Unofficially, this week marks the start of 2025. Seasonal holidays have concluded. Today, most workers return to their jobs, children head back to school, and governments resume their normal functions. It is an opportune time to consider the global economic outlook, alongside key themes we are following for 2025.
The consensus of economists calls for a moderate global economic expansion in 2025, accompanied by modest inflation. Most economists believe US protectionist policies on trade and immigration will have a negative impact on global growth, only partially offset by rising US corporate spending spurred by business-friendly tax and regulatory changes.
We agree. Overall, the global economy is on a stable footing. In advanced economies, private sector imbalances are absent. Gaps between aggregate demand and supply that emerged during the pandemic, and caused sharp jumps in prices, have disappeared. Even China’s massive property market debt burden poses more of a long-term corrosive challenge to its growth than a short-term calamity.
US inflation remains too high and is unlikely to decelerate as fast as the Federal Reserve or financial markets wish. But its decline over the past two years, alongside similar reductions in Europe or China, have facilitated lower interest rates and created more latitude for monetary policy flexibility, if needed.
Potential disturbances include a dramatic escalation of trade conflicts, the outbreak of war, or another pandemic. All are risks worth heeding, yet none is now so prominent to warrant expectations for a dramatic downturn in the world economy this year.
That said, global growth will not be evenly distributed. The US benefits from high levels of employment, low household indebtedness (relative to personal income), rapid growth in information technology, favorable costs of capital, and a profits-friendly regulatory and tax environment. Those factors will likely underpin another year of US GDP growth ‘exceptionalism’.
In contrast, China’s lackluster growth, flagging world trade, tepid prospects for traditional industrial sectors, ageing populations, and low levels of household and business confidence outside the US point to another year of sluggish economic activity across much of Asia, Europe, and the emerging economy complex.
If that summary of global economic prospects sounds like ‘more of the same’, it largely is. But beneath the veneer of steady and resilient (if unspectacular) global growth, other dynamics are at work, ones that may prove decisive for the economic, financial, and political fortunes of many in 2025. We now turn to those themes.
Sticky US inflation
The first is sticky US inflation. Completing the journey from high inflation in 2022 to the Fed’s 2.0% inflation target is proving to be difficult. Inflation has recently become stuck about a percentage point (depending on the measure) above where the Fed wants it to be.
To make matters worse, stubborn inflation is not down to a single factor.
Housing inflation is the by-product of insufficient supply amid strong demand. Supply constraints range from regulatory (permitting) to financial (holders of low-interest mortgages unwilling to sell) to higher material and labor costs. Demand for housing is boosted by population and jobs growth.
Services price inflation is boosted by rising insurance premiums, which reflect lags from higher prices for houses and cars as well as the soaring costs of natural disasters. Healthcare inflation is famously invariant to the business cycle. Strong demand for labor amid shortages for skilled and unskilled workers puts upward pressure on wages. To wit, even after some moderation last year, annual increases in unit labor costs since 2022 are running more than a percentage point faster than their average rate over the preceding fifteen years.
Higher US interest rates
Sticky US inflation has several important implications for public policy and financial markets. As the Federal Reserve has recently acknowledged, stubborn inflation reduces the scope for future interest rate cuts. Those reductions could become even less likely if new tariffs and curbs on immigration push up more prices and wages this year.
For financial markets, a more cautious Fed narrows the scope for stock market gains, given the market’s high valuations (more than 30% above long-term norms). The combination of high valuations and higher interest rates places the onus squarely on corporate profits to beat already lofty expectations. Indeed, as company earnings guidance has become more cautious in since early December, the stock market has wobbled.
The bond market has also dipped as diminished hopes for Fed rate cuts have translated into higher bond yields. The same story is playing out in global currency markets, where the trade-weighted value of the US dollar has advanced over 6% in the past three months, fueled both by rising US interest rates and the threat of new US tariffs. Compounding matters, dollar strength hurts the US equity market by reducing the dollar value of foreign-sourced earnings for US companies.
A shaky US equity market, higher borrowing rates for consumers and business, and a stronger dollar are unwelcome developments for the incoming Trump Administration. That reality could put the White House and the Federal Reserve on a collision course in 2025, a concern we have previously highlighted in these pages.
