Macro Views: Growth grinds, inflation grows

US economy: Heading into a stagflationary drift?

The US economy regained some momentum in the first quarter (Q1) after a soft end to 2025, helped by tech-driven investment and a rebound in federal spending following last October’s government shutdown. But the backdrop is becoming more stagflationary. Consumer spending growth softened, especially in discretionary categories, suggesting households are becoming more selective. Earlier expectations were that investment (supported by accelerated depreciation under the One Big Beautiful Bill Act), strong consumer spending, a tight labor market and reduced trade uncertainty would keep growth well above trend in 2026. The Middle East conflict has complicated that view by introducing downside risks to growth and upside risks to inflation. Sharply higher oil prices and supply-chain shocks tied to the closure of the Strait of Hormuz are now central to both. The longer oil prices stay elevated, and supply chains remain choked, the greater the likelihood that inflation becomes broader and more persistent, weighing on household purchasing power and the wider economy. Recent Institute for Supply Management data already point in a more stagflationary direction, with expansion occurring at a more inflationary price while employment expectations remain stagnant.

Inflation remains sticky and increasingly demand-led. Five years after the COVID-19-driven inflation shock and the Ukraine-Russia-driven energy shock, most measures of trend inflation suggest inflation may be structurally closer to 3%. More fundamentally, aggregate demand is driving inflation persistence. Two conditions stand out: While the unemployment rate is near equilibrium, output still stands above potential by about one percentage point, a mix consistent with inflation remaining well above the Federal Reserve’s (Fed’s) target. The San Francisco Fed’s inflation decomposition analysis also shows demand continuing to be one of the dominant drivers of the inflation overshoot relative to 2019, reinforcing the view that demand-driven inflation pressures remain underappreciated.

Aside from structurally stronger demand, there is also a cyclical source of hotter inflation: AI demand. The Fed’s Beige Book anecdotes describe very sharp increases in computing hardware costs and moderate to large increases in software costs, including for previously free AI tools. Hard data suggest AI-related demand is pushing up tech-related sub-categories of personal consumption expenditures (PCE) inflation and the Producer Price Index (PPI). Tariffs may be part of the story, but not all of it. In the near term, AI has likely sparked a strong positive demand shock, with surging investment across software, chips, hardware and data centers lifting prices, creating supply bottlenecks and raising costs. The oil shock adds another layer. Oil prices will, undoubtedly, determine the near-term path of headline inflation, but the market is using oil futures as a proxy for assessing the inflation and rate implications of the shock, implicitly treating the Iran shock as energy specific and transitory. Oil futures capture the direct energy-price impulse but miss the broader effects of nearly four months of disrupted logistics, rerouted trade, stranded liquefied natural gas (LNG) cargoes, and rising input delays and costs. These supply-chain frictions will likely persist well beyond the initial shock itself. The New York Fed’s Global Supply Chain Pressure Index saw its largest one-month rise in April since 2021, indicating a rapid tightening in global logistics, along with the Bureau of Labor Statistics’ four-stage production flow producer price data, suggest the shock may be in the early stages of moving from a commodity-local to a system-wide shock, where cost pressures cascade through production networks. The key will be to identify whether upstream cost pressures have moved beyond raw materials and are now embedded in intermediate manufacturing, making them far harder to reverse. As noted above, we are only seeing early signs of this so far (and they remain well below COVID-19-era extremes), but if they accelerates, pricing power will likely become more pervasive across sectors and core inflation would become less sensitive to easing commodity prices.

Tech continues to lead growth. Tech-driven investment remains one of the strongest drivers of activity, spending more than 10% above its longer-term trend. Housing remains stagnant, manufacturing has been declining for well over a year, and spending on power and water supply, a useful proxy for data-center construction, remains strong. Core capital goods orders dipped slightly in April, but only after a sharp March increase to a new all-time high, much of which likely reflects the AI data center boom. Credit standards remain slightly tight, yet demand for credit by large firms is robust, which links to the AI buildout. With the big four hyperscalers expected to accelerate AI spending, this tech-driven boost to growth looks set to continue. The main risk is supply-chain stress from the Strait of Hormuz closure. Petrochemicals sit deep in industrial value chains and AI-linked supply chains were already under strain before the conflict (as memory prices surged). Looking ahead, semiconductor production faces the risk of helium shortages given that roughly one-third of global supply transits via the Strait. Moreover, Asian manufacturing networks remain a key transmission channel. For the United States, growing reliance on the Association of Southeast Asian Nations for intermediate and high-tech goods tied to AI infrastructure increases exposure to higher input costs, longer delivery times and, in worse cases, outright shortages. Supply pressures have already risen rapidly across Asia outside China, with delivery times extending to near multi-year highs (outside of the pandemic).

