Expect mediocre growth and, in America, too much inflation in the year aheadThe EconomistThe EconomistWed, 31 December 2025 10:51AMCommentsComments
For years the world economy has defied doomsayers.
When the coronavirus pandemic struck, many people expected a long slump; instead there was a fast and inflationary rebound. When central banks then raised interest rates to quell prices, a widely forecasted recession never came.
And after President Donald Trump slapped Liberation Day tariffs on trading partners in April, markets tanked. Investors feared an enormous trade war and a deep crisis. But the tariffs were watered down and stock markets began an astonishing bull run.
At the same time America’s real economy has grown at a rate that, though noticeably slower than before, is far from recessionary. Globally, too, growth has slowed but not stopped.
Will this resilience continue in 2026?
The threats to growth are almost too many to count. The lesson of recent years is that they are less likely to cause a crash than some might fear. Yet they could still throw plenty more sand in the gears of the world economy.
For a start, Mr Trump’s trade war is far from over. At the time of writing the tariff rate on goods imported to America, calculated from customs revenue, was only 10.5 per cent (versus a threatened 28 per cent calculated by wonks at the height of April’s scare).
But the worst tariffs on China, the sole country to have seriously retaliated against Mr Trump, are merely paused, whatever the recent conciliatory rhetoric of both sides. And although the Supreme Court is likely to curtail Mr Trump’s power to set tariffs at his total discretion, his administration is preparing every legal alternative in its arsenal to keep levies high. A shift from one legal mechanism to others would create upheaval and uncertainty.
One live danger from the tariffs is their impact on the Federal Reserve’s monetary policy. By the spring of 2026 tariffs will probably be boosting America’s underlying rate of annual inflation by about one percentage point.
That could make the Fed reluctant to cut interest rates as much as markets hope. At least in 2022 and 2023 labour markets were booming as inflation surged. But because tariffs hurt, rather than help, economic growth, the Fed might have to put up with a softer-than-ideal labour market to keep a lid on prices.
The mirror-image of that danger is the risk that Mr Trump bends the Fed to his will in 2026, casting doubt on the central bank’s long-term inflation-fighting credibility. Jerome Powell, the Fed’s chair, is due to step down in May.
His departure could set off a succession drama at the central bank. His likeliest replacement is Chris Waller, a technocratic governor whom Mr Trump appointed in his first term. If Mr Trump chooses someone more partisan, expect Mr Powell to stay on as a Fed governor — a separate role for which his term does not expire until 2028 — in an attempt to preserve the institution’s independence.
The threat that Mr Powell could hang around is probably helpful to Mr Waller’s chances. But the Supreme Court will also rule on Mr Trump’s attempt to remove Lisa Cook, another governor, for alleged improprieties in old mortgage applications. If the president is able to force out Ms Cook, his administration may try the trick on other governors, too — perhaps including Mr Powell, if he has not left the Fed’s board.
Threats to central-bank independence compound another of the world economy’s problems: the parlous state of government budgets. Deficit spending contributed to the world’s resilience after the pandemic. Yet the crisis took advanced-economy public debt higher than in any period since the aftermath of the Napoleonic wars.
France has lost five prime ministers in two years as it wrestles with its budget; Britain’s government is set to levy its highest taxes since the 1950s, yet is still cash-strapped; and even after accounting for revenue from tariffs, America will probably run a deficit of around 6 per cent of GDP in 2026.
It is an astonishing trajectory. And it brings with it the danger that governments lean on central banks to keep rates low to ease their debt burdens — a factor that Mr Trump has cited in his campaign against the Fed.
The growing dangers posed by reckless fiscal policy and compromised monetary policy are raising the odds of a bond-market crisis, like that which Britain suffered in 2022. A steep bond sell-off in a major economy such as France or Japan could tighten global financial conditions; a bond-market crash in America would be a seismic event.
The last serious danger to the world economy is a collapse of stock market confidence. One explanation for this year’s resilience is that growth has been buttressed by the boom in artificial intelligence. With respect to America’s real economy, this argument is often overstated, because the vast majority of AI chips, for example, are imported.
But the astonishing strength of stock markets, driven by faith in AI, is almost certainly making Americans feel wealthier, supporting their spending. If the boom fizzled out, the reverse would happen. Without the boom, there need not be a recession. But, plagued by tariffs, debt and a growth slowdown, there would not be much left to celebrate about the world economy.
The Economist
Get the latest news from thewest.com.au in your inbox.
Sign up for our emails
Read more on The West Australian
