OECD Economic Outlook, Volume 2023 Issue 2

1. General Assessment of the macroeconomic situation

Introduction

The global economy continues to confront the challenges of persistent inflation and subdued growth prospects. GDP growth has been stronger than expected so far in 2023, but is now moderating as the impact of tighter financial conditions, weak trade growth and lower business and consumer confidence is increasingly felt. Financial conditions are restrictive, with forward-looking real interest rates having generally risen further in recent months. Activity has slowed in interest-sensitive sectors, particularly housing markets, and in economies reliant on bank‑based finance, especially in Europe. Heightened geopolitical tensions are also again adding to uncertainty about the near-term outlook. Headline inflation has fallen in almost all economies, easing pressures on household incomes, but core inflation remains relatively high.

Global GDP growth is projected to ease to 2.7% in 2024, from 2.9% this year, before edging up to 3% in 2025 as real income growth recovers and policy interest rates start to be lowered (Table 1.1). A growing divergence across economies is expected to persist in the near term, with growth in the emerging‑market economies generally holding up better than in the advanced economies, and growth in Europe being relatively subdued compared to that in North America and the major Asian economies. Annual consumer price inflation in the G20 economies is projected to continue easing gradually as cost pressures moderate, declining to 5.8% and 3.8% in 2024 and 2025 respectively, from 6.2% in 2023. By 2025, inflation is projected to be back on target in most major economies.

Risks to the near-term global outlook remain tilted to the downside. Heightened geopolitical tensions due to the conflict following the terrorist attacks on Israel by Hamas are a key near-term concern, particularly if the conflict were to broaden. This could result in significant disruptions to energy markets and major trade routes, and additional risk repricing in financial markets, that would slow growth and add to inflation. Headwinds from rising trade restrictions, inward-looking policies and the restructuring of global value chains are also contributing to the uncertain outlook for global trade, which is a key concern given the importance of trade for productivity and development. Continuing cost pressures, renewed rises in energy and food prices, or signs of an upward drift in inflation expectations could compel central banks to keep policy rates higher for longer than expected, potentially generating additional stress in financial markets. Conversely, the impact of higher interest rates and tighter credit standards could prove stronger than anticipated, leading to a more severe slowdown in spending, rising unemployment and higher bankruptcies. Tighter-than-expected global financial conditions would also intensify financial vulnerabilities, including in emerging-market and developing economies, and add to debt‑servicing pressures in lower-income countries. On the upside, the global economy and financial markets have so far proved relatively resilient to the tightening of monetary policy, and inflation could return to target without a marked growth slowdown or a sharp rise in unemployment. A continuation of this pattern would imply better‑than‑expected growth in 2024 while inflation eases. Growth would also be stronger if households were willing to spend excess savings accumulated during the pandemic, but inflation persistence might also be prolonged.

Against this backdrop, the key policy priorities are to ensure that inflation is durably reduced, address mounting fiscal pressures, and improve the prospects for sustainable and inclusive growth in the medium term.

• Monetary policy needs to remain restrictive until there are clear signs that underlying inflationary pressures are durably lowered, with inflation expectations moderating further and a rebalancing of supply and demand in labour and product markets. Policy rates appear to be at or close to their peak in most advanced economies, although some additional rate rises could still be needed if underlying inflationary pressures prove persistent. The need to maintain downward pressure on inflation will limit scope for policy rate reductions until well into 2024, with nominal rates then being lowered in parallel with inflation. In Japan, a gradual increase in policy interest rates would be appropriate in 2024-25 provided inflation settles at 2%, as projected. Policy rate reductions have already begun in some emerging-market economies where policy tightening was initiated at a relatively early stage and inflation has eased significantly. There is scope for further rate reductions over 2024‑25, although tight global financial conditions and the need to ensure anchored inflation expectations limit the pace at which these can occur.

• Governments face rising fiscal pressures from high debt burdens and additional spending on ageing populations, the climate transition and defence. Debt-service costs are also increasing as low‑yielding debt matures and is replaced by new issuance. Without action, future debt burdens are likely to rise significantly. Past episodes of sustained debt reductions have generally been achieved with countries maintaining a primary budget surplus. On current plans, few countries are likely to achieve this in 2024-25, suggesting it will be more challenging to reduce high debt now than in the past. Stronger near-term efforts are necessary to create space to meet future spending pressures. A key step is to ensure that fiscal support measures, including remaining energy support schemes, are either withdrawn or become better targeted towards those most in need. Credible medium-term fiscal frameworks, with clear spending and tax plans that address future fiscal pressures and preserve the investment needed to support long-term growth and the climate transition, are also essential to ensure sustainability and provide flexibility to respond to future shocks.

• Enhanced multilateral co-operation is required to revive global trade. In an interconnected world, open and well-functioning international markets under a rules-based global trading system are an important source of long-term prosperity for both advanced and emerging‑market economies. A key policy challenge is to balance the need for enhanced resilience of global value chains without eroding their benefits for efficiency or losing sight of the income gains that could accrue from lowering trade barriers, especially in service sectors.

• Given the long-term decline in economic growth and the pressing challenges from ageing populations, the climate transition and digitalisation, ambitious structural reforms are needed to reinvigorate growth and improve its quality. As emphasised in the 2023 edition of the OECD Going for Growth report, renewed efforts to reduce constraints in product and labour markets, strengthen investment and labour force participation and enhance skills development would improve productivity prospects and maximise the gains from the digital transformation. Faster progress towards decarbonisation is also essential. Increasing green and digital infrastructure investment and support for innovation, strengthening standards to enable a reduction in emissions, and raising the scope and level of carbon pricing are all key areas for policy action.

Table 1.1. Global growth is projected to remain subdued

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Recent developments

Global growth has proved resilient, but there are signs of a slowdown

In the context of the negative shocks from Russia’s war of aggression against Ukraine and the sharp tightening of monetary policy as central banks responded to above-target inflation, global growth has been unexpectedly resilient. The global economy expanded at an annualised rate of 3.1% in the first half of 2023, up from 2.8% in the second half of 2022, similar to the pre-pandemic trend (Figure 1.1). Available data for the third quarter of 2023 suggest that growth was little changed for the OECD economies as a whole, though with some slowdown among emerging-market and developing economies. There are also signs of increasing divergence across countries. Growth has slowed in many advanced economies, especially in Europe, where the importance of bank finance is relatively high and where the drag on incomes from higher energy costs has been particularly strong. The euro area economy grew by only 0.1% in the year to the third quarter of 2023, and several countries experienced output declines over the same period, particularly in Central and Eastern Europe. In contrast, GDP growth has held up better in the United States and many other commodity‑producing economies, and the emerging‑market and developing economies have collectively maintained growth rates close to those seen prior to the pandemic. Japan, the only major advanced economy yet to tighten monetary policy, has also experienced above‑trend growth over the past year despite facing higher energy prices, though output declined in the third quarter of 2023. Growth in China has been volatile since the reopening of the economy at the start of 2023, amidst ongoing pressures in the property sector, but stabilised in the third quarter, helped by the implementation of a wide range of policy measures to support activity.

Across much of the world, tighter financial conditions are increasingly weighing on interest‑sensitive expenditures. However, total household consumption has held up better than expected in the advanced economies, given the fall in real incomes over the past two years, and continued to expand steadily in most major emerging-market economies. Spending has been supported by tight labour markets, with job growth remaining sufficiently strong to keep unemployment rates near historic lows in many countries. In a number of economies, most notably the United States, household spending is also being sustained by the continued low level of household saving rates, with excess savings from the first year of the pandemic being reduced over the past two years. Business investment was also surprisingly positive in some OECD countries in the first half of 2023, despite the rise in the cost of external finance and, in some cases, near‑stagnant GDP. In part this may have reflected the greater scope for internal finance of new investment given the rise in profit shares since the start of the pandemic. However, business investment declined in both the United States and Japan in the third quarter of 2023.

A range of recent developments suggest that growth has begun to lose momentum in many economies. These include: the weak PMI readings in many major economies – with India a notable exception (Figure 1.2); slowing credit growth in many economies; and persistently low levels of consumer confidence. These factors all point to a weakening of global growth prospects amidst a widening cross‑country divergence.

Figure 1.1. Global growth proved resilient in the first half of 2023

Quarter-on-quarter change in real GDP

Source: OECD Economic Outlook 114 database; and OECD calculations.

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Figure 1.2. Survey indicators suggest that growth is slowing in many countries

Note: Values below 50 indicate that a balance of firms reports a contraction in output. Panel B includes the November Flash PMIs for the advanced economies.

Source: S&P Global.

Among the signs that tighter financial conditions are curtailing demand is the increase in corporate bankruptcies in many OECD countries (see risk section). Firms are being squeezed by higher debt‑service burdens, tighter credit standards and, for many, slowing sales growth. New lending to non‑financial corporations in the major advanced economies is either growing more slowly or even contracting, and this should be reflected in a slowdown in OECD non-residential investment. Housing investment is particularly sensitive to interest rates, and was generally weak among OECD economies in the second half of 2022 and the first half of this year as mortgage rates and other long-term lending rates followed policy rates upward (Figure 1.3). Amongst the emerging-market economies, residential investment has slowed this year in Chile, China, Colombia and South Africa, but has stabilised in Mexico after earlier declines. The rise in house prices, strong in many countries in 2021 and much of 2022, has slowed and in some cases reversed. House prices are down almost everywhere in real terms, and the volume of transactions has declined sharply. While there are signs of a bottoming out of housing sector investment in some countries where it has already fallen sharply, including the United States, sales and investment continue to soften in many other countries, especially in Europe.

While unemployment rates remain low, signs of labour market easing have started to appear in many economies, including a slowdown in annual employment growth, falling quit rates, lower vacancies, and in some cases a mild upturn in unemployment rates (Figure 1.4, Panel A). However, labour force growth has remained strong, rising by over 1½ per cent over the year to the third quarter of 2023 in the OECD as a whole, helped by continued high inflows of economic migrants in many countries and, in Europe, the integration of refugees into the labour market (OECD, 2023a). Nominal wage growth has begun to moderate in many economies (Figure 1.4, Panel B), but unit labour cost growth still remains high due to weak productivity growth, with costs rising by more than 4% per annum in many OECD countries over the past year.

Figure 1.3. Housing market activity is slowing

Gross fixed capital formation, housing, volume

Source: OECD Economic Outlook 114 database; and OECD calculations.

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Figure 1.4. Labour market pressures have begun to ease

Note: Panel A: Seasonally adjusted stock of unfilled job vacancies, based on data for 12 OECD economies. Panel B: The Indeed Wage Tracker is based on the median of the annual change in wages and salaries advertised in job postings on Indeed, controlling for job titles.

Source: Indeed; OECD Short-Term Labour Market Statistics database; and OECD calculations.

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Headline inflation has declined but core inflation is proving sticky

Headline inflation has fallen almost everywhere over the past year, primarily because of the partial reversal of the very large rise in energy prices over the previous two years. However, since June production cuts by key OPEC+ economies have contributed to higher prices. A variety of supply disruptions, alongside rising geopolitical tensions, have also contributed to volatility in European natural gas prices in the latter half of 2023. The upturn in oil prices since June has been reflected in retail prices for petrol, with headline inflation turning back up in some advanced and emerging-market countries.

Most measures of underlying inflation, including core inflation (excluding food and energy), have moderated, but with smaller declines so far. Even so, on a seasonally adjusted quarter‑on‑quarter basis, core inflation is estimated to have fallen to an annualised rate of below 3% in the G7 economies as a whole in the third quarter of 2023, down from over 4¼ per cent during the first half of the year. Services price inflation remains stickier than goods price inflation as wages are generally the main production cost in services. This is reflected in the distribution of price changes within the inflation basket, with over half of the items still having annual inflation rates above 4% in the United States, the euro area and the United Kingdom (Figure 1.5).

