Weekly global economic update
What’s happening this week in economics? Deloitte’s team of economists examines news and trends from around the world.
Powell hints at further rate hikes
- At the annual meeting of central bankers in Jackson Hole, Wyoming, Federal Reserve Chair Powell said that, although inflation has declined, it remains “too high.” Consequently, he said that “we are prepared to raise rates further if appropriate and intend to hold policy at a restrictive level until we are confident that inflation is moving sustainably down toward our objective.” In addition, he said that the Fed will “proceed carefully as we decide whether to tighten further or, instead, to hold the policy rate constant and await further data.” As such, investors did not get too much information about the Fed’s next move. Most investors expect the Fed to hold rates next month.
The Fed’s objective, of course, is inflation of 2%. However, some pundits are wondering if Powell would be satisfied with 3% inflation, which is roughly where we are right now. It is highly unlikely that Powell would explicitly change the Fed’s goal. Doing so would likely be hugely disruptive to financial markets. Yet if inflation remains at 3% and the economy does well, should the Fed tighten further and potentially create a recession? Powell said that “doing too much could also do unnecessary harm to the economy.”
Powell evidently worries that the current strength of the economy might push inflation higher, especially given the tightness of the labor market. He said that “additional evidence of persistently above-trend growth could put further progress on inflation at risk and could warrant further tightening of monetary policy.” He added that “there is substantial further ground to cover to get back to price stability.” He also noted that monetary policy tends to influence the economy with a lag, suggesting that the tightening that has already taken place could be sufficient.
Market reaction to Powell’s comments was relatively muted, likely reflecting the fact that Powell left many investors wondering. Investors have lately pushed up borrowing costs substantially, with bond yields and mortgage interest rates up considerably. It could be that the recent rise in borrowing costs will, in the coming months, have a negative impact on economic activity, especially housing, thereby helping to reduce inflationary pressure. Higher bond yields likely stem from a variety of factors, including concerns about rising government borrowing costs, economic strength, fear of a rebound in inflation, and fear that Japan’s central bank might start to tighten monetary policy. The latter could lead Japanese investors to reduce holdings of US Treasuries.
What next? The answer is it depends on what happens with inflation and with the economy. Once the Fed feels comfortable in reducing rates, then bond yields will likely follow. Moreover, if the economy weakens, bond yields will probably fall absent a commensurate rise in expectations of inflation. On the other hand, continued economic strength will likely keep yields elevated.
BRICS countries attempt to boost their global footprint
- China wants to build the so-called BRICS countries into an alternative to the G7. First, a few definitions. The G7, or Group of Seven, are the seven largest democratic economies: the United States, Canada, the United Kingdom, Germany, France, Italy, and Japan. The group was formed in the 1970s at a time of economic turmoil (when is there not any turmoil?) with the goal of coordinating macroeconomic policies. G7 leaders have met every year since then but have often focused on foreign policy rather than economic issues. Still, as an alliance it carries considerable weight given its economic size and military potential.
The BRICS countries were the invention of an economist at Goldman Sachs. In 2001, then Goldman Chief Economist Jim O’Neill published an article entitled “Building better economic BRICs.” In it, he predicted that four major emerging economies (Brazil, Russia, India, and China) would grow far more rapidly than the G7 in the decades to come, thereby becoming immensely important. The acronym BRIC soon took off, and eventually the leaders of the four countries started to have annual meetings, adding an S to BRIC by including South Africa. Hence, the BRICS economies. Since O’Neill’s article, China and India have, indeed, grown rapidly. However, Brazil, Russia, and South Africa have not.
Now, China wants to take the BRICS to a new level. The leaders of the BRICS countries invited six other countries to join the group. This is part of China’s effort to convert the BRICS group into something akin to the G7. The six countries are Argentina, Egypt, Ethiopia, Iran, Saudi Arabia, and the United Arab Emirates. Only the last two are strong economies. Perhaps most notable is that three major oil exporters are included in the group. It is not yet clear if all the invitees will join. Saudi Arabia’s foreign minister said that more information is needed concerning “the nature of membership and its components, and based on that and on our internal procedures, we’ll take the appropriate decision.”
