Newton's Third Law applies in some form to economies
For every action there is a reaction, this applies to economies too. Looking into 2025, we are expecting three key themes to dominate -- Trump's agenda and its reaction from China among others; how economies adjust to high policy rates; and how expansive fiscal policy is managed.
In the physical world, for every action there is an equal and opposite reaction. For the economy, the opposing forces are rarely equal, but they are nonetheless important. Whenever we consider the effects of big shifts or policy actions on economic outcomes (or indeed political ones), we cannot ignore how others will react to those actions. Looking ahead to 2025 and beyond, the landscape – and especially the risks around the base case – will be shaped by both action and reaction.
As inauguration day approaches, some of the incoming Trump administration’s policy agenda is taking shape. Increased tariffs on Chinese imports are a given. The threat of tariffs on neighbouring countries has also been used to achieve other policy objectives. Corporate tax cuts and other businessfriendly policies are also on the table, which has generated something of an ‘American Exceptionalism’ tone in asset markets, especially for equities and FX.
It is not clear how much of this agenda can be enacted. It is clear, though, that these policies cannot be viewed in isolation. The Chinese government has already announced several stimulus packages, as well as export bans for rare-earth minerals. More broadly, some reconfiguration of supply chains to put later stages of production outside China is already occurring, and more can be expected. The investment to achieve this will help offset the generally negative effect of trade restrictions and policy uncertainty on investment found by the IMF, stemming from delays to investment decisions.
For Australia, the effect of US tariffs will likely be mostly indirect, though there might be some minor impacts in thirdcountry markets where Australian and US exports compete. To the extent that the net effect of trade measures and domestic policy responses slow activity in China, Australia’s exports and terms of trade will weaken. Our base-case forecast of a 9% fall in commodity prices reflects our assessment of the likely net effect of trade restrictions: relatively minor for growth, but visible in commodity prices and the exchange rate.
While a weaker exchange rate would add to imported inflation, a partial offset may occur to the extent Australia is the beneficiary of trade diversion. For example, we note that many of the countries that have not announced plans to impose or increase tariffs on Chinese electric vehicles are also right-hand-drive (left side of the road) countries such as Japan and India. Any redirection of Chinese vehicle exports to these markets will also work for Australia.
Policy rates across central banks are expected to end at a higher level than prior to the pandemic. While the question through 2024 was ‘when?’, in 2025 markets will be asking ‘how much more?’. Where this higher end-point sits in relation to neutral differs widely. In developed markets, the fiscal support during the pandemic – some of which remains in the system – implies a higher end point than in emerging markets.
In Europe and Canada, the market’s assessment of the terminal rate in 2025 is below neutral, reflecting risks to growth from an extended period of monetary tightening, a slowdown in global demand and – in some European economies such as France – the threat of fiscal consolidation.
For the United States and Australia, the objective is more likely for monetary policy settings to be at or above neutral, mindful of the risks of sticky inflation. Looking beyond 2025, policy rates could drift up as growth risks unwind, arguably rising to above neutral in the United States.
To the extent that ‘American Exceptionalism’ flows through to different growth trajectories – which is by no means certain – this will also flow through to short-term rates and exchange rates. This runs counter to the longer-term tendency for exchange rates to converge to fair value based on purchasing power parity – on that metric, the USD looks richly valued and is likely to remain so for a while yet. A sudden unwinding in this differentiation in views of growth prospects would affect market pricing for yields, FX and equities.
For emerging markets, less fiscal stimulus during the pandemic meant activity was often slower to come back to previous trends than in developed markets, if it did at all. Inflation was also a lot more benign and much of the tightening came in response to moves by the FOMC rather than risks to the domestic inflation outlook. As we have previously discussed, this will mean policy rates end at a narrower spread to the fed funds rate than was historically typical. EMs will therefore need to attract capital through their growth prospects rather than through the carry trade, a task that may become harder given the potential disruptions to trade patterns. Maintaining higher spreads would weigh on domestic demand, but it would also support exchange rates. This tradeoff will be especially difficult to navigate for countries where imported inflation remains an issue, such as India.
In Australia, the disinflation journey has been similar to its developed-economy peers, but on a later timetable. As the RBA has gained confidence in the inflation outlook, it has shifted away from the ‘not ruling anything in or out’ language it used for most of 2024, and it is now clearly contemplating cutting rates in the first half of 2025. The exact timing still depends on the data flow from here.
How far central banks ease depends on demand conditions and how they feed in to inflation pressures once the current pandemic-related surge in inflation unwinds. Fiscal policy is an important factor in this, and a range of actions and reactions are driving policy in an expansive direction in many developed economies. These include: increased defence spending as a reaction to geopolitical risks and the incoming Trump administration’s expectations of its allies; increased health spending as a reaction to population ageing; and increased investment in energy infrastructure as a reaction to the challenges of climate change.
With the US federal deficit already at 6% of GDP for the past few years, US fiscal policy was always going to be adding to the level of demand regardless of who won the Presidential election. At the margin though, Trump’s victory and the Republican clean sweep adds to the stimulatory stance, the mix set to favour lower taxes and lower government spending.
The reaction to looser fiscal policy – and a tilt towards investment versus saving more broadly – has been and will continue to be seen in yields. Bond yields in advanced economies are already noticeably higher than pre-pandemic and we expect that to continue.
Ultimately, the time will come to consider what the pace of growth in debt should be, taking into account inflation, GDP growth and higher interest rates. For the countries embarking on some fiscal consolidation, such as those in Europe, growth risks will be front and centre in 2025. Not just that, fiscal consolidation tends to be politically unpopular and will only further add to political risks in the region. These risks will be exacerbated if the consolidation is partly motivated by a need to make room for increased defence spending. And while the experience of the NDIS program in Australia shows that a sustained period of rapid expansion in fiscal spending can result in attempts to rein in that growth, the pace of consolidation is difficult to predict and rarely smooth.
These forces inform our longstanding house view that the global structure of interest rates will be higher going forward than it was in the period between the GFC and the pandemic. This includes a higher neutral policy rate; term and risk premia are also likely to be wider than the pre-pandemic ‘search for yield’ phase.
Because the overall global rate structure is driven by global forces, the rates structure in Australia will be affected even though the fiscal situation here is different to that in the United States. Policy rates will continue to be set according to local demand and inflation pressures, and country risk spreads can change over time. However, the average rate structure around which policy rates fluctuate is shaped by global forces.
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