Corrosive US dollar strength
Moreover, a strong US dollar presents a ‘lose-lose’ proposition for the world economy. For the US, dollar strength erodes competitiveness and reduces the value of foreign sourced profits. A strong dollar could therefore be a key risk for the US equity market, whose valuations demand positive earnings surprises to sustain upside momentum.
For the rest of the world, however, the corresponding depreciation of their currencies may not improve their effective competitiveness. That’s because of rising barriers to trade. Channels to grow exports will be narrowed by US tariff and non-tariff restrictions on imports.
That can have negative global after-effects. For instance, China may wish to divert exports to Europe should the Trump Administration impose 60% across-the-board tariffs on Chinese imports, but Europe is unlikely to accept that outcome and, if necessary, may impose import barriers of its own.
As such, actions and reactions may cascade across the global trading system, impinging total world exports, including for countries with weaker currencies. Yet at the same time, the depreciation of their currencies increases the cost of imports (e.g., for energy), which then erodes domestic purchasing power and confidence.
In short, dollar strength could have a pernicious impact on all countries, with negative reverberations amplifying its adverse effects on global growth and exacerbating international tensions.
Germany’s ‘debt brake’
In two months, Germany will hold elections. The outcome merits close attention. Domestically, the established postwar parties fear populism, above all from the right. Yet many observers also recognize that Germany must adapt to a changing world in economic, financial, and national security dimensions.
A new German government is likely to advocate for cuts in corporate income tax rates to restore competitiveness and to attract foreign capital. It will also be under pressure to increase spending on defense and national security. At the same time, large cuts in the social safety net are unpopular and more, not less, government spending is required to address the grievances of those enticed by right-wing populism.
Accordingly, there will be significant pressure for Germany to relax, or possibly even remove, its constitutionally mandated ‘debt brake’, which limits Germany’s structural federal government deficit to 0.35% of GDP. Doing so, however, would require a two-thirds majority in the Bundestag and Bundesrat, which probably requires the formation of an otherwise unpopular ‘grand coalition’ following this year’s elections. Although other ‘workarounds’ to Germany’s fiscal straitjacket may be possible (special purpose vehicles or public-private infrastructure ventures), Germany nevertheless finds itself at a crossroads. It must do more to promote growth, ensure domestic tranquility, and provide for its national defense—goals that are probably incompatible with its existing ‘debt brake’.
Global military spending
The perception, largely correct, that Donald Trump represents a more isolationist US is unnerving for most countries. It creates uncertainty and anxiety in a world that this century has seen countries resort to force to achieve their aims. With flagging confidence in benign US military and diplomatic hegemony, the logical response for most countries is to take greater responsibility for their national security.
That statement may itself sound benign and even welcome to Americans long tired of financing and sacrificing for others. It is certainly good news for defense and security contractors, already enjoying the largest single-year percentage increase in military spending since 2009, topping $2.4 trillion in 2023. That trend is likely to continue as countries increasingly feel they must fend for themselves as the US withdraws.
Whether the changing size, distribution, and nature of global military spending is security enhancing or its opposite, we’ll leave for others to speculate. We’ll simply make two observations. First, Hobbesian states of nature and power vacuums are not generally seen as preconditions for peace and stability. Second, arms races benefit those who produce armaments, which today spans both traditional military contractors and those at the cutting edge of technology.
Summary
In sum, the world economy in 2025 superficially resembles that of 2024. Moderate growth and inflation are probable. Endogenously, the global economy is in pretty good shape.
But can the same be said for factors seen as exogenous—politics, discord, and strife?
Beneath a tranquil economic surface, important changes are taking place. Many include dynamics that neither financial markets nor ordinary citizens can easily incorporate into their everyday decision-making. Financial markets, famously, do not anticipate discontinuity.
A seemingly healthy world economy masks unhealthy habits, which may gradually—and then suddenly—change perceptions. Economics alone cannot reveal the fault lines now emerging. Other facets demand our attention, including old-fashioned politics. The global trading system finds itself in its most perilous state in nearly a century. Not coincidentally, the same can be said for international relations and national security.
A fulsome assessment of the 2025 global economic outlook, in other words, must go beyond economics.
