends, though with local variations (Figure 11) – our economists will write about these contrasts in the coming weeks and in the December Outlook published on December 19.
• BOJ tightening. Meanwhile, we do see the BOJ ending ZIRP with a hike in the BOJ policy rate and this will be followed with further moves in to bring the policy rate to +0.25% in 2025.However, given that we see Japanese inflation stuck well below 2%, our central view is that the BOJ will likely not hike aggressively. Crucially this assumes that the BOJ tightening cycle will be similar to 2000 and 2006. If the BOJ were to shift to positive real interest rates then this would mean a much higher profile for BOJ policy, but also provide an interest rate shock to Japan (here).

Figure 10: DM Official Rate Forecasts 2023-28 (%)

Source: Continuum Economics.

Figure 11: Other DM Official Rate Forecasts 2023-28 (%)

Source: Continuum Economics. SNB deposit rate

EM central banks future policy paths also vary. China faces disinflation forces that will bring down the policy rate into 2024 and 2025, with the 7 days reverse repo rate likely to fall to 1.25% (Figure 12). However, the PBOC and China authorities appear reluctant to go further to ultra-easy policy that would involve a significant negative real policy rate and/or QE unless an economic hard landing were evident.While we see growth slowing to 3%, this will likely not cause a material shift in strategy that is aimed at banks sustaining money supply growth in the low double digit i.e. the quantity of money is more important than the price. Other Big EM will likely converge towards their neutral policy rate. For Brazil this means consistent easing in 2024-25. For India and S Africa, it will be a slower pace and initially designed to stop the real policy rate from rising.

Figure 12: EM Official Rate Forecasts 2023-28 (%)

Source: Continuum Economics

[1] For the full sample, which covers the period 1900-2015 excluding WW1 and WW2, a one-percentage-point shock in domestic short-term interest rates causes GDP to decline by 4.6% over 12 years. When restricting the sample to post-WW2, the drop 12 years after the impact is 3.9%.