Consumers are still spending, but they have less cushion. Household balance sheets remain healthy and nominal spending growth has held up despite weak sentiment. Even with the recent rise, oil prices adjusted for inflation or average hourly earnings are still below March 2022 levels, but pressure is building. Tax refunds that were expected to support discretionary spending have instead largely buffered the spike in gasoline prices. As that support fades in the second half of the year, consumers will still likely face higher pump prices, while a temporary federal gas-tax suspension would offset only a modest share of the increase and would come with a material deficit cost. Real incomes are already under pressure as they declined for a third straight month in April and have fallen year over year; a pattern that outside of stimulus or tax distortions has usually appeared during or shortly after recessions. Spending composition is also deteriorating, as real goods spending has increased given gasoline prices rather than discretionary demand, durable goods spending has turned slightly negative, and real retail spending excluding energy has stalled. However, consumers have not yet retrenched. The decline in the personal saving rate, which fell to its lowest level since June 2022 (2.6%), suggests consumers appear to have stretched their balance sheets further in response to higher gas prices. That, however, does leave households more exposed to additional shocks.

The labor market still looks stable and roughly in balance. Payroll growth rebounded in March and April, the unemployment rate has held at 4.3%, and jobless claims remain exceptionally low. Layoffs have picked up from the lows of the past year but are still historically low, while quit rates have risen back to their 2025 average, helping support nominal growth in the face of rising inflation. Construction jobs and wage growth have strengthened over the past six months, likely because of the AI buildout. That said, even though jobless claims are signaling strength, the reliability of this signal may be distorted. Claims are not just low in absolute terms but unprecedented relative to population size, and this may partly reflect immigration dynamics and enforcement actions rather than pure labor market strength. The Household Survey suggests employment among foreign-born workers has declined since last summer even as unemployment rates for immigrants have also fallen, implying withdrawal from measured labor force activity rather than genuine improvement. Therefore, rather than reflecting fewer layoffs, the unusually low jobless claims may be partly due to reduced participation in formal systems. Immigrants, especially those potentially affected by enforcement actions, may be less likely to file jobless claims or even report labor market status accurately to official surveys, thus suppressing measured unemployment and jobless claims.

On monetary policy, the bear case still holds. Market pricing has shifted from expecting two to three 25-basis-point (bps) interest-rate cuts to pricing a full 25-bps hike by December 2026, driven by the Middle East conflict and incoming data. Fed communication has also moved away from an easing bias toward a more symmetric reaction function. The April Federal Open Market Committee (FOMC) meeting minutes showed a majority open to hikes if inflation remains elevated, and recent commentary suggests inflation, rather than the labor market, has become the main policy driver. Our base case remains a protracted hold in rates, but policy is finely balanced. Steady upward revisions to core-PCE forecasts at future FOMC meetings, implying inflation pressures are turning broader, with growth still expected to remain at or above trend, will likely mean tighter policy. Moreover, labor market dynamics remain central; while conditions are stabilizing, a significant re-tightening would reduce the Fed’s tolerance for demand-driven inflation, especially with the emergence of supply-side pressures. With inflation rising and the policy rate on hold, real rates have already turned lower—monetary policy is implicitly turning easier. This is likely to further add to the debate whether the policy rate poses enough of a restraint on inflation. There is also an alternate scenario in which rising inflation causes broader demand destruction and a weaker labor market, bringing an easing bias back into play. For longer-term yields, we remain bearish on the 10-year Treasury. Although yields are off their peak, they remain materially higher since the start of the Middle East conflict, and term premium remains well below longer-run norms, leaving room for further upside especially given uncertainties and upside risks around inflation, the outlook for fiscal deficits, bond supply (not just in the United States, but globally) and the Treasury’s reliance on foreign demand, which has waned materially over the past 12 months as US Treasuries and US corporate bonds have been engaged in a fierce tug-of-war for investor capital.

