Global Resilience Sunshine Despite Very Cloudy Skies

A new Citi Research report from a team led by Global Chief Economist Nathan Sheets finds our “global resilience” narrative firmly intact, as the global economy's production side has grown more flexible and adaptable and AI spending has emerged as a robust engine of growth.

This story of resilience comes despite the global economy continuing to face an unusually wide range of challenges. Conflicts in Iran and Ukraine remain unresolved, the U. S. is redefining its role in the world, oil prices have been trading near $100 per barrel, central banks are tightening policy, and long-term interest rates have risen sharply across many countries. Unsurprisingly, both consumer and business confidence remain weak.

The global economy continues to expand nonetheless. We now forecast global growth of 2.6% this year, a slightly stronger forecast than last month’s. While that’s about 25 basis points (bp) below our forecast before the U.S.-Iran conflict began, it is also about 10 bp higher than our July outlook. Looking ahead, we expect growth to strengthen to 2.8% next year as pressures from the Middle East gradually ease.

What stands out most is how well the global economy has absorbed a significant energy shock. Despite much higher oil prices and elevated geopolitical uncertainty, economic activity has remained remarkably resilient. Firms have become more adaptable over the past decade, developing greater flexibility in responding to disruptions. As a result, it now takes a larger shock than in the past to push the global economy into a downturn.

Recent business surveys reinforce this picture. The global services sector weakened briefly during the early stages of the U.S.-Iran conflict but has since recovered. Manufacturing activity has been even stronger, reaching its highest levels since 2022. Some of that reflects inventory building as companies sought to secure critical inputs amid uncertainty. But a more important driver has been the rapid expansion of artificial intelligence.

AI Has Become a Global Growth Engine

Spending on AI has emerged as a major source of global growth. Although investment has been led by the U.S., its effects are increasingly visible across Asia, particularly in economies such as South Korea, Taiwan and China that are deeply integrated into technology supply chains.

We estimate that U.S. AI investment reached nearly $300 billion last year and accelerated further during the first half of this year, averaging $466 billion. Our projections suggest that investment will continue to rise sharply over the coming years.

The economic implications are increasingly significant. AI-related demand is supporting manufacturing activity, boosting technology exports and driving investment across a wide range of sectors. At the same time, debates about the societal impact of AI are intensifying, and political support for the technology appears to be weakening in some places. We believe AI will bring profound changes to both the economy and society. Policymakers should carefully evaluate those changes, but they also need to avoid unnecessarily constraining a technology that has the potential to generate substantial economic benefits.

Higher Energy Prices Are Pushing Inflation Up

Energy remains the most important near-term inflation challenge.

Oil prices have eased slightly amid hopes of renewed negotiations between the U.S. and Iran and the restart of a major Saudi pipeline. Even so, Brent crude remains near $100 a barrel. If sustained, those prices would create upside risks to inflation and downside risks to growth.

More concerning, refined fuel markets are tighter than the crude oil market itself. Limited global refining capacity has pushed gasoline prices roughly 20% above the increase in oil prices, while diesel prices have risen nearly 50% more than crude. Additional risks stem from potential restrictions on U.S. diesel exports.

As a result, we now expect global headline inflation to reach 3.5% this year, nearly a full percentage point above what we expected at the start of the year. This increase has been driven primarily by energy costs. Food prices have remained relatively subdued, though weather-related risks associated with El Niño could create pressures later this year and into next year.
Core inflation has also moved higher, though less dramatically. Across many major economies, projected core inflation has increased by roughly 50 bp since February. Much of that reflects higher transportation costs and supply-chain pressures linked to energy markets and critical industrial inputs such as aluminum, petrochemicals, and fertilizers.

Central Banks Have Turned More Hawkish

Faced with higher inflation, central banks have generally responded by tightening policy.

In theory, an energy shock presents a difficult choice, as higher energy prices can slow growth while simultaneously raising inflation. Central banks must decide whether supporting economic activity or controlling inflation is the greater priority.

This time, most central banks have chosen to focus on inflation. We have raised our policy-rate forecasts relative to February for 20 of the 27 major central banks we track.

Central banks in developed markets appear determined not to repeat what they view as a key mistake following the pandemic, when many initially underestimated inflation pressures. Emerging markets’ central banks, which generally navigated the post-pandemic inflation period more successfully, are also relying on familiar tightening strategies.

The European Central Bank has already raised rates twice and, in our view, is likely to deliver two additional increases over the next six months. The Fed also raised rates in September, reflecting the combination of a durable economy and inflation that remains above target. Markets now expect additional tightening, although we are less convinced such an aggressive path will ultimately be necessary.

Japan is also moving toward tighter policy. While the Bank of Japan has historically been cautious given decades of low inflation, a combination of stronger growth, firmer inflation and rising pressures in financial markets suggest a more restrictive stance is warranted. We expect Japan to opt for three additional rate increases by the end of next year, bringing its policy rate to 2%.

Why Long-Term Bond Yields Are Rising

Long-term bond yields have risen sharply around the world, both compared with pre-pandemic levels and since the Iran conflict began. In many countries, 10-year yields have increased by 60 to 100 bp since February.

We see four principal drivers of this move higher.

First, government borrowing requirements continue to rise. In the U.S., we expect fiscal deficits to average around 6% of gross domestic product over the coming decade, resulting in nearly $25 trillion of additional debt issuance.

Second, AI investment is increasingly being financed through long-term credit markets. As investment continues to expand, competition for available savings is intensifying.

Third, investors are demanding higher premiums for uncertainty. Political, geopolitical and technological risks have all increased, pushing risk premiums higher.

Fourth, estimates of neutral interest rates may be rising. The Fed's estimate of the neutral policy rate has gradually increased from 2.5% in early 2024 to 3.2% today, with some policymakers suggesting it could move even higher. If neutral rates rise, long-term yields naturally rise alongside them.

The key question going forward is whether central banks can successfully return inflation to target. In our view, they can, but the task remains unfinished. Encouragingly, longer-term inflation expectations remain relatively well anchored across major economies, suggesting that investors still have confidence in central banks' ability to maintain price stability.