The cost counterpart to the high levels of inflation over the past two years has been higher unit labour costs and higher unit profits. National accounts data for OECD countries indicate that both factors helped to account for the increase in domestically generated inflation in 2022 (OECD, 2023b), a pattern last seen in the 1970s, when energy prices were also rising rapidly. In most advanced economies there was an increase in the profit share of national income in 2022 relative to 2019. In 2023, as inflation has subsided, the contribution of unit profits to inflation has fallen, although it remains higher than prior to the pandemic in most OECD economies. In contrast, the contributions from unit labour costs have increased (Figure 1.6). The experience to date does not point to a large structural shift in the distribution of national income towards firms – rather, it suggests that wages, which initially lagged behind prices, are now catching up, pushing the labour share of income back up. Moreover, firm-level studies do not indicate a generalised increase in mark-ups as inflation rose; mark-ups even fell for some sectors despite a rise in sectoral unit profits, as the latter omits some corporate costs (Piton et al., 2023).

Figure 1.5. Inflation is easing, but prices are still rising rapidly for many items

Share of consumer price basket accounted for by items in different inflation ranges

Source: Bank of England; Bank of Japan; Bureau of Economic Analysis; Eurostat; and OECD calculations.

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Figure 1.6. Unit labour costs are now contributing more to inflation

Contribution to year-on-year change in the GDP deflator

Note: Based on data for 33 OECD countries. Unit profits are measured as the adjusted gross operating surplus per unit of real GDP, and unit labour costs as the adjusted labour compensation per unit of real GDP. The published gross operating surplus data are adjusted by allocating part of self-employment income to labour compensation, following the methodology in Schwellnus et al., (2018).

Source: OECD Economic Outlook 114 database; and OECD calculations.

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Trade growth is weak and trade openness has declined

Global trade growth has been surprisingly weak over the past year. Volumes of traded goods and services are estimated to have grown by only 0.1% at an annualised rate in the first half of 2023, following the weak expansion in the latter half of 2022. Merchandise trade volumes fell by 1.9% annualised in the first half of the year, whilst services trade volumes are estimated to have risen by 6.6%, as the ongoing normalisation of travel in Asia helped to boost tourism. Trade volumes rose sharply in China in the first half of 2023 after a very weak second half of 2022, but growth in the OECD economies slowed (Figure 1.7, Panel A). Data for the third quarter show some recovery in trade growth in the United States, Japan and Korea, alongside slower, but still positive Chinese trade growth. By contrast, trade volumes in Germany, France, Spain and the Netherlands contracted.

Near-term indicators suggest that trade will recover only gradually from the current slowdown. Aggregate container port activity indicators point to a mild recovery in total volumes, despite the strong upturn in China (Figure 1.7, Panel B). Freight transport prices are also subdued despite rising energy costs. Shipping rates for most routes remain low, at levels close to their average over the decade prior to the pandemic, although the Baltic Dry index has picked up since mid-2023, supported by strong demand for large vessels carrying coal and iron ore. Survey measures of new export orders remain weak in manufacturing and have slowed sharply in services at a global level (Figure 1.7, Panel C). Notwithstanding these signs of weakening, car production picked up in the third quarter, and there are signs that tech-related production in Asia has begun to improve, albeit from low levels (Figure 1.7, Panel D). International tourism has largely recovered from the pandemic shock, although the number of Chinese tourists remains about 45% lower than pre-pandemic levels. To date, the conflict following the terrorist attacks on Israel by Hamas has not disrupted the flow of goods or oil through the Strait of Hormuz or the Suez Canal, but it represents a significant risk (see below).

Figure 1.7. Trade growth is weak and near-term indicators are subdued

Note: Panel A: Trade based on the average of import and export volumes of goods and services, valued in USD at 2015 prices. Dynamic Asian Economies include Hong Kong (China), Malaysia, the Philippines, Singapore, Chinese Taipei, Thailand and Viet Nam. The European Union includes the 22 OECD countries who are members of the European Union, plus Bulgaria, Croatia and Romania. Panel C: A reading above (below) 50 signals that a balance of firms report an expansion (contraction) of orders. Panel D: Global auto production in October is an estimate based on the growth of production in China, France, Germany, Japan, Korea and the United States. The Asian tech cycle is an export-weighted index of tech-related production in Japan, Korea, Singapore and Chinese Taipei. Commercial flights from FlightRadar include both passenger and cargo flights.

Source: OECD Economic Outlook 114 database; RWI/ISL Container Throughput Index; S&P Global; Bloomberg; FlightRadar; IATA; and OECD calculations.

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Following a rapid recovery from the early months of the pandemic, the ratio of global trade to GDP rose above 2018 levels by the fourth quarter of 2021 and remained there until the third quarter of 2022 (Figure 1.8, Panel A). Nonetheless, the ratio of trade to GDP has remained below the path expected if it had continued to rise at the same pace as in the decade prior to the pandemic. Since mid-2022, lower merchandise trade has pushed down total trade relative to GDP. This recent slowdown, and the broader plateauing of the trade-to-GDP ratio since the global financial crisis, reflect a combination of cyclical and structural factors. Understanding whether cyclical or structural factors dominate provides a sense of the risks to the trade outlook and also the potential avenues through which policy might help trade growth to revive.

Over the last decade, much of the slowdown appears to be structural, with trade intensity either declining in some countries, such as China, or growing more slowly in others (Figure 1.8, Panel B). This reflects in part a slowdown in the pace of global value chain integration, as well as the steady increase in restrictive trade policies being implemented throughout the world and increasingly inward‑focused domestic policies (Arriola et al, 2021, Cigna et al, 2022, Antràs, 2021, Baldwin, 2022a). There has also been a steady rise in the share of less trade-intensive emerging economies in world GDP (Haugh et al, 2016; ECB, 2016).

Figure 1.8. Global trade intensity has recently declined

Note: Trade are based on the average of export and import volumes, valued in USD at 2015 prices. Panel B: Shift-share decomposition of changes in the global ratio of trade to GDP into contributions from the change in the trade intensity of each country or region ("trade") and contributions from the change in the share of each country or region in global GDP (“GDP”). Other countries shows the net effect of changes in trade intensity and GDP shares in the rest of the world. Dynamic Asian Economies (DAE) include Hong Kong (China), Malaysia, the Philippines, Singapore, Chinese Taipei, Thailand and Viet Nam. The European Union (EU) includes the 22 OECD countries who are members of the European Union plus Bulgaria, Croatia and Romania, and includes intra-EU trade. 2023 includes projected values where no data are available.

Source: OECD Economic Outlook 114 database; and OECD calculations.

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More recently, cyclical differences in growth drivers across countries have clearly contributed to the current trade slowdown.

• Amongst the advanced economies, domestic demand has slowed more sharply in recent quarters in trade‑intensive Europe and dynamic Asia than in less trade-intensive economies such as the United States and Japan. This reshuffling of demand has lowered global trade to GDP (Figure 1.8, Panel B).

• Declining trade intensity within economies is being driven by cyclical shifts in the composition of demand. Durable goods spending, which supported the rebound in trade growth in 2021, has softened, whilst households’ services consumption has risen in OECD economies – implying, for a given rise in demand, weaker import growth (Figure 1.9, Panel A).

• Manufacturing inventories, which tend to be procyclical and relatively trade intensive, have fallen sharply since the third quarter of 2022 in many economies, as firms seek to respond to softening demand for goods.

• Intermediate goods trade, which reflects in part activity in global value chains, has also slowed following a robust rise in 2021. The WTO estimates that the share of intermediate goods in the value of non-fuel merchandise trade has fallen from a post-pandemic peak of 53.5% in the third quarter of 2021 to 48.3% in the second quarter of 2023 (WTO, 2023a).

• Higher interest rates and tighter credit conditions are also beginning to affect the cost and availability of trade finance. A survey from the Asian Development Bank suggests that the cost of trade finance has risen sharply for firms, and is now the second most important barrier to business for firms (ADB, 2023). Over a third of firms highlight insufficient financing as a significant supply chain issue, while 22% highlight it as the most pressing obstacle to growth (Figure 1.9, Panel B).

Figure 1.9. Cyclical shifts in demand and credit are now weakening trade intensity

Note: Panel A: Data calculated in seasonally adjusted volume terms, chain-linked and weighted in PPP. The OECD aggregate excludes countries for which data is not available. Panel B: Share of businesses citing each factor as a barrier.

Source: OECD Quarterly National Accounts database; Asian Development Bank; and OECD calculations.

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Financial conditions have become more restrictive

Financial conditions have tightened in most major economies, reflecting the cumulative effects of past policy rate increases and quantitative tightening, reassessment by market participants of the expected future path of policy rates, and some repricing of risk amidst rising geopolitical tensions. Nonetheless, indicators of systemic financial stress generally remain contained, and there are some signs that risk appetite has begun to revive recently as disinflation continues.

Forward-looking real interest rates are positive in most major economies (Figure 1.10), Japan being an exception, with nominal long-term government bond yields also rising substantially in recent months in most advanced economies. In the United States, both real and nominal long‑term rates are now around the levels observed prior to the global financial crisis. An upward shift in market expectations of the future policy interest rate path has contributed to the rise in long‑term rates, but term premia have also increased in many advanced economies. Longer-term interest rates and government bond spreads have also risen in most emerging-market economies. However, nominal sovereign bond yields have declined in Brazil, with falling inflation allowing the central bank to begin reducing the policy rate, though real longer‑term rates remain high.

The rise in policy interest rates is being transmitted swiftly into bank lending rates to firms and households (Figure 1.11, Panel A). Bank lending standards have tightened in the euro area and the United States (Figure 1.11, Panel B), although not in Japan. The growth of credit to both households and firms has also slowed sharply, reflecting a combination of tighter credit supply and falling credit demand. In the euro area and in the United Kingdom, the slowdown in credit demand has been relatively important, whereas weaker credit supply has mattered more in the United States (Quaglietti, 2023), as reflected in the significant tightening of credit standards for companies (Figure 1.11, Panel B).

Sovereign bond spreads have increased since the summer in Italy, but generally remain contained across the euro area, helped by the availability of the ECB’s Transmission Protection Instrument and flexibility across countries in Eurosystem bond reinvestments. Corporate bond spreads have also widened especially in high-yield segments, and issuance has been subdued. Higher long-term interest rates (Figure 1.12, Panel A) are also weighing on equity prices, particularly in many advanced economies (Figure 1.12, Panel B). The US dollar has appreciated against most currencies over the past six months (Figure 1.12, Panel C), helped by safe‑haven effects amidst heightened geopolitical tensions. There have also been sizeable currency depreciations in some emerging-market economies with relatively high or rising inflation and, to a lesser extent, in Japan.

Figure 1.10. Forward-looking real interest rates continue to rise or remain high

Note: Latest available data up to 23 November 2023. Panel A: Real short-term interest rates are calculated using nominal one-year government bond yields and one year-ahead inflation expectations by consumers in the United States, the euro area and the United Kingdom, by corporates participating the Tankan Survey in Japan, and by market professionals participating the Focus Survey in Brazil. Panel B: Real long-term interest rates show 10-year inflation-linked bond yields.

Source: OECD Economic Outlook 114 database; Banco Central do Brasil; Bank of England; Bank of Japan; Board of Governors of the Federal Reserve System; European Central Bank; University of Michigan; and OECD calculations.

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Figure 1.11. Bank loan rates have risen sharply and credit standards have tightened

Note: Panel A: The advanced countries included are Australia, Canada, Denmark, France, Germany, Italy, Japan, New Zealand, Norway, Spain, Sweden, Switzerland, the United Kingdom and the United States. Panel B: Net percentages are defined as the difference between the sum of the share of banks reporting a tightening in credit standards and the sum of the share of banks reporting a loosening of credit standards. A positive (negative) balance indicates tighter (easier) credit standards. For the United States and Japan, credit standards to non-financial corporations are for large firms.

Source: Bank of Canada; Bank of England; Bank of Japan; Danmarks Nationalbank; European Central Bank; Japan Housing Finance Agency; Reserve Bank of Australia; Reserve Bank of New Zealand; Statistics Norway; Statistics Sweden; Swiss National Bank; US Federal Reserve; and OECD calculations.

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Figure 1.12. Bond yields have increased and the US dollar has strengthened

Note: “Latest” refers to the change between average of May 2023 and the latest available data up to 23 November 2023. Maximum and Minimum refers to the biggest falls and increases from the average of May 2023. Based on a 10-day average of daily observations. Panel C: A positive value indicates a depreciation relative to the USD.

