Horizon Q2│2024 - Economics

US: Fiscal policy supports economy despite high interest rates

Despite the Fed's vigorous rate hikes, the US economy continues to perform better than expected. Even the interest rate-sensitive housing sector, which initially slumped by 20%, is slowly emerging from the trough. Thanks to a still robust labour market, consumer spending remains strong. Companies have also not cut back on their investments despite higher financing costs. Thanks to high reserves, they are less dependent on credit than before. Moreover, unlike in previous cycles, they have not built up excess capacity in recent years. Therefore, they do not need to compensate for this with lower investment.

The most important reason for the sustained high growth in the US is fiscal policy. First, tax incentives for green (and some other) investments are counteracting tight monetary policy. Second, the government is massively increasing its own spending, by 4.5% in real terms in the final quarter of 2023 compared with the previous year. Thanks to high federal subsidies, the states and municipalities were even able to increase their investments by 16.3%.

Of course, significant risks remain. This is because monetary policy has a lagged effect. It could therefore slow down the economy this year, even though the US (and Europe) had already reached the interest rate peak in autumn 2023. However, fiscal policy is likely to remain expansionary in the election year of 2024. We have raised our forecast for US growth this year from 2.2% to 2.4% after 2.5% last year. After a good start to the year, we continue to expect growth to slow somewhat in the spring and summer before regaining momentum in late 2024 following an initial easing of monetary policy.

Mixed outlook for Europe

Two very different forces are shaping the outlook for the European economy in the months ahead. First, the continent has weathered the second winter after the Putin shock well. As we approach the end of the regular heating season, gas storage levels are still exceptionally high at 60%. As a result, the wholesale price of natural gas is only about half of what it was a year ago. In addition, consumer incomes have been rising faster than prices since the spring of 2023, thanks to falling inflation, a broadly stable labour market and higher wage growth. Consumers therefore have more money in their pockets in real terms – i.e. after inflation.

In contrast, the manufacturing sector remains in recession. Weak global trade is particularly affecting countries such as Germany that specialise in exporting goods. This effect is exacerbated by a pronounced inventory correction. Many companies had taken advantage of the end of the pandemic-related bottlenecks in the supply chain in 2022 to build up stocks of raw materials and finished goods. As demand has weakened, they have been reducing their inventories since spring 2023. For the time being, they are therefore producing less than they are selling.

However, there are now increasing signs that this inventory correction may soon be over. The rise in the purchasing managers' indices suggests that the manufacturing sector will be able to grow from the spring onwards.

After stagnating over the winter, the eurozone is poised for a rebound in spring. Once the economy has regained some momentum following the end of the inventory correction, many companies will start to invest again to restructure supply chains and replace scarce labour. Although China will remain structurally weak, exports to the country should recover slightly. All in all, China should grow by around 3-4% in 2024, although the official growth target of 5% will probably only be achieved with statistical tricks. With better news from the manufacturing sector, consumer spending in the eurozone should also pick up in the spring. Driven by rising domestic demand, the eurozone economy could return to slightly above trend growth of 1.3% in the autumn. Southern Europe will continue to outperform Germany thanks to the reforms of recent years and a more expansionary fiscal policy. We expect the UK to perform similarly to the eurozone.

The big inflationary spurt is over

Price pressures have eased considerably on both sides of the Atlantic. Core inflation rates (excluding volatile energy and food prices) are likely to fall further in the coming months. However, with domestic demand remaining robust, we do not expect US inflation to fall to 2%. Instead, there are increasing signs that it will stabilise at around 2.5% or slightly higher.

With many energy prices falling and the sharp rise in food prices coming to an end, eurozone inflation could fall to around 2% in autumn. But as the recovery takes hold, companies will regain pricing power in 2025. In the longer term, persistently high wage growth will continue to push up prices for labour-intensive services. As the costs of climate protection will also have an impact, we expect inflation in Europe to rise back to 2.5% over the course of 2025.

Central banks: first interest rate cuts in June

The Fed would like to avoid a significant rise in unemployment. For many US central bankers, an inflation rate of around 2.5% is acceptable. The Fed is therefore likely to start cutting its key rate again from June 2024, probably from the current 5.5% to 4.75% by the end of 2024 and to 4% by mid-2025. We also expect the first interest rate cuts in the eurozone (and the UK) from June 2024 in view of falling inflation rates.