European economic outlook

EU economy: It’s not a (2022) déjà vu

While Europe’s macro narrative since the start of the Middle East conflict has resembled a textbook stagflationary shock, it is not a 2022 déjà vu. In 2022, the Ukraine invasion and subsequent gas crisis offered the obvious template for thinking about higher energy prices, weaker growth, and stronger inflation. But the current shock is different. The closure of the Strait of Hormuz is framed as a global shock rather than a Europe-specific gas crisis, reducing the asymmetry in market sentiment that defined 2022. The euro area remains a major energy importer, but its direct exposure to Gulf oil and gas is relatively manageable albeit uneven across European Union countries. At the same time, Europe has improved supply diversification, including through US liquefied natural gas imports, and lowered gas consumption, with more renewables in countries like Spain and Finland, as well as a recovery in French nuclear production. As a result, energy availability is no longer the prominent concern it was in 2022. A global oil squeeze would still hurt the eurozone, especially through higher transport and aviation costs and even possible jet fuel shortages, but a broader industrial shutdown caused by unavailable energy looks much less likely. The bigger concern is that the eurozone would enter this shock from a weaker cyclical starting point, which raises questions about growth resilience, labor markets and the inflation impact of a new cost-push shock. 

Initial conditions matter, especially because the labor market is no longer tight. The 2022 energy shock hit a post-pandemic world marked by unusually high savings and strong reopening demand. Households had accumulated forced savings during COVID-19, which helped smooth consumption and provided substantial dry powder. Savings are high by historical standards today, but there is clearly less demand support than in 2022. Labor market conditions have also changed materially. The reopening surge created exceptional labor demand, particularly in services, and job vacancies and labor shortages climbed sharply. Those measures have largely returned to pre-COVID-19 levels, suggesting labor market tightness has faded. Employment growth, which averaged a robust 2.5% year-over-year in 2023, has slowed back to a below-trend pace, with Spain carrying most of the gains while Germany and France have been marginally shedding jobs, especially in the private sector. Unemployment remains historically low, but this seems to reflect a new equilibrium of higher participation and employment since the pandemic rather than renewed tightness. 

Softer domestic demand, looser labor market conditions, and reduced pricing power should lead to weaker domestic second-round effects than during the last energy shock. Inflation was already much hotter going into 2022 and monetary policy very accommodative. Headline Harmonized Index of Consumer Prices (HICP), core inflation, energy, goods, and food inflation were all running at much higher rates before the Ukraine invasion than before the Middle East conflict. The one exception was services inflation, which is somewhat firmer now, but at that time wage growth had not yet fully passed through. In 2022, strong domestic demand gave firms room not only to pass higher energy and input costs through to consumers, but also to expand profit margins. The current shock is still a global cost push which will inevitably lead to higher core inflation, with global producer prices and euro area import prices already rising, but firms’ pricing power appears weaker today. That means that part of the shock is likely to be absorbed in firms’ margins. This time, the ECB responded quickly to rising inflation, unlike in 2022. Wage growth did pick up in 2023 and 2024 as households tried to recover lost purchasing power, supported by still-strong labor demand and despite rising participation, but it seems harder to envisage a meaningful overshoot this time. However, the risk is that the weaker starting point makes recession more likely if oil supply remains constrained for long enough. 

Are incoming data trends starting to disappoint? Data releases covering the period following the breakout of the Iran hostilities have been only limited but broadly consistent with the thesis of higher inflation and weaker growth following an energy shock. Growth surprises have been more negative than initially expected, with the Citi Economic Surprise Index turning negative from mid-March. But when analyzing the details, the disappointment is concentrated in survey and sentiment data rather than hard data, for now. Inflation data, importantly, has behaved largely in line with economists’ and markets’ expectations. This differs from 2022, when inflation itself was the dominant upside surprise even before and after the Ukraine invasion. Sentiment and fresh inflation memories may be playing an outsized role in current surveys, meaning they likely overstate the coming slowdown. A negative second-quarter print cannot be ruled out as uncertainty and inflation weigh on consumption and investment, but recession is not the base case—only in the event of a severe global energy crunch. 

ECB is in for a moderate response to inflation. Our forecast reflects a balanced but cautious view: baseline growth slows sharply, with very soft quarterly real gross domestic product (GDP) prints through 2026 before a modest recovery in 2027, while HICP reaccelerates above 3% in the near term before easing again in 2027. Against that backdrop, the ECB discussion is framed around the idea that “looking through” is no longer an option. The persistence of higher prices has exceeded expectations and is seen as materially relevant for second-round effects. In that setting, the signaling value of even a modest rate adjustment matters because inflation memory remains fresh. The April meeting was already close, but the ECB opted to wait until June to hike interest rates by 25-bps. This was the first hike since the (late) cycle in 2023 and exactly one year after the last cut. 

The updated forecasts were the markets' focus. The baseline scenario was revised up for headline and core inflation in 2026 and 2027 but with only marginal downward revisions to growth. Only the alterative “severe” scenario foresees a technical recession in the second half of 2026, assuming oil surging above US$160 per barrel in Q3 and remaining persistently high.  