In addition, in 2015 the BRICS created a development bank that will soon start lending in local currencies as part of an effort to shift the world from a unipolar currency system to a multipolar system.
What might be accomplished by creating an alternative to the G7? And will it have much of an impact? First, let’s consider some data. The International Monetary Fund (IMF) estimates that, this year, global GDP will be US$105.6 trillion when measured using current exchange rates. The GDP of the G7 will be US$46.0 trillion, of which the United States will account for 58%. The BRICS economies will have a GDP of US$27.7 trillion, of which China will account for 70%. Thus, the BRICS group is quite substantial, but smaller than the G7 and more heavily dominated by its largest member. If others join the BRICS, it will become larger. Adding Argentina, Saudi Arabia, and Indonesia will make the BRICS’ GDP US$30.8 trillion.
The organizers of the recent BRICS meeting have said that development of a common currency was not on the agenda. Rather, there was discussion about promoting more intra-BRICS trade through local currencies rather than the dominant US dollar. Intra-BRICS trade is growing faster than Chinese trade with the G7 nations. In part, this reflects the impact of trade restrictions imposed by Western governments. In part it reflects a shift in global company investment away from China, mostly as an insurance policy against political risk. Thus, from China’s perspective, if trade is going to shift, then why not intensify it through closer relations and, ultimately, more liberalization of intra-BRICS trade. Moreover, why not use this increased trade to reduce the dominance of the US dollar. After all, China has been keen to boost the global role of the renminbi.
Meanwhile, it is reported that there is disagreement between China and India over the role that ought to be played by the BRICS alliance. India is said to favor a nonaligned approach in which the members seek the economic benefits of closer relations. India is concerned that China sees the BRICS alliance as a power center meant to offset the economic and political power of the Western alliance. This could be problematic for India given its membership in the so-called “Quad,” a military alliance of India, Australia, Japan, and the United States that is meant to offset the growing military activity of China in the Indo-Pacific region. Aside from the Quad and membership in the BRICS, India is also purchasing cheap oil from Russia at a time when Western powers are boycotting Russian oil.
Perhaps the biggest obstacle to making the BRICS an important player is the relative economic weakness of its three smaller members: Brazil, Russia, and South Africa. Unlike the predictions made 23 years ago, these economies have faltered while their near-term outlooks are not promising. Thus, adding new members would appear to be a necessity. Certainly, major economies like Saudi Arabia and Indonesia can add much to the group. But others such as Argentina, Venezuela, and Iran are more problematic. As China seeks to build a better alliance, it is constrained by the paucity of strong economies outside the Western alliance.
The strength of the G7 lies, in part, in the common characteristics of the member countries. They are all affluent, market-oriented, democracies with adherence to rules-based governance practices. They all participate in military alliances with one another and cooperate on military and political goals. And, between them, they issue three of the world’s most important currencies.
The BRICS countries, on the other hand, have per capita income levels that vary widely, have different economic and political systems, and are not aligned militarily. In fact, India is partly aligned with the Western powers. Thus, it is not clear how the enlarged BRICS will be able to exert the kind of influence that is emblematic of the G7. Moreover, the BRICS countries mostly rely on the US dollar for trading and reserves. Although they aspire to reduce the role of the dollar through more local currency settlement of intra-BRICS trade, they have no plans to create a common currency.
IMF says that world still massively subsidizes fossil fuels
- At a time when many countries are offering hundreds of billions of dollars in subsidies to boost clean energy production, the IMF says that the world still provides trillions in subsidies for fossil fuel production. That is because, to maintain social and political stability, many governments don’t want consumers to have to pay the true cost of fossil fuels. The IMF estimates that, in 2022, there were US$1.5 trillion in direct, or explicit, subsidies for fossil fuels. This is the difference between what consumers pay and the cost of producing the fuel. This was triple the level from three years previously, largely because of government efforts to support consumers through the pandemic. The IMF expects that these explicit subsidies will decline in coming years.