Source: OECD Exchange Rates database; FactSet; and OECD calculations.

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Projections

A mild slowdown is projected, with a continued moderation of inflation

The broad picture for the world economy over the next two years is one of a moderate slowdown followed by eventual normalisation, with growth returning to near-trend rates, and inflation converging back to central bank targets by 2025. Global GDP growth is projected to remain subdued through the first half of 2024, with only a modest improvement thereafter. The tightening of monetary policy since early 2022 is increasingly visible, with forward-looking real interest rates still rising in many economies, slowing domestic demand growth. Fiscal policy is also expected to remain mildly restrictive in most countries, particularly in 2024, with remaining energy support measures being phased out. Labour market prospects are a relative bright spot, with OECD-wide unemployment projected to remain at a low level. Real wages are projected to recover as inflation eases, with part of the increase in labour costs being absorbed by a decline in profit shares in many countries.

Global growth in 2023 is projected to be 2.9%, and weaken to 2.7% in 2024, the lowest annual rate since the global financial crisis other than the first year of the pandemic (Figure 1.13, Panel A). As inflation abates further and real incomes strengthen, the world economy is projected to grow by 3.0% in 2025. These outcomes remain highly dependent on the fast-growing Asian economies (Figure 1.13, Panel B).

After a relatively strong start to 2023, quarterly global growth is expected to have slowed gradually to an annualised rate just above 2½ per cent in the latter half of the year. Quarterly growth is projected to pick back up to about 3% from the latter half of 2024 and to remain around that level through 2025, helped by the gradual easing of policy rates. The near-term slowdown is relatively mild. Among the advanced economies, employment growth is projected to slow during 2024-25, but remain positive, alongside a gradual recovery in real wages. With household saving rates expected to remain broadly stable in most countries, the resulting increase in labour compensation is expected to sustain real private OECD‑wide consumption growth of about 1.5% per annum on average during 2024-25. Steady but subdued growth is also projected for OECD-wide government consumption, while the annualised increase in total fixed capital investment is expected to pick up from below 1% in the final two quarters of 2023 to about 2¾ per cent by the latter half of 2025. Housing investment, which has already weakened significantly in several countries, is expected to continue declining until mid‑2024. Business investment is projected to stagnate in the near term in many countries before picking up gradually through the latter half of 2024 and 2025.

The prospects for individual major economies and regions are as follows:

• In the United States and Canada, domestic demand growth is expected to moderate until mid‑2024 due to tighter monetary and financial conditions, with slower job growth and a mild pick‑up in unemployment. Monetary policy is expected to ease from the second half of 2024 as inflation continues to decline and is projected to help strengthen domestic demand growth in 2025. Real GDP growth is projected to slow in both countries in 2024, to 1.5% in the United States from 2.4% in 2023, and in Canada to 0.8% from 1.2%, before growth recovers in 2025 to 1.7% in the United States and 1.9% in Canada.

• Growth in the major European economies, which have been relatively hard-hit by the energy price shock in 2022 and the war in Ukraine, is expected to remain weak in the near term but improve gradually as inflation wanes, monetary policy easing gets underway and real incomes recover. Annual GDP growth in the euro area is projected to pick up from 0.6% in 2023 to 0.9% in 2024 and 1.5% in 2025. In the United Kingdom, GDP growth is projected to be subdued, with higher fiscal pressure weighing on household disposable incomes, but to improve from 0.5% in 2023 to 0.7% in 2024 and 1.2% in 2025. Tight labour markets will contribute to inflation persistence in the many countries, but as pressures ease inflation is projected to return to target in the euro area and the United Kingdom by the end of 2025.

Figure 1.13. Global growth will remain modest and come mainly from the major Asian economies

Note: In Panel B, Emerging Asia comprises China, India, Indonesia and the Dynamic Asian Economies (Hong Kong (China), Malaysia, Chinese Taipei, the Philippines, Singapore, Thailand and Viet Nam). Latin America comprises Argentina, Brazil, Chile, Colombia, Costa Rica, Mexico and Peru. Contributions calculated moving PPP shares of global GDP.

Source: OECD Economic Outlook 114 database; and OECD calculations.

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• The war in Ukraine and its initial effects on commodity prices had a pronounced adverse impact on growth and inflation in Central and Eastern Europe, on top of the necessary adoption of more restrictive monetary policies in most economies. As inflation pressures abate, and provided the war in Ukraine does not escalate further, steady growth is projected to resume in 2024‑25, with inflation falling back towards central bank targets. Reconstruction efforts following the earthquakes in early 2023 have boosted demand in Türkiye, but with monetary and fiscal policies now being tightened to cool inflation and stabilise the public finances, GDP growth is expected to moderate to around 3% on average over 2024-25, with inflation remaining high but easing gradually.

• The advanced Asian economies are projected to have somewhat divergent growth profiles over 2024-25, reflecting in part different policy stances. In Japan, where monetary policy has remained accommodative, growth is projected to increase to 1.7% in 2023 before moderating to 1% in 2024 and 1.2% in 2025 as the positive contribution from net exports fades and macroeconomic policies begin to be tightened. Wage growth is projected to strengthen gradually, with inflation settling durably at 2% in 2024-25. Real GDP growth in Korea is expected to bottom out at 1.4% in 2023, held back by weak export demand and tighter monetary policy, recovering to 2.3% and 2.1% in 2024 and 2025 respectively as global semiconductor demand picks up and policy interest rates are lowered.

• GDP growth in China is projected to have rebounded to 5.2% in 2023, but is expected to slow to 4.7% in 2024 and 4.2% in 2025. Consumption growth remains subdued and activity in the real estate sector continues to weaken, but monetary policy easing and additional infrastructure investment will help underpin domestic demand. Consumer price inflation is expected to remain very low, at under 2% in 2024 and 2025.

• India has been relatively unaffected by the surge in energy prices in 2022 and the tightening of monetary conditions in the advanced economies over the past two years. Real GDP growth is projected to be 6.3% in FY 2023-24 and 6.1% in FY 2024-25. Surging services exports and public investment will continue to drive the economy. Inflation is also projected to decline progressively, supporting purchasing power. By FY 2025-26, the expected end of the El Niño weather pattern and productivity gains from recent policy reforms are projected to help growth pick up to 6.5%. GDP growth is also projected to remain brisk in Indonesia, at 4.9% this year and 5.2% in 2024 and 2025, with improved labour market conditions and confidence supporting consumer spending. Inflation in Indonesia has already been pushed down by tighter monetary policy and is projected to be 2.4% in 2024 and 2025. Inflation in India is now below the upper band of the central bank’s target range, and is projected to be 5.3% in FY 2024-25 and 4.2% in FY 2025-26.

• Current economic conditions in the Latin American economies vary widely, with growth in the first half of 2023 having remained solid in countries such as Brazil, Mexico and Costa Rica, but slowing in Colombia and Chile and weak in Peru and Argentina, with the latter remaining in the grip of an economic crisis. Over 2024-25 some convergence is expected, however, with most of these economies projected to have GDP growth in the range of 2-3% in 2025. A common feature is that inflation is expected to continue to subside, facilitating a recovery of real incomes.

OECD unemployment rates have remained surprisingly low over the past year and a half, even where output has grown slowly or stagnated in the wake of adverse shocks. This would not be expected to persist if growth weakened significantly, but in the projections steady, if lacklustre, growth continues in most countries. The baseline is for OECD-wide unemployment to rise only modestly from the record‑low level of 4.8% in September 2023, stabilising at 5.1% in 2024-25. The projected increases are somewhat larger in the United States, the United Kingdom, Canada and Australia, but in Japan and the euro area unemployment is expected to remain low and close to current levels.

Global trade growth is projected to recover gradually alongside global demand, with some support from the end of inventory declines, the ongoing recovery in Asian trade and, in 2025, a pick‑up in global investment growth (Figure 1.14). These cyclical forces will provide some offset to the expected continuation of longer‑term structural drags on trade growth, such as the projected moderate demand growth in more trade‑intensive European economies and the burden of trade restrictions. World trade volumes are projected to rise by 2.7% and 3.3% in 2024 and 2025 respectively, up from 1.1% in 2023.

In the absence of further large shocks to food and energy prices – by assumption, commodity prices are held fixed in the projections (Annex 1.A) – projected headline and core (excluding food and energy) inflation rates return to levels consistent with central bank targets in most major economies by the end of 2025. Headline inflation has fallen earlier and faster than core over the past year given the steep fall in energy prices until mid-2023, but with oil and gas prices having picked up since June, and with commodity prices assumed to be fixed near recent levels through 2024-25, core and headline measures are projected to decline at similar rates from this point onward. In most emerging‑market economies, other than economies with very high inflation at present, inflation is projected to reach target ranges by 2025.

Figure 1.14. Global trade is projected to slowly recover but remain weak by historical standards

Note: OECD North America includes Canada and the United States; Other Asia includes Japan, Korea, the Dynamic Asian Economies (Hong Kong (China), Malaysia, Chinese Taipei, the Philippines, Singapore, Thailand and Viet Nam), India and Indonesia. Trade growth is based on the average of imports and exports, in volume terms, in USD. Trade intensity calculated as the ratio of the average growth rate of imports and export volumes to GDP growth. Both series are in constant 2015 USD.

Source: OECD Economic Outlook 114 database; and OECD calculations.

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Risks

There is a range of risks around the baseline projections through 2025. The unusually fast and large‑scale tightening of monetary policy in most major economies during 2022-23 creates considerable uncertainty about the full range of effects, and could continue to expose vulnerabilities among households, firms, financial market participants and countries. Rising geopolitical tensions could also slow growth and add to inflation. Continued structural stresses in China create another downside risk to the global growth projections given China’s overall importance in the global economy. In addition, ongoing climate change yields an ever-higher risk of extreme weather events, some of which have the potential to result in negative supply shocks with global effects. The El Niño episode that began earlier this year heightens the risks of extreme weather events, as well as potential near‑term adverse effects on agricultural output in Australia and New Zealand, Southeast Asia, South Africa and many Latin American economies. Overall, the risks to the projections remain skewed to the downside, even if more favourable outcomes are also possible.

Heightened geopolitical tensions are a key source of uncertainty

Heightened geopolitical tensions remain a key source of near-term uncertainty and have been raised further following Hamas’ terrorist attacks on Israel and the subsequent conflict. The economic effects of this conflict are uncertain and depend on its duration and scope. A temporary but pronounced slowdown is incorporated in the projections for Israel, amid considerable domestic disruptions to supply, but the broader direct effects from this for the world economy are relatively limited. If the conflict were to intensify and broaden within the wider region, there are much stronger risks that could slow growth and push up inflation.

• Oil and gas prices could strengthen significantly. Although less important than in the past, production in the Middle East economies continues to account for an important share of total global oil and liquefied natural gas (LNG) output and could be disrupted in the event of a wider conflict (World Bank, 2023). While the global economy has become less oil‑intensive, particularly in the advanced economies, macroeconomic model estimates suggest that a USD 10 per barrel rise in oil prices could raise global inflation by 0.2 percentage points in the first year, and lower growth by 0.1 percentage points, with differential effects across oil producers and oil-importing economies.

• Trade flows could be significantly disrupted, creating supply-chain bottlenecks. Two key shipping routes are the Strait of Hormuz, with significant daily oil and LNG traffic, and the Suez Canal, with daily traffic representing between 12-15 per cent of global merchandise trade.1

• A hit to activity could also be accompanied by a sudden pullback from risky assets in financial markets. This could raise bond spreads, lower asset prices and result in losses for firms and investors exposed to these risks (Federal Reserve, 2023).

The anticipated pick-up in global trade could fail to materialise

There are additional significant downside risks to global trade. The longer-term decline in the trade intensity of growth is driven by structural factors, and the mild projected cyclical upturn in 2024 and 2025 could be weaker than expected. A weaker-than-forecast investment recovery in advanced economies, or tighter monetary conditions that further raise the costs of trade credit could soften trade growth. Structural forces could also intensify, posing risks to trade growth over the longer term. In particular, the increasingly inward‑looking orientation of trade and investment policies and heightened geopolitical tensions could add to the downward trend in import intensity in many economies, including the United States and China. Lower trade in relation to GDP could have knock-on effects for potential growth, to the extent it weakens competition, raises prices, hinders productivity growth, and reduces the scope for economies to make use of new technologies to improve their growth prospects. These costs may be particularly heavy for emerging‑market economies.

