Summary
Highlights
Adam Posen welcomes everyone to the Peterson Institute for International Economics' semiannual global economic prospects event. He explains the format, which focuses on the growth outlook for major economies, particularly the US, given its current role as a major source of uncertainty and volatility. He introduces Karen Dynan, who will present the global economic prospects, and Arvin Subramanian, who will discuss 'China shock 2.0'.
Karen Dynan discusses the global economic outlook, noting that growth continues despite headwinds and risks. Incoming data has been stronger than expected, with major economies, especially the US and China, outperforming earlier forecasts. However, she believes this resilience is not sustainable and forecasts a slowing of the global economy, with GDP growth at 3.1% this year and 2.9% next year.
Karen Dynan details the economic outlook for large advanced economies. Most are expected to downshift by 2025. The US is seeing supported GDP growth due to AI optimism but faces intensifying tariff drag. Europe shows steady growth in the south but headwinds in Germany and France. Japan's growth is expected to pick up in 2026 due to fiscal and monetary policies, but inflation will rise. The UK continues to struggle with fiscal restraint, a strong pound, and weak productivity growth.
Karen Dynan highlights that India and China continue to lead among emerging market economies, even with tariff pressures. Chinese exports have held up, but a significant property downturn will lead to slowing next year. India's growth is sustained by domestic demand and a potential fiscal boost. Russia's economy is weighed down by a weak oil market and sanctions. Brazil is projected to see slower growth due to tight monetary policy and tariffs.
Karen Dynan delves into the US labor market, noting a stall in payroll growth, partly attributed to tighter immigration policies, which have significantly reduced net immigration. While interpreting this is complex, a broad-based slowing is evident. Other indicators like unemployment, job openings, and initial unemployment claims suggest a softening in 2023-2024 but not a significant deterioration in 2025, driven by the balance between reduced labor supply and demand.
Karen Dynan discusses the significant impact of US policy, particularly the highest tariffs in 90 years. These tariffs are expected to raise inflation and weaken consumer purchasing power. Coupled with high economic policy uncertainty, demand is likely to be weighed down. She explains that the inflationary effects of tariffs, though not fully visible yet due to delayed pass-throughs, importer absorption of costs, and stockpiling, are expected to materialize.
Karen Dynan highlights surprisingly strong productivity growth since the pandemic, attributing this more to better job matches and organizational changes rather than AI. However, moving forward, there's significant optimism surrounding AI's potential to drive productivity advances, as evidenced by rapid adoption rates of technologies like ChatGPT. This AI optimism is profoundly influencing the economy, particularly business investment and the stock market.
Karen Dynan analyzes US aggregate demand, pointing out that business investment has held up well, primarily driven by AI-related investments (information processing equipment, R&D, software). Other categories of fixed investment are weak. AI optimism also reflects in the highly concentrated S&P 500 growth, largely by the 'Magnificent Seven' tech firms. Consumption growth has slowed due to reduced immigration, slower income growth, and lower consumer sentiment, but it is supported by high household wealth.
Karen Dynan discusses the Federal Reserve's likely actions. Given stable inflation expectations, she anticipates two more rate cuts this year and an additional one early next year, driven by concerns about labor market deterioration and potential AI disappointments. These cuts are expected to put a floor on growth. She forecasts a rise in PCE inflation to three and a half percent next year, remaining above 3%, and a modest increase in the unemployment rate.
Karen Dynan concludes that her baseline economic outlook is fragile. While AI is expected to boost productivity and output growth over time, the path there may be uneven. She warns that any disappointments in AI, even temporary ones, could sap economic momentum, leading to larger negative impacts from tariffs, immigration, and other policy changes.
Arvin Subramanian presents his and Shomitro Chaty's view on 'China Shock 2.0', emphasizing its greater impact on low and middle-income developing countries than on advanced economies. He argues that while 'China Shock 1.0' impacted advanced countries significantly, current 'China shock' effects (imports from China) for developing countries are much larger, both in level and pace, as a percentage of GDP, indicating China's continued dominance in low-skilled goods exports.
Arvin Subramanian highlights that China continues to export a vast amount of goods despite its manufacturing wages being three to five times higher than those in other developing countries. He uses the apparel sector as an example, showing China's sustained high global market share. He poses whether this is due to technology and robotics or distortions like exchange rates, excess capacity, and subsidies, suggesting that China has not 'vacated space' for developing countries in low-skill production.
Arvin Subramanian notes that developing countries' exports of low-skilled goods to China have declined since the Global Financial Crisis, raising questions about the openness of the Chinese market. He discusses China's aspirations to be a global hegemon, which, like historical hegemons, should provide public goods like open markets. He suggests that while China has made some positive moves, its mercantilism towards developing countries needs to reverse to demonstrate its commitment to global leadership.
Adam Posen presents his argument that US inflation will be significantly higher and more persistent over the next two years than most forecasts predict. He notes that recent trends (lower unemployment, higher growth, lower dollar) already imply more inflation. His argument is structured around three main points: the macroeconomic outlook, loose monetary policy, and less anchored inflation expectations.
Adam Posen details the macroeconomic factors contributing to higher inflation. He emphasizes that the full effects of tariffs, including price pass-through, have not yet materialized due to initial disbelief, stockpiling, political pressure, and the complexity of supply chain adjustments. He also highlights the stagflationary effects of deportation policies, arguing that migrant labor still underpins key sectors, and the labor market shows little slack.
Adam Posen predicts that fiscal policy will be meaningfully looser in 2026, primarily due to an estimated 20 billion dollar loss in tax collection from IRS budget cuts and significant declines in tariff revenues as consumption or sourcing shifts. Regarding monetary policy, he argues it’s looser than the FOMC perceives, as financial conditions remain benign, credit spreads are low, and much investment is internally financed or less interest-rate sensitive. He also suggests that the natural rate of interest (r-star) is higher in this cycle.
Adam Posen speculates that inflation expectations are less well-anchored than surveys indicate, where recent experience of inflation has a lasting impact. He warns of a sequence of staggered, salient price hikes visible to consumers. Critically, he expresses concern about the weakening of Federal Reserve independence, highlighting potential political interference with Reserve Bank president reappointments and the overall impact on the Fed's ability to maintain low inflation. He invites attendees to a conference on central bank independence.
Jim Alonus from QIG macro poses a question about the Fed's reaction function, suggesting that if inflation unfolds as Adam believes, the Fed will raise rates, potentially damaging its credibility and accelerating the path to losing independence. Karen Dynan acknowledges that a recession would also hurt Fed credibility and could push towards easier policy to protect independence. Adam Posen agrees that the current macro outcomes don't justify rate cuts and notes the Fed's historical tendency to fight the last war.
Hector Torres asks about the consistency of dollar dominance with a pursuit of self-sufficiency. He compares it to failed import substitution policies in Latin America. Adam Posen explains that while dollar dominance can persist due to a lack of alternatives and market depth, a protectionist stance is not conducive to long-term dominance. He notes that the dollar becomes less central, and other currencies or assets might step up partially, leading to a world with a higher shortage of safe assets.
Karen Dynan adds that the undermining of dollar dominance and its decline already offset some import substitution from tariffs. She stresses that the loss of dominance happens slowly but can be irreversible if alternatives emerge. Adam Posen concludes by reiterating that it's not an 'all or nothing' scenario for the dollar but rather a gradual decentering. He plugs upcoming Peterson Institute events on Europe's role in the changing international monetary system.