Beyond June, the debate shifts to pace and the terminal level. During the press conference, Lagarde did not provide guidance but strongly hinted that the ECB is in for a moderate and measured response. This aligns to our view of two hikes overall, enough to warn price setters and wage earners, preserve credibility on inflation symmetry, and impose a moderate drag on activity and inflation. While a back-to-back July hike might still happen, September still feels like a better candidate when new projections will be available. More than two hikes would likely require a clearer replay of domestically generated inflation through wages and labor markets than the eurozone has shown so far.

Japan economic outlook

Japan’s economy: Impending risks

Growth—holding up so far. Japan’s near-term story remains one of resilience on the surface, but with a growing set of risks building underneath. On growth, the economy held up better than expected in Q1 of 2026. The second preliminary Q1 GDP figures came in at 1.8% quarter/quarter (q/q) seasonally adjusted annual rate (saar), above our more reserved estimate of 0.8%. On a quarter basis, growth rose 0.5% q/q sa from 0.2% in the fourth quarter, and in annual terms growth rose 0.4% y/y, bringing the first half of 2026 average to 0.3% year/year (y/y). Strong exports and consumption spearheaded growth. Net exports contributed 0.3% to real GDP, whereas private consumption rose 1.4% q/q saar, aided by sustained wage growth and government subsidies. Public investment also rose 1.5% q/q saar. Exports were solid despite softer tourism inflows weighing on service exports, while machinery order data indicates greater investment in data centers and industrial robots. Capital expenditure plans for fiscal year 2026 are 1.3% y/y, up from the start of the year according to the Tankan survey, and government investment in AI, semiconductors and defense is expected to support the new administration’s growth strategy.

Still, the growth picture is not without strain. Supply constraints related to the Middle East are expected to weigh on activity in the second and third quarter, and the Purchasing Managers’ Index (PMI) already paints a softer outlook. While households are still cushioned for now, the business outlook is turning sour as input and output prices surge. Not only do PMI readings point to sharply higher prices, but PPI prices are rising acutely. Consumer sentiment has also tanked, largely led by expectations of higher inflation going forward, and household expectations that prices will rise more than 5% in the next 12 months have risen sharply. While real wages have turned positive for now, the big risk comes from stunting consumer confidence and yen weakness finally adding to weaker real wages in the coming months, which would become a headwind for 2027 growth. The export outlook continues to be firm, particularly with semiconductors expected to remain bright, even if visitor arrivals have slowed in 2026 so far, especially from China. Inbound consumption and service growth are still expected to remain resilient as the yen remains weak relative to peers. A supplementary budget of ¥3tn, announced to counter inflationary pressures from the energy crisis, should help cushion the economy in the near term through gasoline subsidies, electricity and gas support, and corporate financing measures, but it is far from a stimulus that could boost growth materially. For now, the GDP forecast is only marginally adjusted, with growth of 0.8% y/y in 2026 and 1.0% y/y in 2027, though the Middle East crisis and its lasting impact remain a tail risk to the baseline.

Inflation—muted on policy. Inflation, by contrast, continues to underwhelm in the headline data, even if the underlying price momentum remains intact. April Consumer Price Index (CPI) was more muted than expected, with headline CPI rising just 1.4% y/y, below market expectations of 1.6% and March’s 1.5%. Core inflation excluding fresh food also rose 1.4% y/y, the third straight month below 2%, while core-core CPI excluding fresh food and energy rose 1.9% y/y but fell 0.2% month/month (m/m). Policy support is sharply capping energy and education costs. Tuition fees for private high schools have been made free starting in April, building on the earlier measure that made public high school tuition free, while retail gasoline prices are being capped at ¥170 per litre and electricity and gas subsidies are still restraining household bills. Overall energy prices remain weak in annual terms, but the monthly momentum is shifting as the impact of the Middle East conflict gradually filters through. Supply constraints are now kicking in, with both export and import prices rising materially, including PPI costs for both goods and services. From June onwards, the impact of higher energy costs should become more visible in household utility bills, since thermal fuel costs usually get passed on with a lag. Recreation costs are also going up across multiple categories, and the import price of petroleum was already up 50% y/y in April. The supplementary budget may extend some of these energy subsidies by a few months, but the longer oil prices stay elevated, the tougher it will be for inflation to stay controlled. As a result, the forecast for the BoJ’s version of core CPI is now expected to average 2.1% in 2026, with the second half of 2026 seen as more inflationary and 2027 forecasts revised up as energy costs pass through with a lag.