The extent and full impact of monetary policy tightening remains uncertain

Headline inflation has come down quickly in most economies over the past year, but generally remains some distance from target, and positive base effects from the reduction in energy prices are now fading. Core inflation has proved sticky, and services inflation remains elevated relative to pre‑pandemic norms. A risk is that persistent high inflation, or a renewed surge in energy and food prices, might affect the inflation expectations of firms and households, making it more difficult to bring inflation back to target. There is evidence of threshold effects in the attention that people pay to inflation (Figure 1.15). With inflation having been above estimated thresholds (around 3% in many advanced economies) for some time already, it is possible that a degree of “belief scarring” has set in that could keep inflation expectations elevated. Combined with inertia in housing costs, this could make it more difficult than projected to reduce inflation from its current levels and potentially lead to additional monetary policy tightening that could further expose financial vulnerabilities.

It is also possible that the full effects on demand of past monetary policy will be greater than expected, particularly given the simultaneous tightening across many economies. Calibrating policy responses, which is always difficult, has been further complicated by the economic changes resulting from the pandemic and volatile commodity markets. Although the risk of a “hard landing” in the United States and elsewhere appears to be lower now than it was a few months ago, the confluence of weak housing markets, high oil prices and subdued credit growth mean that some empirical models still signal risks of recession in the coming year that are high by historical standards (Chalaux and Turner, 2023).

Figure 1.15. Higher inflation raises awareness of inflation and may hinder a fall in inflation expectations

Note: The charts show an index of Google searches of the word “inflation” plotted against year-on-year headline inflation, monthly, from 2004 onward. The orange triangles refer to the observed values for the Google search index for inflation and the green ones to the fitted values of the threshold regression model. The red vertical lines indicate the estimated threshold for the inflation rate.

Source: OECD Economic Outlook 114 database; Google Trends data; and OECD calculations.

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Tighter financial conditions could expose financial vulnerabilities

Financial markets have so far been relatively resilient to the tightening of monetary policy, but sizeable risks remain. If interest rates remain elevated for longer than currently expected, or if the impact of past rate rises on activity proves greater than anticipated, the capacity of households and non‑financial firms to service debt could deteriorate further, generating credit losses for banks and non‑bank financial institutions. Financial institutions also remain vulnerable to liquidity and interest rate risks.

Bank lending rates to households and firms have continued to rise, reaching around 5% on average in the OECD advanced economies, 3 percentage points above end-2019 levels. The rising cost of credit is being reflected in the interest expenses paid by households. In the advanced economies, these rose from an average 1.4% of disposable income in 2019 to 3.3% in the second quarter of 2023 (Figure 1.16, Panel A). Debt-servicing costs have risen particularly in countries where mortgages are predominantly issued at variable rates, including Finland and Sweden, as well as countries where mortgage rates are fixed for a relatively short period, including Italy and the United Kingdom. Interest expenses paid by non‑financial corporations have also surged, from an average 9% of the gross operating surplus in 2019 in the major advanced economies to 14.3% in the second quarter of 2023 (Figure 1.16, Panel B).

If interest rates were to increase further, or to stay elevated for a long period of time, households and corporates could experience increasing difficulties in making loan repayments. Borrowers could even fall into distress in the event of a sharp deterioration of economic activity or incomes. The overall number of mortgages in arrears has started to rise across several advanced economies in 2023, but remains low by historical standards (IMF 2023; Bank of England, 2023). In contrast, corporate bankruptcies have risen more noticeably in 2023, and in several countries the number of bankruptcies in 2023 has already exceeded that during 2008-09 (Figure 1.17). Non-financial corporations have emerged from the pandemic with a higher debt stock, at 170% of GDP in the median OECD economy in 2022, and face sizeable repayment and refinancing costs.

Large swings in real estate prices could also jeopardise the ability of households and corporations to service debt. Nominal residential house prices have fallen recently in more than half of the OECD countries, but valuations remain high by historical standards in many countries. Risks of large valuation corrections also remain in commercial real estate markets, where structural changes associated with remote working are adding to the impact of higher financing costs. Commercial real estate prices have declined by 4% in the United States, 10% in the euro area and 20% in the United Kingdom over the past year, with real estate investment trust indices pointing to further falls ahead (Green Street, 2023).

Figure 1.16. Household and corporate interest payments have risen substantially

Note: For non-financial corporations interest payments are reported as shares of gross operating surplus and mixed income.

Source: OECD National Accounts database; and OECD calculations.

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Figure 1.17. Corporate bankruptcies have risen back to 2008-2009 levels in some countries

Note: Based on data for the total number of corporate bankruptcies. The green bars are computed as averages of Q1 and Q2. To account for seasonality, the 2008-09 index value is also computed as an average of Q1-Q2 in these years.

Source: OECD Timely Indicators of Entrepreneurship; Eurostat; and OECD calculations.

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Banks and non-bank financial institutions also face elevated risks. Credit losses could increase if firms and households struggle to repay their debts, potentially weighing on the supply of new credit to the economy, as well as declines in collateral values securing existing loans. Loans to households account for a substantial share of bank assets in some countries, particularly Australia and the United States. The recent further surge in bond yields also intensifies duration risks for financial institutions from declines in the mark‑to-market value of fixed-income securities as interest rates rise. In addition, as demonstrated by the failure of some US regional banks earlier in 2023, balance sheet pressures can also materialise rapidly if banks have to sell bonds to meet unexpected deposit outflows (OECD, 2023b).

In emerging-market economies, debt vulnerabilities compound risks from tight global financial conditions

The recent increases in long-term interest rates are also a potential source of risks for many emerging‑market economies. Sovereign bond spreads have been volatile in recent months, and net portfolio capital inflows have declined, driven by net outflows from both equities and debt across most regions (Figure 1.18). Persistently high global interest rates could also exacerbate refinancing risks in countries where sovereign debt is high and debt maturities are short. Some countries also have a large share of foreign currency debt, including Argentina, Colombia and Egypt.

While emerging-market economies have shown considerable resilience over the past year, countries characterised by structural debt vulnerabilities have come under tighter market scrutiny. Sovereign spreads have increased by more in countries with elevated sovereign debt, a larger share of foreign-currency debt and a poorer credit rating (Figure 1.19). In several emerging-market economies, including Colombia, Peru and Romania, foreign-currency-denominated debt also still accounts for more than half of outstanding government debt. This is a potential source of refinancing risk. Moreover, the share of short-term debt over total debt also remains elevated in some economies. Coupled with low foreign exchange reserves, a high share of short-term debt exposes borrowers to rollover risks in the event of a significant further tightening of global financial conditions.

Figure 1.18. Portfolio capital outflows have resumed and sovereign spreads have been volatile

Note: Based on data up to 23 November 2023. Panel A shows the gross portfolio inflows data from the OECD Monthly Capital Flow dataset for 21 emerging-market economies grouped by four geographical areas and the Bloomberg proxy index of capital flows. The latter is a monthly composite index, reflecting the performance of commodity, equity, foreign-currency-denominated government bond and currency asset classes. Increasing (decreasing) values of the index indicate capital flows into (out of) emerging-market economies. Panel B shows unweighted regional averages for the JP Morgan EMBI global bond spread; a measure of the sovereign risk spread of USD-denominated emerging-market economy government bonds over US government bonds. 'EME - Europe' covers Romania and Türkiye. 'EME - Asia' covers China, Indonesia, India, Malaysia, the Philippines and Viet Nam. 'EME - Latin America' covers Brazil, Chile, Colombia, Costa Rica, Mexico and Peru. The ‘EME’ aggregate covers all mentioned countries plus South Africa and Ukraine.

Source: OECD Monthly Capital Flow dataset; Bloomberg; Factset; and OECD calculations.

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Figure 1.19. Sovereign bond spreads have risen faster in countries with higher debt vulnerabilities

Basis point changes in EMBI sovereign spreads between 2021 and November 2023

Note: Based on average changes in EMBI sovereign spreads across a sample of emerging-market and developing economies between the 2021 trough and November 2023. The country composition differs in the three panels, with the left and centre panels based on a smaller sample (34 countries) compared to the right panel (60 countries). Ratings are based on Standard & Poor’s classification.

Source: Bloomberg; International Monetary Fund; and OECD calculations.

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In about 20% of a sample of emerging-market and developing economies, USD-denominated sovereign spreads to US bonds were close to or higher than 10% in November 2023, a level at which market access can become restricted. In addition, about 15% of low-income countries are in debt distress, and an additional 45% are estimated to be at high risk of debt distress (IMF, 2023). In an environment of high global interest rates, more countries could lose access to international capital markets if creditors become increasingly concerned that large and growing debt burdens are unsustainable.

A further slowdown in China would hit global growth

China is the largest national economy in the world (in purchasing power parity terms) and has been a key driver of global growth in recent decades, as well as the largest beneficiary of reductions of the numbers living in absolute poverty. Financial stresses in China’s large property sector threaten to diminish its economic growth by more than expected and potentially trigger additional financial distress. The difficulties being experienced by leading property developers have an impact on the public finances in many local authorities, on consumer sentiment, and on the balance sheets of banks and other lenders. There is a clear risk that the property crisis could have a larger and longer-lasting impact on the Chinese economy than projected. This would not only represent a drag on global growth directly, but would also slow growth in other countries. Illustrative scenarios suggest that an unanticipated one‑year decline of 3 percentage points in China’s domestic demand growth could directly lower global GDP growth by 0.6 percentage points, and potentially by over 1 percentage point in the event of a significant tightening of global financial conditions (OECD, 2023c). Countries with strong trade links with China would be hit hardest by any slowdown in Chinese demand, but the effects would be more widely felt, particularly in advanced economies, if financial conditions were to deteriorate, with risk premia rising and equity prices declining.

Upside risks

The world economy has been hit by a succession of negative supply shocks in recent years, which have hindered output growth and raised prices, but positive supply shocks are also possible. These would both improve near-term global growth prospects while also helping with disinflation. In particular, a reversal of recent oil output cuts by key OPEC+ countries could see oil prices move back down significantly, particularly given the prospects for stronger supply in 2024 from some non-OPEC producers. This would act as a shock absorber for the current slowdown in demand, provide a renewed downward impetus to consumer price inflation and boost real incomes in oil-importing countries. Continued strong labour force growth would also help to ease tensions in labour markets and limit cost pressures.

Another key area of uncertainty that could provide scope for upside growth surprises is the degree to which excess savings accumulated since the start of the pandemic are reduced. The excess savings phenomenon applies primarily to the advanced economies, where government measures to support household income in the first phase of the pandemic were generally substantial and consumption possibilities were constrained by mobility restrictions and the closing down of parts of the economy, especially in service sectors. Such income support was either absent or less generous in many emerging‑market and developing economies, reflecting widespread informality and less-developed social security systems. So far, the extent to which excess savings have been drawn down varies considerably across the advanced economies (Box 1.1). In some large economies, saving rates have remained close to pre‑pandemic averages. The baseline projections keep household saving rates in 2024‑25 close to recent levels, but lower saving ratios and stronger consumer spending are possible, with excess savings being drawn down. While this would be positive for growth, it would also imply a slower‑than‑projected reduction in inflation pressures. In a similar vein, if demand-boosting policy measures in China are more successful than expected, this would be positive for global growth but imply more upward pressure on commodity prices and therefore slower-than-projected disinflation.

Box 1.1. The evolution of excess household savings

In most advanced economies, the estimated level of excess household savings accumulated during the pandemic and as yet unspent is high (Figure 1.20, Panel A). Whether and when these accumulated additional savings will be run down remains a key source of uncertainty. An analysis of the composition and distribution of the estimated excess savings suggests that the likelihood that they will be drawn down is limited given the sizeable share held by high‑income households and the small proportion held in liquid assets. In addition, recent declines in equity and house prices will have started to reduce the value of the invested savings.