However, the IMF said that there are also implicit subsidies, which include the cost to the environment and the climate of producing fossil fuels. In an ideal policy environment, governments would charge consumers for that cost, thereby compelling a quicker transition to clean energy. The IMF says that the combined cost of explicit and implicit subsidies in 2022 was roughly US$7.1 trillion, or about 7% of global GDP. The implication is that current policy is potentially acting as an obstacle to the transition to clean energy.
The IMF suggests that meeting the world’s climate targets will be challenging absent a change in policy. Of course, asking governments to reduce explicit subsidies is difficult politically. Asking them to impose taxes that would eliminate or reduce implicit subsidies is an even bigger problem. The European Union is trying to deal with this issue through carbon taxes, but even that effort is modest at best.
PMIs point to slowdown in the United States and Europe
- The global economy appears to be decelerating, according to the latest purchasing managers’ indices (PMIs) from S&P Global. PMIs are forward-looking indicators meant to signal the direction of activity in broad sectors of the economy. They are based on subindices such as output, new orders, employment, input and output pricing, backlogs, inventories, and sentiment. A reading above 50 indicates growing activity. The higher the number, the faster the growth—and vice versa.
The latest flash PMIs for Europe and the United States, which together account for roughly half of global economic output, worsened from July to August, signaling that tightening monetary policy on both sides of the Atlantic is constraining activity. Meanwhile, Japan’s PMIs signal that the economy continues to expand at a moderate and steady pace.
Eurozone
In the Eurozone, the PMIs had already indicated declining economic activity in July, with declines in manufacturing activity being only partly offset by modest gains in the broad services sector. In August, things worsened, with activity in manufacturing falling at a faster pace and activity in services starting to decline. Specifically, the PMI for services fell from 50.9 in July to 48.3 in August, a 30-month low. The PMI for manufacturing increased from 42.7 in July to 43.7 in August. The result was that the composite PMI fell from 48.6 in July to 47.0 in August, a 33-month low indicating a moderate rate of decline.
S&P Global reports declining output and new orders and stagnant employment. It also reports a surprising pickup in inflationary pressure, for both input and output prices. The worst overall performance was in Germany where the manufacturing PMI hit 39.1 and the composite PMI hit 44.7, a 39-month low. Germany’s manufacturing sector has been damaged by relatively high energy prices that have worsened the competitiveness of heavy industry, as well as the weakness of the Chinese economy, which is a major market for German exporters.
The poor composite PMI led S&P to comment that “the eurozone will shrink by 0.2% in the third quarter.” For the European Central Bank (ECB), this report is troubling in that it indicates worsening economic activity combined with accelerating inflation. Despite weak activity, the Eurozone’s labor market remains relatively tight, with rising wages. Yet productivity is growing slowly, meaning that wage gains will likely be passed onto consumers in the form of higher prices. This suggests that the ECB needs to weaken the labor market through further interest-rate increases. On the other hand, the PMIs show that the economy is already weakening, suggesting that the ECB can stop tightening. That latter notion is how investors interpreted today’s data, pushing down the value of the euro and pushing down bond yields.
United Kingdom
In the United Kingdom, the situation is similar to that of the Eurozone. The services PMI fell from 51.5 in July to 48.7 in August, while the manufacturing PMI fell from 45.3 in July to 42.5 in August, a 39-month low. The result was that the composite PMI fell from 50.8 in July (indicating modest growth) to 47.9 in August (indicating a sharp decline in activity). Across the board there was declining output, new orders, and backlogs.
As in the Eurozone, input pricing accelerated, likely due to rising wages amidst a persistently tight labor market. S&P said that the PMI results were consistent with a 0.2% decline in real GDP. Also, S&P reported a decline in hiring in August, suggesting that the tight monetary policy is already starting to weaken the labor market, which bodes well for future wage restraint. As such, S&P said that the inflation outlook is likely promising, even though it may entail a modest recession.
United States
The US economy has been unusually strong lately, but the latest PMIs suggest some weakening. The services PMI fell from 52.3 in July to 51.0 in August while the manufacturing PMI fell from 49.0 in July to 47.0 in August. The result was that the composite PMI fell from 52.0 in July to 50.4 in August, a six-month low indicating very slow growth in activity. Unlike Europe, however, the PMIs for the United States do not yet suggest an economic downturn. However, there was a decline in new orders for both manufacturers and service providers, boding poorly for future output.