BoJ—we expect a June rate hike. That inflation backdrop is central to the BoJ story. At the April meeting, the BoJ broadly kept policy settings steady, even while upgrading its inflation forecasts from the January estimates by more than markets anticipated. Our expectation had been for a rate hike in April, but that call has now shifted to June. The BoJ remains cautious, reflecting the structural mindset of households and corporations that are still used to lower rates. Hiking sharply and frequently while these economic agents are adjusting to a higher-rate environment could amplify shocks and damage the economy. That cautious thought process has led to a view of more paced out rate hikes every year until a sufficient neutral rate is reached, though where that neutral rate lies remains open to debate. While 2% could be the neutral rate, the BoJ is likely to be very cautious around 1.5% as it gauges the impact before moving further. This is why some market participants feel the BoJ is falling behind the curve. That risk is rising as inflation expectations continue to move higher. If inflationary expectations remain firm and another inflation shock hits, especially through energy, prices could increase disproportionately. The BoJ therefore faces a difficult balancing act; it wants to be gradual as the economy adjusts, but it also cannot ignore the risk that increasingly higher inflation expectations fuel stronger inflation than anticipated. We stick to our view of a June rate hike and that expectations of a higher terminal rate closer to our forecasts will gather momentum. This is broadly consistent with the BoJ’s own inflation projections, which show fiscal year 2028 official core inflation at 2% and inflation excluding energy and fresh food at 2.2% (both above the 2% target). The summary of opinions also showed that many members were mindful of upside inflation risks, and Junko Koeda’s 21 May lecture highlighted the possibility that inflation may exceed 2% in the near term with long-term inflation expectations already high. Taken together, the call remains for two 25-bps hikes in 2026, with further hikes to come in 2027.

Currency outlook

US dollar (USD)

The USD is caught in crosscurrents. Near-term geopolitical developments dominate: The Middle East conflict supports the dollar through safe haven flows and the US energy surplus, with the currency strengthening on escalation and weakening when tensions ease. But despite resilient macro fundamentals and inflationary pressures, markets are not yet pricing an aggressive Fed hiking cycle, which limits policy-driven upside. Compared with 2022, the absence of a strong, unexpected tightening cycle has reduced the dollar’s structural support. Rate differentials have weakened significantly, leaving the USD with multi-year low yield support, while muted improvement in US terms of trade also limits strength, as natural gas prices have lagged and import prices have risen. Strong earnings momentum outside the United States has also helped the rest of the world’s equity performance keep pace with the United States, a backdrop that has historically coincided with a softer dollar. Overall, upside risks come from renewed geopolitical escalation, persistently high oil prices and any shift toward pricing Fed hikes, while downside risks stem from de-escalation, lower energy prices and sustained risk-on sentiment.

Euro (EUR)

On the euro, the story is less about Europe and more about the US dollar. In mid-March, the expectation was that a worsening euro-area terms-of-trade shock and risk-off sentiment would weigh on the euro, especially against the dollar, since energy imports are mostly dollar-priced. Yet several factors have limited the downside: this is a global oil shock rather than a euro-specific gas crisis; Europe’s energy sourcing is better than in 2022; recession risks appear more contained; and the ECB has looked relatively hawkish versus the Fed. As a result, EUR/USD has been fairly resilient and only modestly below pre-war levels. Recent moves have reinforced this interpretation. The widening in US-euro area growth and rates differentials, helped by stronger US labor market data and less expected Fed easing, has not translated into a large EUR/USD decline. That suggests the pair may continue trading in its broad range. The main downside risk for the euro would be a much more severe oil scenario that sharply widens recession risks in Europe. But so long as that remains a tail risk rather than the base case, the euro is likely to remain relatively stable. 

Japenese yen (JPY)

JPY—More weakness ahead. Broader fundamentals suggest that unless the BoJ becomes materially more hawkish and the Fed simultaneously resumes rate cuts—which is not the baseline—USD/JPY is unlikely to trend lower in a sustained way. There has also been a break in the correlation between USD/JPY and yield differentials, driven perhaps by the market’s assessment that the BoJ is behind the curve and by fiscal risks under the new Takaichi administration. Despite the possible rate hike in June, the rate differentials with the United States will not be enough to move the needle for the yen, in our view. More forceful intervention by authorities or a sharply hawkish BoJ rhetoric could be more meaningful instead. Yet, although the risk of intervention remains high, the effectiveness of the action remains uncertain. In that case, it is only left to the BoJ to shore up the yen’s fortunes by signaling to markets they are on top of inflation concerns, either through more frequent rate hikes or outsized hikes. We see little respite for the yen unless this materializes.