The estimates use the difference between household saving in each quarter since the first quarter of 2020 and the level if the saving rate had been at its average pre-pandemic level (2015-19). A positive value is considered to be “excess” saving in that quarter, and the sum of the quarterly flows from the first quarter of 2020 onward gives the cumulative stock of excess savings.1 There are large cross-country differences in excess savings levels, with these estimated to be more than 20% of disposable income in Ireland and Canada but less than 5% in Denmark. Over the past year, households in the United States have reduced these savings, whereas they have been stable or increasing in Canada, the euro area as a whole, Japan, and the United Kingdom.

Projected saving rates in 2024-25 are significantly above their 2015-19 average in the euro area as a whole, implying further additions to the stock of excess savings, contrasting with continued low projected saving rates in the United States where excess savings continue to decline through 2024 and 2025 (Figure 1.20, Panel B). This is consistent with more precautionary saving in most European countries than in the United States.

Figure 1.20. Estimated current stocks of household excess savings and projected saving rates

Note: Based on gross household savings. Panel A: ‘Last’ corresponds to 2023Q3 for the United States. Excess savings are the cumulated sum of quarterly saving flows since 2020Q1 relative to the levels that would have occurred if the saving rate had been equal to the average 2015-19 saving rate. Saving rates for Japan are estimated from 2021Q1 onwards.

Source: OECD Economic Outlook 114 database; OECD, Quarterly National Accounts database; and OECD calculations.

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The distribution of excess savings is a key factor affecting the extent to which they are likely to be run down. The estimated share of excess savings held by the top 10% of the income distribution rose from under 50% at the end of the first quarter of 2020 in the United States and the euro area to more than 75% and 67%, respectively, by the end of 2022 (Battistini et al., 2023). This shift also likely helps to explain the fact that excess savings have increasingly been held in less liquid assets. The propensity to spend is higher at the bottom of the income distribution, so the shift in the distribution of excess savings towards better‑off households means that the overall propensity to spend excess savings has been declining over time, reducing the potential for higher consumer expenditure out of excess savings. The proportion of savings held in liquid form (currency and deposits) also tends to be higher for lower-income households, so a shift in the distribution of excess savings towards higher-income households lowers the share of such savings held in liquid, ready-to-spend form.

1. This estimation method, measuring the deviation of saving rates from a baseline, is similar to those used by Alves and Martínez-Carrascal (2023), Colabella et al. (2023), de Soyres et al. (2023) and Klitgaard and Higgins (2023). The choice of period used as the baseline for the household saving rate affects the results, but generally within a limited range. For example, using 2019 as the baseline reduces estimated excess savings by about 4 percentage points for the United States.

Policies

Monetary policy needs to remain restrictive in most advanced economies until inflation declines durably

Since September, policy interest rates have been held constant in most advanced economies. Central bank balance sheet reductions, mainly reflecting reductions in bond holdings (quantitative tightening), have continued along well‑communicated paths and in some cases gathered pace, adding upward pressure on long-term interest rates. With its long‑standing accommodative policy stance, Japan remains an exception, though the conduct of yield curve control has been modified to allow wider fluctuations in the long-term government bond yield from the target rate.

Forward-looking real interest rates are now positive in most advanced economies, but the full effects of the cumulative tightening over the past two years have yet to be felt. Monetary policy needs to remain restrictive until there are clear signs that underlying inflationary pressures are durably lowered, with near‑term inflation expectations moderating further and excess resource pressures fading in labour and product markets. As inflation eventually returns towards target, central banks will be able to lower policy interest rates, although they might not return to the very low levels which prevailed prior to the pandemic (see below).

Policy decisions will need to continue to be communicated clearly given the ongoing uncertainty about the strength of the impact on inflation and output from the rapid rise in interest rates. Changes in economic structure – such as the increased prevalence of fixed or semi‑fixed‑rate debt in some housing markets, or higher levels of debt than in previous tightening episodes – and in financial markets, with the increased role of non-bank financial institutions, are affecting the transmission of monetary policy. The rapid and simultaneous tightening in many jurisdictions has also made the transmission mechanism more complex and uncertain, especially for smaller open economies, and may also affect outcomes as policy rates start to be lowered at a different pace across economies. Should inflation pressures prove more persistent than expected, some additional rate increases could still be needed. Conversely, faster disinflation than projected could pave the way for earlier policy rate cuts. In the event of additional financial market stress, central banks should make full use of the available financial policy instruments to enhance liquidity and minimise contagion risks.

On the basis of the projected outlook for inflation and growth, policy interest rates in all major advanced economies other than Japan are expected to be at, or close to, their peak (Figure 1.21). However, no rate reductions are expected before the second half of 2024, and in some economies not before 2025.

• In the United States, reductions in the federal funds rate are projected to begin in the second half of 2024, as core inflation declines prove sustained, and proceed in 2025, with policy interest rates being lowered to 4-4¼ per cent by the end of 2025. Bond holdings are expected to decline further following a pre-announced path.

• In the euro area, where core inflation pressures are still relatively-elevated, the main refinancing rate and the deposit rate are projected to remain unchanged until the spring of 2025, with subsequent modest rate reductions through the year. Bond holdings are expected to continue to decline with no reinvestment of Asset Purchase Programme redemptions but full reinvestment, at least until end‑2024, of maturing Pandemic Emergency Purchase Programme securities.

• In Japan, an exit from the negative short-term policy rate is warranted next year, with the policy rate increasing gradually to 0.7% by the end of 2025, when inflation is projected to have durably settled at 2% and spare capacity is projected to be eliminated. Nevertheless, the monetary policy stance is expected to remain accommodative for some time, with negative real interest rates persisting until the end of 2025.

• No further policy rate increases are projected in Australia, Canada, Korea and the United Kingdom. Reductions in policy rates are projected to start in the second half of 2024 in Australia, Canada and Korea and in early 2025 in the United Kingdom. Central bank bond holdings are assumed to decline further in all these countries other than Korea.

Figure 1.21. Policy rates are projected to decline only gradually in most advanced economies

Policy interest rate for selected advanced economies

Source: OECD Economic Outlook 114 database; and OECD calculations.

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In the medium term, central banks will aim to bring policy interest rates back towards levels consistent with neutral real rates. However, the neutral real rate – the real interest rate at which the policy stance is neither accommodative or restrictive – is unobserved, difficult to estimate, and will vary over time due to changes in the underlying factors driving the demand for and supply of savings. Recent estimates of neutral real rates for the United States, the euro area and Canada have typically varied between 0 and 2% (Federal Reserve Bank of New York, 2023; Federal Reserve Bank of Richmond, 2023; Champagne et al., 2023). These are lower than the current yields on some long-term inflation-indexed bonds in financial markets, particularly in the United States, but broadly consistent with longer-term estimates of equilibrium real rates (Grigoli et al., 2023). Estimates of neutral nominal rates have, however, risen recently in some countries (Ferreira and Davin, 2022). Thus, nominal policy rates may remain at higher levels than prior to the pandemic, provided inflation settles at target rather than dropping persistently below target as in the decade after the global financial crisis.

Some factors behind the gradual longer-term decline in estimated neutral real rates persist, including demographic effects from ageing societies and weak potential output growth. However, the supply of public debt to be absorbed is set to be greater than expected prior to the pandemic, which might increase the neutral rate. This reflects the increase in debt since the pandemic began, rising future fiscal pressures, and the move by central banks to sell bonds held on their balance sheets. Stronger investment to achieve the climate transition in some conditions might also add to investment demand, increasing the neutral rate, although investment growth currently remains modest.

Fiscal policy needs to ensure debt sustainability while responding to new priorities

In 2023, fiscal policy has been mildly restrictive. The underlying primary balance in the median OECD advanced economy is expected to have improved by 0.4% of potential GDP (Figure 1.22) partly due to the full-year expiry of pandemic-related support. Many governments have continued to provide sizeable help to energy users, although energy prices falling from their peaks have helped to moderate the costs and support has already been withdrawn fully or partially in some countries. Defence spending has also been raised in several countries, particularly in Europe (OECD, 2023c), and faster implementation of Next Generation EU plans has boosted expenditure in some European economies. In the United States, higher spending on social security and healthcare and lower-than-expected tax revenues have generated an easing in the fiscal stance.

Fiscal projections for 2024-25 are conditional on announced government measures and OECD assessments of current plans (Annex 1.A.). Fiscal consolidation is expected in the vast majority of countries, but often at a mild pace, with the underlying primary balance in the median OECD economy improving by 0.5% of potential GDP in 2024 and 0.3% of potential GDP in 2025 (Figure 1.22). This largely reflects the further phasing out of support to energy consumers in 2024.

• In the United States, after sizeable fiscal easing in 2023, the fiscal stance is projected to become restrictive in 2024 as the unexpected shocks to receipts and expenditure in the current year fade, with the underlying primary balance rising by 1.5% of GDP. In 2025, a broadly neutral stance is expected.

• In the euro area, moderate fiscal consolidation is projected to continue in 2024‑25, with the underlying primary balance improving by 1¼ per cent of GDP in total over this period, largely as a result of the progressive withdrawal of energy support measures. About one-quarter of the change in the underlying primary balance stems from a change in the accounting treatment of tax credits for home improvements in Italy.2

• In Japan, despite an expected increase in defence spending and a new economic package to support households’ income and medium-term investment, the underlying primary balance is projected to improve by a cumulative 1¾ per cent of GDP over 2024-25, reflecting the full expiry of pandemic-related measures and a gradual phase-out of sizeable energy support.

• Among other large advanced economies, fiscal policy in 2024-25 is projected to be restrictive in Australia, Canada, Korea and the United Kingdom. Among smaller economies, Iceland and Slovenia envisage cumulative improvements in the underlying primary balance in 2024-25 of more than 2% of GDP to rebuild fiscal space and reduce inflationary pressures, whereas in Israel a conflict-related fiscal expansion of about 1¼ per cent of GDP is projected.

Figure 1.22. Modest fiscal consolidation is expected to continue in 2024-25

Change in the ratio of the underlying primary balance to potential GDP

Note: The vertical red line indicates the median of the OECD advanced economies.

Source: OECD Economic Outlook 114 database; and OECD calculations.

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Public debt levels are generally higher than before the pandemic, and in many countries at levels relative to GDP seen before only in wartime. Interest payments on general government debt are set to rise further in 2024-25 as low-yielding debt matures and is replaced by new higher-yielding issuance (Figure 1.23). In the typical OECD economy, the implicit interest rate paid on debt in 2025 is projected to be 1.2 percentage points higher than the rate paid in 2021, with relatively large increases occurring in a number of smaller European economies.

Government debt maturities in many countries have lengthened since the global financial crisis (Figure 1.24), as governments took advantage of low long-term interest rates when issuing new debt. However, in several countries, the impact has been fully offset by the increase in central bank holdings of sovereign bonds. This lowers the effective average maturity of consolidated public debt, by around two years in the typical economy, as the main counterpart of the bond holdings in central bank liabilities is overnight bank reserves. It also magnifies the overall impact of rising interest rates on the wider public finances (when the central bank is included in consolidated accounts), as the central bank is paying interest on commercial bank cash reserves held at the central bank. Recent short-term interest rate increases thus generate larger interest payments to commercial banks as well as a loss of revenue payable from the central bank to national governments (De Grauwe and Ji, 2023).3

Figure 1.23. Interest rates on government debt are set to rise further

Note: The implicit interest rate is defined as general government gross interest payments in a given year divided by general government gross financial liabilities at the end of the preceding year.

Source: OECD Economic Outlook 114 database; and OECD calculations.

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Figure 1.24. Quantitative easing has lowered the average maturity of public sector debt

Average debt maturity

Note: For each country the red triangle is computed by assigning a zero maturity to central bank holdings of central government debt, since their counterpart in central bank liabilities is typically overnight bank reserves. Debt maturity as of end-August in 2023 and at end-year 2007.

Source: Bloomberg; Bank of England; Bank of Japan; European Central Bank; Ministry of Finance Japan; Reserve Bank of Australia; Reserve Bank of New Zealand; Sveriges Riksbank; US Federal Reserve; OECD Central Government Debt statistics; and OECD calculations.

