Global Resilience: Many Storm Clouds, but Still Little Rain

A new Citi Research report from a team led by Global Chief Economist Nathan Sheets considers two factors that continue to shape the global outlook: The first is the U.S.-Iran conflict, oil prices and associated uncertainties. The second is the global economy's still solid expansion despite these headwinds. The push and pull between these forces is driving two-sided risks to both our growth and inflation forecasts.

The first factor shaping our outlook is that the U.S.-Iran conflict remains unresolved, and restrictions on shipping through the Strait of Hormuz continue to create risks for energy markets. Oil prices have generally stayed at or below $90 per barrel in recent weeks, partly because markets believe the U.S. is still seeking a diplomatic path out of the conflict. But negotiations have yet to produce a breakthrough, and the risk of a renewed surge in oil prices remains significant.

The second factor is that the global economy has shown remarkable resilience. Despite geopolitical tensions and higher energy costs, global growth remains relatively solid. That growth looks like it’s running 2.6% this year, down slightly from last year's pace but still respectable given the scale of recent shocks. Growth is slowing across many advanced and developing economies, including the euro area, Canada, Japan, China, Brazil, and Chile. Yet a number of countries — among them South Korea, Germany, Italy, Mexico and Sweden — are bucking this trend.

This resilience is visible in business surveys. Global activity in services industries has recovered from its initial decline and remains consistent with continued economic expansion. Manufacturing activity has softened modestly in recent months but remains stronger than it was during much of the past several years.

A major reason is the rapid expansion of investment related to artificial intelligence (AI). Growing demand for advanced computing infrastructure has boosted production and exports in economies heavily involved in technology supply chains, particularly Taiwan, Japan, South Korea and the U.S.

Recent economic data tell a slightly more mixed story. Economic indicators in the euro area have improved considerably, with both business sentiment and some measures of actual activity showing signs of strengthening. By contrast, recent U.S. data have been somewhat softer than expected, particularly in employment and retail spending. Readings for China remain weak, with exports continuing to support growth but domestic private-sector activity staying soft.

The U.S.-Iran conflict has led to a noticeable increase in inflation forecasts around the world. We currently see global headline inflation running at 3.4% this year, up from 2.8% last year and roughly 0.75 percentage point higher than we expected before the conflict.

Oil-importing countries such as the Philippines, Thailand and Italy have been hit particularly hard. At the same time, disruptions to supply chains have raised costs beyond energy alone. Products linked to petrochemicals, fertilizers, and aluminum have become more expensive, creating broader inflationary pressures. As a result, forecasts for underlying inflation have also been revised higher in many countries. Brazil has seen one of the largest upward revisions, while increases have also been significant in South Korea, Thailand, Australia, the euro area, the U.S., and Japan.

This leaves us with appreciable two-sided risks to our forecasts for both growth and inflation. If the U.S.-Iran conflict intensifies and oil prices rise above $100 per barrel, global growth would likely weaken while inflation would rise further. Conversely, a sustained reopening of the Strait of Hormuz could push oil prices back toward $80 per barrel or lower, supporting stronger growth and easing inflation pressures.

Other risks also deserve watching. Investors could become less optimistic about the profitability of AI investments, and rising government debt burdens in many countries could place upward pressure on long-term interest rates.

In response to higher inflation risks, many central banks have shifted toward tighter monetary policy. Across our panel of 27 major central banks, interest-rate expectations have moved higher for 17.

Japan has become an especially important focus for financial markets. Following joint intervention by the U.S. and Japan to support the yen, expectations for additional interest-rate increases by the Bank of Japan have risen. Rates are now expected to reach 2% over the next two years, plausibly in the neighborhood of neutral. But policymakers face a delicate balancing act: They must convince markets that they are serious about controlling inflation without undermining the economic progress Japan has made after years of weak price growth.

U.S. policy, meanwhile, remains a meaningful question mark for the global economy. Inflation has exceeded the Fed's 2% target over the last five years, and Fed Chair Warsh has emphasized his commitment to restoring price stability. Yet he has provided only limited guidance about how he intends to achieve that objective, leaving investors searching for clues about the future direction of policy.

Chair Warsh’s speech at the annual Jackson Hole conference strikes us an important opportunity to explain his strategy more clearly, including addressing how he intends to bring inflation down and some insight regarding his reaction function. If he fails to tackle these issues head on, however, he ultimately may be pressed to demonstrate his inflation-fighting commitment by actually hiking rates. Current economic conditions leave us doubtful that such a step is needed, but at some point central bankers must act as necessary to defend their credibility.

In Europe, the situation looks somewhat less complicated. The Bank of England is expected to leave rates unchanged this year before beginning to lower them next year, while the European Central Bank may implement one additional increase before inflation gradually moderates enough to allow policymakers to pause. The life of a central banker is never easy.

Looking beyond short-term developments, it is useful to assess which economies have performed best since the pandemic

Among developed markets, three broad groups emerge.

The strongest performers have been the U.S., Australia and Canada. Their economies have expanded by 11% to 16% in total since late 2019, which implies average annual growth rates of 1.6% to 2.3%.

A middle group consists of the euro area, the UK and Japan, where annual growth has been more modest.

Germany stands out as the weakest performer, with cumulative growth of only 1.75% since the pandemic began.

When population growth is taken into account, the picture changes in several notable ways. The U.S. looks even stronger, with per capita gross domestic product (GDP) rising 13% since the pandemic. Germany's performance appears even weaker, with essentially no increase.

Japan, by contrast, moves near the top of the rankings. Per capita GDP has grown strongly despite a shrinking population, making Japan the second-best performer among the major developed markets by this measure. This highlights the intense demographic headwinds Japan has faced.

Canada and Australia move down the rankings when measured on a per capita basis because much of their overall growth reflects rapid population increases rather than stronger productivity.

The major emerging economies in Asia have generally delivered much faster growth than developed markets

Vietnam, Taiwan, China and India have all expanded by more than 30% since the pandemic, far exceeding the pace recorded in even the strongest developed markets. Taiwan's performance has been particularly notable since early 2023, supported by booming demand for semiconductors used in AI applications. And South Korea has grown more slowly than its regional peers but still matched or exceeded many developed market.

Looking at per capita real GDP reveals an important demographic divide. Taiwan, China and South Korea appear stronger because they have experienced little or no population growth; their gains largely reflect investment and productivity improvements. India, Vietnam and Indonesia look somewhat less impressive on a per capita basis because their populations have continued to grow rapidly. While younger populations can support future economic expansion, they also require economies to create enough jobs and opportunities to absorb new workers.

The picture is less encouraging in Latin America. Growth rates for Brazil, Chile, Colombia and Mexico have generally been more similar to developed markets than to the faster-growing economies of Asia. On a per capita basis, Brazil and Chile have performed reasonably well, roughly matching the U.S.

Mexico stands out as a weaker performer. Per capita growth has been only about 3.5% since the pandemic and essentially zero since mid-2023. Several factors help explain this. Mexico remains highly dependent on the U.S. economy, particularly manufacturing demand. Uncertainty about trade policy has added further pressure. And domestic-policy changes have also weakened investor confidence and reduced capital investment. As a result, Mexico may continue to face significant challenges.

Overall, the post-pandemic period has reinforced several important trends: the continued outperformance of the U.S. among developed markets, the surprisingly strong performance of Japan on a per capita basis, the rapid expansion of emerging Asia, and the relatively weak growth of Latin America.