Base scenario for the global economy in 2025.

It is a kind of tradition that every December we look back on the year that is ending and think about what lies ahead. Such a custom is not only on a personal level - in my family, we usually do it at dinner - but we also find it in a broader sense, as a time suitable to analyze the intersection of economics, national politics and global geopolitics.

It is understandable if, as a starting point, you would expect these three areas to be aligned. After all, they are deeply interconnected, implying a dynamic process of mutual reinforcement. However, the year 2024 brought an unusual divergence in that relationship, and it actually widened over the course of the year, instead of narrowing.

Let's start with geopolitics. In 2024, Russia gained more advantages in the Ukraine war than the predictions of a year ago suggested. Likewise, the human suffering and physical destruction caused by the war between Israel and Hamas in the Gaza Strip has exceeded the already gloomy expectations of most observers and has spread to other countries, such as Lebanon. The apparent impunity of the powerful, coupled with the absence of effective mechanisms to prevent severe humanitarian crises, has further reinforced the sense among many that the global order is fundamentally unbalanced and devoid of any applicable safeguards.

As for domestic politics, turmoil has become the norm in many countries. The governments of France and Germany, Europe's largest economies, have fallen, leaving the European Union without political leadership. And after Donald Trump's victory in the presidential election in November, America is preparing for a political transition that will likely bring a significant increase in the political influence of the new "counter-elite."

At the same time, the "axis of reversal", consisting of China, Iran, North Korea and Russia, is trying to challenge the international order dominated by the West. Other recent events - notably the South Korean president's sudden declaration of a now revoked and lifted state of emergency and the fall of Bashar al-Assad's regime in Syria - have further reinforced the impression that we live in a time of extreme geopolitical and political instability.

The past year also brought a number of worrying macroeconomic trends. The economic "disease" in Europe is intensifying because countries cannot cope with low growth rates and large budget deficits. China has failed to respond convincingly to the clear and obvious threat of "Japanization", with adverse demographic trends, high indebtedness and a prolonged housing market slump undermining growth, economic efficiency and consumer confidence.

Still, the stock market remained relatively stable and saw strong returns, including nearly 60 days with record high closes for the S&P index. One of the main reasons for this is the exceptional situation in the American economy. Contrary to the expectations of most economists, the American economy not only did not weaken, but also advanced. When the volume of foreign capital America attracts and the volume of investment in the future drivers of productivity, competitiveness and growth are taken into account, the US will likely still be ahead of other major economies in 2025.

One of the consequences of this success was the refusal of the US Federal Reserve to ease interest rates by 1,75-2 percentage points, which the markets were counting on a year ago. This trend is likely to continue: at the December meeting, the FED announced that there will be fewer cuts in 2025 and that the "terminal" (long-term) rate will be raised.

However, political and geopolitical instability - and limited prospects for significant improvements - pose risks to the preservation of America's economic exceptionalism. Even if the US continues to outperform its rivals, as expected, the range of possible outcomes (economic growth and inflation rate) is now wider. In fact, today the range of possible economic and political outcomes around the world has expanded, not only because of increased negative risks, but also because of positive innovations (artificial intelligence, life sciences, food security, health care, defense) that could transform entire sectors and accelerate increasing productivity.

Barring a major policy shift, my baseline scenario for the US is slower economic growth (albeit higher than peer economies) and persistent inflation. This will force the Fed to choose whether to accept inflation above its target level or try to contain it at the risk of pushing the economy into recession.

Globally, economic fragmentation will continue, forcing some countries to increasingly diversify their foreign exchange reserves against the US dollar and explore alternatives to Western payment systems. The yield on 4,75-year US Treasuries (the global benchmark) will rise slightly and trade mostly in the 5-XNUMX% range. When it comes to financial markets, it could face greater challenges in maintaining the status of a "good house" in a problematic geo-economic environment.

That's the way things are right now. But, in addition to recognizing the wider dispersion of possible economic outcomes in 2025, it will be crucial to periodically check the actual evolution of any baseline that is adopted.

The author is President of Queens College, University of Cambridge and Professor at the Wharton School of the University of Pennsylvania

Copyright: Project Syndicate, 2024. (translation: NR)