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Governments face mounting fiscal pressures. Beyond 2025, for most countries, the implicit interest rate on public debt is projected to exceed the nominal GDP growth rate, putting upward pressure on debt‑to‑GDP ratios, as will the impact of ageing populations on health and long-term care expenditure and pensions expenditure (Guillemette and Château, 2023). In the absence of offsetting spending adjustments or a higher tax burden, such changes will add significantly to current debt levels in many countries (Box 1.2). The climate transition and plans to raise defence expenditure are additional sources of future spending pressures (OECD, 2023a).

Box 1.2. Long-run fiscal sustainability in G7 countries

All governments face significant challenges from future spending pressures. In the absence of offsetting adjustments to the composition of spending or the level of revenue, government debt will rise. This box uses stylised economic and fiscal projections to trace out the possible evolution of government debt and financing needs in the G7 countries through to 2040. Both of these indicators show that policy changes are needed to prevent sizeable risks to long-run fiscal sustainability in many countries, keeping in mind that there are no specific thresholds for any one fiscal indicator (government debt, fiscal balance, interest rate, etc.) beyond which a country’s fiscal position can reliably be characterised as unsustainable (Blanchard et al., 2021).

This Outlook’s short-run economic and fiscal projections provide the starting point for the debt projections shown in this box, which are mechanical simulations based on a no policy change scenario. The resulting path for government net debt can be broken down into various components (Figure 1.25):

• Initial structural primary balance. This component illustrates the contribution that the structural primary government budget balance would make to the evolution of debt if it remained at its projected 2025 value in the future, ignoring the effects of other components discussed below. This is illustrative, not necessarily in line with official medium-term fiscal targets, and does not build in any corrective action in response to rising debt ratios.

Figure 1.25. Public debt is on a worrisome path in much of the G7

Net government debt, difference from 2025 in percentage points of GDP

Note: The debt projections shown here are mechanical simulations based on a scenario of no policy change. The underlying economic scenario is described in Guillemette and Château (2023). See Box 1.1 of that study for methodological details regarding the long-term government expenditure projections. See main text for a description of the components in the legend.

Source: OECD Economic Outlook 114 database; and OECD calculations.

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• r – g. This component is the implicit average interest rate paid on government debt minus the nominal GDP growth rate (but also accounts for interest received on financial assets). The projection of this implicit average rate accounts for the gradual refinancing of outstanding debt at projected market interest rates, assuming that the debt maturity structure remains as it is now. Projected market interest rates include fiscal risk premia that are functions of budget balances and debt-to-GDP ratios. Given that market interest rates have recently risen and are projected to remain higher through 2040 than they have been in recent history, and that nominal GDP growth generally slows due to declining potential growth and normalising inflation rates, this component worsens debt dynamics. It adds 25 percentage points of GDP in government debt by 2040 in the median G7 country, but much more in countries with relatively high initial debt levels.

• Health and long-term care expenditure. Projected increases in public health and long-term care expenditure, due to population ageing and the rising relative price of government services, cause structural fiscal positions to deteriorate in all G7 countries, adding 9 percentage points of GDP of extra debt by 2040 in the median G7 country as spending pressures accumulate.

• Pension expenditure. As for health and long-term care, rising public pension expenditure due to population ageing is projected to add 13 percentage points of GDP to government debt by 2040 in the median G7 country, but with sizeable variation across countries. This projection assumes that current country-specific average pension benefit ratios remain constant over time, except in Italy where the ratio is projected to decline over time reflecting the continued implementation of recent pension reforms.

• Other factors. This component regroups government current expenditure on items other than health, long-term care and pensions (such as education and cash transfers) as well as net capital expenditure. Net capital expenditure includes capital transfers received, such as Next Generation EU grants, which are projected to taper off over the next few years. It also includes any estimated cyclical effect making the fiscal balance better or worse than the structural one in 2025 and which is projected to gradually disappear. Overall, this component contributes little to debt accumulation in the median country, although no account is taken of potential new sources of expenditure pressure such as climate change adaptation and higher defence spending (see, on the latter, OECD (2023c)).

Altogether, these illustrative projections see net government debt increasing by around 70 percentage points of GDP by 2040 in the median G7 country. Put differently, the median OECD country would need to increase annual revenue over time, by about 3½ percentage points of GDP by 2040, and 6½ percentage points of GDP by 2060, to keep government debt ratios from rising beyond projected 2025 levels given projected expenditure trajectories (Guillemette and Château, 2023).

Another useful indicator of fiscal pressure is the projected evolution of general government gross financing needs, defined as new borrowing requirements plus debt maturing during the year (Figure 1.26). After spiking at more than 35% of GDP during the COVID period, annual financing needs are now around 28% of GDP in the median G7 country. In the no policy change scenario outlined above, where budget balances deteriorate due to spending pressures, annual financing needs increase substantially in the years ahead, particularly in the United States (because of a large initial primary deficit), Japan and Italy (because of high initial debt levels). The United Kingdom is helped by a relatively long debt maturity structure, with an average remaining maturity of approximately fourteen years versus seven for the rest of the G7 as of the third quarter of 2023 (Figure 1.24). The projections (and the average maturity structure statistics) do not account for large holdings of government debt by central banks, which effectively shortens the average maturity of outstanding debt for the consolidated public sector.

Figure 1.26. Projected annual gross government financing needs

Note: The underlying economic scenario is described in Guillemette and Château (2023). The fiscal balance and debt projections are the same as in Figure 1.25.

Source: OECD Economic Outlook 114 database, and OECD calculations.

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These illustrative assessments highlight the need for policy changes to help ensure debt sustainability. One of the most effective ways of alleviating future fiscal pressure stemming from population ageing would be to undertake reforms to labour market policies and public pension programmes that seek to raise employment rates and extend working lives (Rouzet et al., 2019). Another would be to index long‑term fiscal programmes to their underlying drivers, such as life expectancy in the case of pensions, which can also help reduce fiscal uncertainty (Orszag et al., 2021). Many countries are already making welcome changes in this direction. According to stylised simulations, ambitious labour market reforms, including linking statutory retirement ages to future gains in life expectancy, could halve long-run fiscal pressure in the median OECD country relative to a no-reform scenario (Guillemette and Turner, 2021). Credible medium-term fiscal plans that spell out the strategies governments will use to contain public debt would help the necessary adjustments to take place and reduce the risks of adverse market events.

Stronger near-term efforts to rebuild fiscal space would enable policy to respond effectively to future shocks and improve the near-term alignment of fiscal and monetary policies, thus reducing the burden on monetary policy to lower demand pressures and inflation. However, many OECD economies, including all G7 countries, are expected to record primary deficits this year, a situation often expected to persist, albeit with some improvement, through to 2025. Together with the potentially-higher level of future real interest rates than prior to the pandemic, this suggests that it may prove harder to achieve a significant reduction in debt than in the past (Arslanalp and Eichengreen, 2023). Over the past four decades, episodes of significant reductions in the debt-to-GDP ratio have generally required achieving a primary surplus and sustaining this over several years as well as the favourable impact of very low real interest rates on debt dynamics (Annex 1.B.; Rawdanowicz et al., 2021). Stronger consolidation efforts than those currently envisaged are thus likely to be needed if debt ratios are to be put on a downward trajectory.

Reinforced and credible medium-term fiscal frameworks, with clear guidance about future spending and tax plans, and reassessments of the composition of public spending would help to ensure debt sustainability while reallocating scarce budgetary resources towards unavoidable future spending pressures. This would help ensure that the necessary consolidation does not come at the expense of the investment needed to help foster the green and digital transitions or spending on other high‑priority, productivity‑enhancing measures such as skills acquisition. During past debt reduction episodes, primary balance improvements have mainly stemmed from declines in the primary expenditure-to-GDP ratio, with some additional, but smaller, revenue increases, especially from direct taxes (Annex 1.B.). Changes to pension expenditure have often accounted for a sizeable share of these declines in the primary expenditure‑to‑GDP ratio, illustrating the importance of ambitious pension reform to reduce expenditure and debt pressures.

Emerging-market economies need to ensure macroeconomic stability

Monetary policy remains restrictive in most emerging-market economies, with core inflation often still far above central bank targets. However, the impact of policy tightening on inflation is appearing at a varying pace across countries. In some economies in which significant policy tightening started at a relatively early stage, including Brazil and Chile, central banks have now begun to reduce policy rates as inflation falls. In others, including India, Mexico and South Africa, policy rates remain unchanged with inflation remaining contained but not declining quickly. In contrast, faced with high inflation or currency depreciation pressures, Argentina, Indonesia, Russia and Türkiye have increased policy rates. China is a notable exception, with inflation remaining very low and policy rates being reduced recently to help support growth.

Monetary policy space in most emerging-market economies remains constrained by tight global financial conditions and the need to keep inflation expectations anchored, with positive real interest rates needed to help moderate inflation (Figure 1.27). Hence, in many countries, policy rates are projected to start declining only in 2024. Türkiye is an exception, with further policy rate increases still likely to be needed next year to curb persistently high inflation.

• In Latin America, policy rates in Brazil are projected to continue declining, with tighter credit conditions expected to steadily reduce core inflation. Mexico is projected to start reducing policy rates at a later stage, in the second half of 2024, when both headline and core inflation are expected to fall below 4%, the upper limit of the inflation target band.

• In Asia, continuing food price pressures in India and the need to firmly anchor inflation expectations in Indonesia, coupled with the common goal of avoiding currency depreciation, are expected to delay policy rate declines in these countries until mid-2024.

• The policy rate in South Africa is projected to start declining in the second half of 2024, when inflation is expected to moderate to the central bank target range.

Figure 1.27. Policy rates are projected to be gradually reduced in many emerging-market economies

Note: Panel A: The emerging-market economies considered are Brazil, Bulgaria, Chile, China, Colombia, Costa Rica, India, Indonesia, Mexico, Peru, Romania, Saudi Arabia and South Africa for headline inflation and the policy rate, and Brazil, Bulgaria, Chile, Colombia, Costa Rica, Mexico, Peru, Romania and South Africa for core inflation.

Source: OECD Economic Outlook 114 database; and OECD calculations.

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Fiscal deficits have continued to decline in many emerging-market economies, reflecting the reining in of pandemic‑related fiscal support and, in some countries, a gradual withdrawal of energy‑related measures. However, revenue windfalls have been deployed to counter the cost-of-living crisis in some countries, including Brazil, leading to a counter-cyclical fiscal expansion. Fiscal developments are expected to vary across countries in 2024. While Mexico is projected to have a sizeable near‑term fiscal expansion, with new infrastructure projects and social programmes, fiscal consolidation is projected in Brazil, India and South Africa. In China, fiscal policy has become more supportive with a new package of spending (worth 0.8% of GDP) announced in October.

The stock of debt in the emerging-market economies is high and has risen sharply in some countries since the global financial crisis, eroding fiscal buffers to mitigate new shocks and increasing refinancing risks (Figure 1.28). Governments need to rebuild fiscal space and ensure fiscal sustainability, while supporting those most in need and making the necessary investments to boost growth and achieve the climate transition. Credible fiscal frameworks, based on transparent fiscal rules, would provide greater flexibility to respond to shocks. In commodity-rich countries, fiscal frameworks could also be designed in a way to delink fiscal policy choices from the volatility of commodity prices. Many countries need to strengthen revenue collection and fight tax evasion, including by improved tax administration, modernised property registries and streamlined corporate tax codes (OECD, 2023d), as well as introducing reforms to reduce informality. This would provide greater scope to expand coverage of social protection systems, especially in countries with a large informal sector. The rise in debt distress among lower-income countries also makes it particularly urgent that creditor countries and institutions take joint action to ensure that debt burdens are sustainable and to mitigate the risk that debt overhangs set back development.

Figure 1.28. Public debt has risen sharply since 2009 in most emerging-market economies

Note: GDP corresponds to the 4-quarter average.

Source: International Monetary Fund Sovereign Debt Investor Base dataset; and OECD calculations.

