Economic and financial risk insights: central banks stay alert to core services inflation pressures as global growth normalises

• The US economy is normalising with still healthy fundamentals. Recovery in Europe and China will narrow global growth divergence.
• Persistence in core services inflation remains the key challenge for the US and Europe. In Asia Pacific, inflation is near the bottom of the cycle and remains soft in China.
• Despite a first ECB rate cut, we still expect the cutting cycle in Europe and the US to be cautious, given resilient growth and core inflation.

Key economies are on the path to normalisation (see Figure 1). In the US, consumer fundamentals remain strong, but there are also signs of economic moderation. Positive real wage growth (March: 1.5% yoy) will continue to support demand and spending amid broad-based rebalancing in labour market conditions (see Figure 2). Europe is seeing a cautious yet earlier and faster-than-expected recovery, driven by stronger external demand at the start of the year. We expect the recovery to sustain through this year as rising real incomes boost domestic demand. We have further raised our UK 2024 GDP forecast to 0.8% (+0.4 ppts) after a strong 1Q24 GDP print that outperformed all other G7 nations. In China, growth momentum is not yet solid. Manufacturing PMIs retreated into contraction territory (May: 49.5), signalling slower sequential growth in 2Q24. That said, moderately improving consumption and investment, and strength in exports should offset prolonged property sector woes. The newly-announced  EU tariff on Chinese EVs should have limited impact, in our view. A potential trade war would, however, raise stagflation risk.

Figure 1: US, euro area and China qoq growth forecasts

Figure 2: US Labor Market Condition Index 

Some additional progress, but turbulence persists (see Figure 3). The US CPI report in May showed further moderation in headline and core inflation. Despite stubborn services inflation, "super-core" services prices declined for the first time since September 2021. In the euro area, May flash estimates suggest an increase in core services inflation to 4.1% yoy (vs 3.7% in April). In the UK, core CPI also surprised to the upside in May at 3.9% yoy. Numerous cultural and sporting events in Europe this summer may add upside to core inflation in the region. In Asia Pacific, inflation is near the bottom of the cycle, and remains muted in China. Soft inflation in Asia has had limited influence inflation persistence in the US and Europe, the latter stemming mainly from structural factors (eg, tight job markets), USD strength (“imported inflation”) and supply chain risks (see Fig.4).

Figure 3: US and euro area inflation forecast

Figure 4: Global shipping routes prices 

Cautious rate cutting cycle expected. The European Central Bank (ECB), short on the heels of the Bank of Canada, cut interest rates by 25bps in June. We see risks potentially skewed to two rather than three rate cuts from both the ECB and Bank of England this year (see Figure 5). For the US, we maintain our view of two Fed rate cuts this year beginning in September despite just one projected 2024 rate cut at the June FOMC policy meeting. Even though easing in G7 nations has started, the global cutting cycle will likely be constrained by resilient growth and as core services inflation persists. In the US and Europe, 10-year yields will likely remain elevated with slower policy normalisation. The Bank of Japan reduced its daily purchases of JGBs, pushing 10-year yields above 1% and adding further pressure to global long-term yields.

Figure 5: Central bank policy rate forecasts and market-implied rate trajectories

Figure 6: Expected change in the policy rate by the end of 2025

Our outlook for major economies remains unchanged. The risk of fewer policy rate cuts and upside to 10-year yields remains.