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Trade policies should focus on expanding trade as well as enhancing resilience

Open and well-functioning international markets under a rules-based global trading system are an important source of improvements in living standards. Through trade, higher productivity, lower prices and greater choice have brought greater prosperity for billions of people, especially in emerging‑market economies. However, the global economy has now experienced over a decade in which trade growth in volume terms has just kept pace with output growth, after previously rising steadily since the 1990s. This has contributed to the broader structural slowdown in output growth since the global financial crisis. In recent years, the cumulative burden of trade restrictions has also risen, especially since 2018.

A key challenge for trade policy is to balance a rising number of policy objectives within an increasingly complex geopolitical environment. Steps to enhance the resilience of global value chains to supply chain disruptions, and reduce over-reliance on individual suppliers and complexity, should avoid eroding the efficiency benefits that value chains provide. Goods essential for the climate transition (Box 1.3) will require particular attention, given the sharp rise in restrictive trade practices for critical raw materials and the tendency of industrial policy to be increasingly inward-focused.

More concerted policy efforts to support trade in services would boost economic growth. Although services make up more than two-thirds of global GDP, they account for just under a quarter of global trade volumes. The OECD Service Trade Restrictiveness Index highlights the continued challenges of regulatory fragmentation and uneven conditions in access to services markets across countries (Figure 1.30, Panel A). The cost of trading is estimated to be typically twice as high for services than for goods, reflecting regulatory divergence across countries and complex procedures (OECD, 2023e). Reducing these costs by improving market access would generate substantial cost savings (OECD-WTO, 2021), raise trade and potentially strengthen productivity, both in service sectors and manufacturing sectors that purchase services inputs (Beverelli et al., 2017; Fiorini, and Hoekman (2017), Baldwin, 2022b). Acting now is critical, since many of the benefits from lowering services restrictions arise mainly over the medium to long term (Benz et al, 2023).

Box 1.3. The restructuring of green trade

There is ample evidence that geopolitical factors are now contributing to the restructuring of aggregate global trade patterns (Antràs, 2021, Baldwin, 2022a, OECD, 2023b). This box highlights that green trade is also changing in the major global economies. Moreover, green trade has not grown particularly quickly in these economies: over the last 5 years, in value terms, imports of environmentally-related goods grew more slowly than total imports, reflecting in particular weakness in China. By contrast, trade in electric vehicles has risen sharply from low levels.

The analysis uses import data for the United States, Japan, the European Union and China based on the OECD combined list of environmental goods (CLEG) (OECD, 2019)1 and trade in electric or hybrid passenger vehicles.2 All data are in nominal US dollars, based on UN Comtrade statistics, as volume data are not available.3 An unavoidable limitation of this approach is that relative price movements across products as well as exchange rate movements could affect some changes in trade shares over time.

In recent years, trade in environmental goods has collectively outpaced total merchandise trade growth (UNCTAD, 2023; WTO, 2023b). However, the share of environmental goods (CLEG) in the combined total imports of the United States, Europe, China and Japan slipped from 6.8% in 2018 to 5.5% in 2022.4 In contrast, the much smaller trade in hybrid and electric passenger vehicles rose from 0.3% of total imports in 2018 to 0.7% in 2022 (Figure 1.29, Panel A).

Figure 1.29. Changes in imports of environmental goods over 2018-22

Note: All data in value terms, USD. For each of the four major economies, Panel B shows the change in the share of their CLEG imports from selected partner economies. OECD Asia includes Korea and Japan; Dynamic Asian Economies include Hong Kong (China), Malaysia, the Philippines, Singapore, Chinese Taipei, Thailand and Viet Nam; USMCA includes the United States, Mexico and Canada; Rest of the world includes all other countries not mentioned elsewhere in the chart.

Source: UN Comtrade; and OECD calculations.

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Changes in the bilateral import shares of the combined list of environmental goods have been sizeable (Figure 1.29, Panel B). In the United States, the share of imports from China declined between 2018 and 2022, offset by rising levels of trade with India and the dynamic Asian economies, at both total trade and broad product categories. There were only small changes in the share of imports from Canada and Mexico. In contrast, China’s share of imports rose in Europe. In Japan, no strong pattern is evident in overall environmental goods trade. For all three of these economies, the trends are similar to changes in trading partners for manufacturing imports as a whole (Koh et al. 2023).

Trade in environmentally-related goods can help diffuse technology (Garsous and Worack, 2021; Bacchetta et al, 2023). In the first half of 2023, trade in these goods has picked up in Europe, Japan and the United States. As efforts to accelerate the climate transition increase, the potential impact of industrial and trade policies on trade in environmentally related goods should be carefully considered.

1. The CLEG is made up of 11 broad product categories, including renewable energy plants and waste-water treatment. The CLEG contains 248 products at HS 6-digit level.

2. This relatively small category is made up of 6 products, only one of which is in the CLEG.

3. To ensure comparability, United Kingdom data are excluded from the UN Comtrade EU aggregate prior to Brexit.

4. Differences in relative prices could explain some of the decline in shares. Global manufactured goods prices (excluding food and fuel) rose around 11% cumulatively between 2018 and 2022. Whilst there is no index of traded goods in environmental goods, the price of environmental technologies is estimated to have declined by around 10% between 2018 and 2022 (IEA, 2023a).

Concerted efforts to support the digital delivery of services could help to overcome some of the growing risks to services trade – such as the rise in limitations on the business activities of foreign companies, foreign direct investment, and the movement of people. Raising digital connectivity between countries can support trade in services as well as in goods (Figure 1.30, Panel B). However, digital services policy remains fragmented and increasingly restrictive, limiting the benefits of digitalisation. The OECD Digital Services Trade Restrictiveness Index shows that trade restrictions introduced in 2022 particularly affected access to communication infrastructure, the movement of information across networks and the lack of pro‑competitive regulations (OECD, 2023f). Governments need to find an appropriate balance between safeguards and ensuring adequate competition in digital services. A set of common, predictable standards for cross-border data flows, privacy and consumer protection, where international agreements are lagging other digitally-related services, would have significant knock-on benefits for trade in services.

Figure 1.30. Reducing services and digital regulation would boost trade growth

Note: Panel A: OECD Service Trade Restrictiveness Index. The OECD aggregate is a simple average of all OECD members. Panel B. Values show the estimated impact of a 1% improvement in bilateral digital connectivity on international trade by sector.

Source: OECD (2023e), OECD Services Trade Restrictiveness Index: Policy Trends up to 2023, OECD Publishing, Paris; and López González, J., S. Sorescu and P.Kaynak (2023), “Of bytes and trade: Quantifying the impact of digitalisation on trade", OECD Trade Policy Papers, No. 273, OECD Publishing, Paris.

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Reforms are needed to strengthen the climate transition

Governments face significant medium and longer-term structural challenges from the ongoing decline in potential output growth, ageing populations, the climate transition, digitalisation, and the AI revolution. The 2023 edition of Going for Growth (OECD, 2023d) provides country-specific advice to help achieve stronger, more inclusive and resilient growth. Specific reform priorities differ by country, and well‑designed policy packages will be needed to address the key challenges. However, securing faster progress towards decarbonisation, strengthening product market competition and contestability, enhancing skills, removing obstacles to the reallocation of labour and capital towards more productive firms, and improving the design and management of social protection programmes are key policy needs in most economies. Finding an appropriate balance between the need for resilient supply chains and the opportunities available to reinvigorate global trade would also strengthen growth and incomes.

Enhanced multilateral co-operation is required to help meet the common challenge of the climate transition. The current policies in place may not lower global greenhouse gas emissions before 2030 (IEA, 2022), making the goal of net-zero emissions by mid-century difficult to attain. Reaching that goal requires structural changes in the economy and will entail substantial reallocation of workers and capital from emission-intensive activities towards greener activities. Accelerating the pace of decarbonisation will require ambitious packages of new policy measures, and action in three major areas: strengthening green investment and innovation; increasing the scope and level of carbon pricing; and enhancing regulations, institutions and standards to enable emission reductions.

• Additional public and private investment in clean energy technologies is needed in all economies. The International Energy Agency (IEA) estimates that investment in clean energy technologies needs to more than double from an estimated USD 1.8 trillion in 2023 to USD 4.5 trillion by 2030 (IEA, 2023b). Governments can foster the needed acceleration by strengthening access to the supply of critical minerals and other products for clean energy investments, and making tax, price and regulatory changes that send clear signals to private investors about the future demand for clean energy technologies. Direct public investment, including support for innovation, also has a clear role to play. Stronger participation by institutional investors in areas such as green infrastructure financing could also support investment given limited fiscal space in many countries.

• A clear and predictable trajectory for the price of carbon would help to incentivise mitigation and provide a clear signal to investors about the long-run returns from investing in low‑carbon technologies (OECD, 2021). Strong and stable price signals are necessary but still lacking in most countries. Alongside this, recycling the revenue raised from carbon pricing would offer opportunities for governments to reduce distortionary taxation and counter the adverse distributional effects of a higher carbon price (D’Arcangelo et al., 2022).

• Large mitigation benefits can be reaped through a clear, predictable and carefully-designed regulatory environment and improved emissions standards (Berestycki et al., 2022; D’Arcangelo et al., 2023). These can directly reduce emissions and enhance the effect of pricing measures and the provision of low-carbon options. Regulations such as requirements for energy renovation, emissions tracking and green certification should be strengthened to facilitate mitigation while minimising costs. In some countries, reducing or removing regulatory barriers would facilitate the expansion of renewable energy.

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Rawdanowicz, Ł., Turban, S., Haas, J., D. Crowe and V. Millot (2021), "Constraints and Demands on Public Finances: Considerations of Resilient Fiscal Policy", OECD Economics Department Working Papers, No. 1694, OECD Publishing, Paris.

Rouzet, D., A. Caldera Sánchez, T. Renault and O. Roehn (2019), “Fiscal Challenges and Inclusive Growth in Ageing Societies”, OECD Economic Policy Papers, No. 27, OECD Publishing, Paris.

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Annex 1.A. Policy and other assumptions underlying the projections

Fiscal policy settings for 2024-25 are based as closely as possible on legislated tax and spending provisions and are consistent with the growth, inflation and wage projections. Where government plans have been announced but not legislated, they are incorporated if it is deemed clear that they will be implemented in a shape close to that announced. Unless otherwise announced, the phasing-out of any remaining energy-related support measures is assumed to be completed by end-2024 at the latest.

Projections for the EU countries account for spending financed by the Next Generation EU (NGEU) grants and loans, based on expert judgments about the distribution across years and different expenditure categories and informed by officially announced plans where available. NGEU grants are assumed to be budget neutral, and increase both capital tax and transfers receipts and government expenditure. In addition, positive net one-offs are added in order to reflect the discretionary stimulus associated with those grants, as measured by changes in underlying primary balances.

For monetary policy, the assumed path of policy interest rates and unconventional measures represents the most likely outcome, conditional upon the OECD projections of activity and inflation. This may differ from the stated path of the monetary authorities. In the euro area, 10-year sovereign spreads relative to Germany are assumed to remain constant over the projection period at levels close to those observed in October 2023.

The projections assume unchanged exchange rates from those prevailing on 10 November 2023: one US dollar equals JPY 151.4, EUR 0.94 (or equivalently one euro equals USD 1.07) and 7.29 renminbi.

The price of a barrel of Brent crude oil is assumed to remain constant at USD 85 until the end of 2025. The TTF natural gas price is assumed to remain constant at EUR 45 MW/h until the end of 2025. Other commodity prices are assumed to be constant over the projection period at their average levels from August 2023.

The cut-off date for information used in the projections is 23 November 2023.

OECD quarterly projections are on a seasonal and working‑day‑adjusted basis for selected key variables. This implies that differences between adjusted and unadjusted annual data may occur, though these in general are quite small. In some countries, official forecasts of annual figures do not include working‑day adjustments. Even when official forecasts do adjust for working days, the size of the adjustment may in some cases differ from that used by the OECD.

Annex 1.B. Addressing high public debt: lessons from past debt reduction episodes

Introduction

Governments face rising fiscal pressures from high debt burdens, increasing debt service costs and additional spending on ageing populations, the climate transition and defence. In dealing with these significant fiscal challenges, governments can potentially draw on the lessons from past episodes in which countries have achieved large and sustained reductions in their debt-to-GDP ratios and changed the composition of public expenditure. The work in this annex builds on earlier studies by the Secretariat (Cournède et al., 2014; Bloch et al., 2016; Rawdanowicz et al., 2021) and examines the drivers of debt reduction episodes in OECD countries since the late 1970s, and the evolution of different revenue and expenditure components during these episodes.

In all, 34 debt reduction episodes since the late 1970s are identified, with 25 OECD member states having experienced at least one episode during this period. On average, these debt-reduction episodes have lasted 9 years, with a total decline of 27 percentage points in the debt-to-GDP ratio.

The key findings are that reductions in the debt-to-GDP ratio have mainly hinged on achieving and sustaining a primary surplus over several years, largely via expenditure restraint, and on favourable cyclical conditions and low interest rates. Declines in the primary expenditure-to-GDP ratio during the episodes have often entailed large cuts in subsidies and certain non-social transfers as a share of GDP, rather than education, healthcare and public investment, as well as containment of spending on pensions. These drivers of debt ratio reductions may be difficult to emulate in the near future (Arslanalp and Eichengreen, 2023), but lessons from past sustained shifts in the composition of expenditure remain highly relevant for present challenges.

Identifying debt reduction episodes and the key drivers of debt dynamics

Debt reduction episodes are defined as ones that persist for a minimum of five years and bring down the gross general government debt-to-GDP ratio by at least 10 percentage points. Temporary and small debt ratio reversals are allowed from one year to the next during such episodes, but all episodes start in a year after the peak in the debt ratio and end when the debt-to-GDP ratio bottoms out.4 The analysis covers the periods from the late 1970s to 2019, though data availability is limited for some OECD countries.

Accounting decompositions of changes in the debt-to-GDP ratio (d) typically consider three components (Rawdanowicz et al., 2021): the primary balance-to-GDP ratio b (hereafter the “primary balance”), the interaction of debt and the differential between the implicit interest rate on debt (i) and GDP growth g (the so‑called “snowball effect”), and a residual stock-flow adjustment as a share of GDP (a). The latter summarises changes in gross debt unaccounted for by the budget balance.5

${\Delta d}_t={\frac{i_t-g_t}{1+g_t}d}_{t-1}-b_t+a_t$ [1]

Equation [1] can also be written in terms of annual averages over the length of each debt reduction episode, denoted as lasting from year 1 to year k:

$\frac{d_k-d_0}{k}=\frac{\sum _{t=1}^k{\frac{i_t-g_t}{1+g_t}d}_{t-1}}{k}-\frac{\sum _{t=1}^k{b}_t}{k}+\frac{\sum _{t=1}^k{a}_t}{k}$ [2]

The average primary balance over each debt reduction episode in [2] can be further decomposed into the initial balance at the time when the debt ratio peaks (year 0) and the average primary balance change over the length of the episode relative to the initial value. Likewise, the aggregate snowball effect can be split to show separate impacts due to the real interest rate (r, with inflation (π) measured by the GDP deflator) and real GDP growth (g^*).

$\frac{d_k-d_0}{k}=\frac{\sum _{t=1}^k{\frac{r_t(1+{\pi }_t)}{1+g_t}d}_{t-1}}{k}-\frac{\sum _{t=1}^k{\frac{g_t^{\mathrm{*}}(1+{\pi }_t)}{1+g_t}d}_{t-1}}{k}-b_0-\left(\frac{\sum _{t=1}^k{b}_t}{k}-b_0\right)+\frac{\sum _{t=1}^k{a}_t}{k}$ [3]

The decomposition of each debt reduction episode is shown in Figure 1.B.1. This highlights two key factors:

• In all but three episodes the primary balance is on average in surplus, thus contributing to a reduction in the debt ratio. This is often (in around 80% of the episodes) due to improvements in the primary balance during the episode itself and, less frequently (in about 40% of the episodes), to a positive starting value of the primary balance.

• In about two thirds of the episodes, and in all but one of the 14 episodes that have begun since the year 2000, the snowball effect contributes positively to debt reductions. GDP growth has on average tended to exceed potential,6 and the real interest rate has often been only marginally positive or even negative.

Annex Figure 1.B.1. Decomposition of the average annual change in the debt ratio during debt reduction episodes

Per cent of GDP

Note: The chart shows the average annual change in the debt ratio over the length of each episode and its decomposition according to equation [3] in the text. Episodes are ordered chronologically by starting year. A negative bar indicates that the particular factor has helped to lower debt over the period shown.

Source: OECD Economic Outlook 113 database; and OECD calculations.

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The evolution of the primary balance during debt reduction episodes

Improvements in the primary balance during debt reduction episodes have clearly been an important source of debt ratio reductions. This raises the question of whether such improvements have occurred mainly through lower primary expenditure to GDP, or from increases in primary revenue to GDP. The separate contributions from expenditure and revenue to the identified change in the primary balance during the 34 debt reduction episodes are shown in Figure 1.B.2.

• The major source of the improvements in the primary balance has been a decline in the share of primary expenditure in GDP. Such declines have occurred in over 80% of the 34 debt reduction episodes.

• Increases in the primary revenue-to-GDP ratio have occurred in fewer than half of the debt reduction episodes, and mostly for episodes that began in the 1980s and 1990s.

Annex Figure 1.B.2. Primary expenditure restraint has often taken place during debt reduction episodes

Changes in ratios to GDP, percentage points, average over each debt reduction episode

Note: The chart shows the average annual change in the primary balance over the length of each episode relative to its initial value and its decomposition into the changes in primary revenue and primary expenditure. The change in the primary balance (triangles) is the same as in Figure 1.B.1 (blue bars), with inverted sign (hence a positive value now indicates an improvement which helps to lower debt). Episodes are ordered chronologically by starting year.

Source: OECD Economic Outlook 113 database; and OECD calculations.

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Compositional changes during debt reduction episodes

The changes in primary expenditure and revenue during debt reduction episodes can be further decomposed to identify shifts in the composition of expenditure and taxation. On the expenditure side (Figure 1.B.3):

• Most categories of primary spending have declined relative to GDP during past debt reduction episodes. There are only a handful of examples in which either public investment or spending on education and health have been raised during debt reduction episodes.

• However, expenditure restraint has often been accompanied, and likely made more sustainable, by growth-friendly shifts in the composition of public spending. Public investment as a share of GDP did decline in about two-thirds of the episodes (23 out of 34), but cuts to investment were often proportionally smaller than other expenditure items. In contrast, large reductions in public investment have often been found in consolidation episodes (Pina, 2016).

• Spending on education, health and family and children, generally regarded as growth- and equity‑friendly (Cournède et al., 2014; Fournier and Johansson, 2016), was also preserved to a larger extent than spending on pensions and the bulk of non-education, non‑health wages and intermediate consumption. Reductions in the latter types of spending as a share of GDP have often been sizeable.

Annex Figure 1.B.3. Growth-friendly expenditure has typically been spared during debt reduction episodes

Changes in ratios to GDP, percentage points, average over each debt reduction episode

Note: The chart decomposes the average annual change in primary expenditure as a share of GDP over the length of each episode relative to its initial value (red bars in Figure 1.B.2) into several expenditure components as defined in the OECD Public Finance Dataset. “Education, health and family” denotes most current spending devoted to education, health care and, within social protection, family and children (expenditure items 1, 2 and 7 in Bloch et al., 2016). “Other wages” includes most wages, as well as intermediate consumption, in functions other than education and health (expenditure item 3 in Bloch et al., 2016). “Others” includes unemployment benefits, sickness and disability spending, subsidies, other primary expenditure (expenditure items 5, 6, 8 and 10 in Bloch et al., 2016, item 10 being adjusted to include non-interest property income paid) and, in some cases, a statistical discrepancy term. In some earlier episodes not all components can be identified due to data limitations. Episodes are ordered chronologically by starting year.

Source: OECD Economic Outlook 113 database; OECD Public Finance Dataset; and OECD calculations.

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• Declines in the GDP share of the remainder of public expenditure, including subsidies, unemployment, sickness and disability benefits, non-social current transfers and capital transfers were often the largest factor behind the lower primary expenditure-to-GDP ratio.7 Many of these items are not growth-enhancing, though some can be very important for incomes, particularly in poorer households.

On the revenue side (Figure 1.B.4):

• Corporate income taxes as a share of GDP increased in almost 90% of all debt reduction episodes, often in tandem with improved cyclical conditions. In 13 of the 15 episodes with an increase in the primary revenue-to-GDP ratio, the contribution of corporate income taxes to that increase was proportionally larger than its initial share in total primary revenue.

• In contrast, an increase in other direct taxes (personal income taxes and social security contributions) as a share of GDP occurred in less than half of all debt reduction episodes. In some cases, debt reductions occurred alongside sizeable reductions in other direct taxes as a share of GDP.

• The contributions of changes in the GDP shares of indirect and property tax revenues to the overall change in primary revenue have typically been relatively small. There have been few debt reduction episodes in which such taxes rose as a share of GDP.

A positive differential between GDP growth and interest rates cannot be relied upon to decrease the debt‑to-GDP ratio in the coming years, and primary surpluses via expenditure restraint will not be easy to achieve (Arslanalp and Eichengreen, 2023), particularly when there are demands to raise public investment. This reflects the multiple future spending pressures governments face. Reductions in the debt ratio may thus be harder to achieve in the coming decade than in the past. Nonetheless, past debt reduction episodes illustrate that it is possible to make significant savings in spending items which often harm growth, such as subsidies and certain transfers. In the current context, where the composition of public expenditure needs to change to address new challenges, that lesson remains highly relevant. Any such changes will need to be accompanied by improvements to the overall targeting and design of spending programmes to maintain support for those who need it most.

Annex Figure 1.B.4. Corporate income taxes have generally increased during debt reduction episodes

Changes in ratios to GDP, percentage points, average over each debt reduction episode

Note: The chart decomposes the average annual change in primary revenue as a share of GDP over the length of each episode relative to its initial value (green bars in Figure 1.B.2) into several revenue components as defined in the OECD Public Finance Dataset. “Other direct taxes” denotes revenues from personal income taxes and social security contributions (revenue items 1 and 2 in Bloch et al., 2016). “Indirect and property taxes” group revenue items 4-7 in Bloch et al., 2016. “Others” includes revenues from sales of goods and services (mainly user charges), other primary revenue (revenue items 8 and 9 in Bloch et al., 2016, item 9 being adjusted to include non-interest property income received) and, in some cases, a statistical discrepancy term. In some earlier episodes not all components can be identified due to data limitations. Episodes are ordered chronologically by starting year.

Source: OECD Economic Outlook 113 database; OECD Public Finance Dataset; and OECD calculations.

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Notes

← 1.  Disruption to production in Israel could also add to supply difficulties, despite the country’s small overall share of global trade. Israel is an important source of several high-tech products, such as integrated circuits and medical instruments, and also provides around 6-8% of global exports of potash and phosphate fertilisers.

← 2.  Tax credits in the Italian Superbonus scheme were initially accounted as non-payable tax credits, giving rise to a loss of revenue over several years after the home renovation took place. They are now treated as payable tax credits, giving rise to increased expenditure in the year the home renovation takes place (Istat, 2023). This improves the fiscal balance in 2024-26 and worsens it in 2021-23 (the three years when most renovations took place) relative to earlier estimates. The scheme is to become less generous as of 2024.

← 3.  Moreover, if short rates and long rates move in the same direction there could be capital losses on the debt that central banks have acquired, potentially adding to central bank losses and reducing payments to the government (OECD, 2023b).

← 4.  Reversals cannot exceed 2 years or a cumulative 5 percentage points.

← 5.  Examples are valuation effects and below-the-line operations. The stock-flow adjustment also includes, with a negative sign, the interest receipts of general government. This helps to explain why it makes the debt ratio fall in about two thirds of the episodes.

← 6.  The output gap has almost always improved relative to that prevailing when the debt ratio peaked.

← 7.  Subsidies and non-social current transfers are also the items which account for the bulk of non-targeted expenditure-side energy support (Hemmerlé et al., 2023; Eurostat, 2023).