Capacity constraints appear to have disappeared, as evidenced by a sharp decline in backlogs. However, as in Europe, wage pressures appear to be having an impact on inflation. Specifically, S&P reported an acceleration in costs, largely due to rising wages. On the other hand, output inflation abated, probably due to weakened demand. From the perspective of the Federal Reserve, the labor market situation is likely of concern. The Fed has already indicated a desire to weaken the labor market to reign in wage inflation. Absent a deceleration in wages, it will be difficult to bring inflation down to the target of 2%.
On balance, the weaker PMI report for the United States “raises doubts over the strength of US economic growth in the third quarter.” S&P added that the decline in “new orders received by firms in August could tip output into contraction in September as firms adjust operating capacity in line with the deteriorating demand environment. Hiring could likewise soon turn into job shedding in the coming months.” On the other hand, despite weakened demand and higher interest rates, business investment has lately been surprisingly robust. One possible explanation is the array of subsidies offered through the CHIPS Act and the Inflation Reduction Act.
China falls into deflation
- In the years just prior to the pandemic, China experienced much higher inflation than in the major Western economies. Then, with COVID-19 restrictions, China transitioned to deflation by the end of 2020. Then, inflation rebounded to a modest level, rising above 2% during much of 2022. Now, however, as Western economies struggle to bring inflation down from 40-year highs, China is suddenly struggling with deflation. This was not meant to be. Rather, when China finally removed all pandemic-related restrictions at the end of 2022, there was an expectation that economic growth would soar while inflation would rise commensurately. Neither happened. Instead, the economy has sputtered while inflation decelerated.
Here are the details: In July, Chinese consumer prices fell 0.3% from a year earlier, the first decline since February 2021. Prices were up 0.2% from the previous month, which suggests a modest positive rate of inflation. Also, when volatile food and energy prices are excluded, core prices were up 0.8% in July from a year earlier. This underlying rate of inflation is still very low.
By category, food prices fell 1.7% in July versus a year earlier, largely due to a sharp decline in pork prices. Nonfood prices were unchanged in July from a year earlier. Clothing prices were up 1% and transport costs were down 4.7%. The prices of automobiles fell 4.4% and the prices of mobile telephones fell 2.6%. On the other hand, prices of airfares and hotels increased 10% while prices of movie tickets increased 5.9%. These movements reflect the shift in consumer spending away from goods and toward services.
Chinese authorities said that they expect a rebound in inflation in the coming months. That is because the low inflation right now is partly due to the base effect of high inflation from a year ago. When that fades, annual inflation will likely resume in positive territory. Even if that happens, inflation will likely remain relatively low due to the weakness of the economy, weak consumer demand, and weak global commodity prices.
Why worry about deflation? Because deflation often leads to high real (inflation-adjusted) borrowing costs, thereby hurting interest-sensitive consumer and business spending. In addition, deflation provides an impetus for consumers to save more, which is not welcome at a time when the government wants to stimulate more consumer spending to offset weak exports. Finally, deflation is simply a reflection of the weakness of the economy. If growth accelerates, inflation will likely increase.
Meanwhile, the government is using various tools to boost economic growth. Yet traditional methods of stimulus might not work if consumers and businesses refuse to respond. Uncertainty is clouding consumer and business confidence, leading to a tendency to hoard cash.
Chinese trade declines sharply
- Chinese exports and imports declined more sharply in July than had been expected. In July, exports (denominated in US dollars) fell 14.5% from a year earlier, the biggest decline since February 2020. Imports fell 12.5%, the biggest drop since January of this year. During the pandemic, strong international trade helped to offset the weakness of domestic demand, which was due to COVID-19–related restrictions. Now, with restrictions having been removed, domestic demand remains weaker than expected. The weakness of trade exacerbates the threat to economic growth.
Weak exports are partly due to the weakness of the global economy, with major markets having decelerated due to monetary policy tightening, especially in Europe and North America. While demand for services in these locations remains strong, demand for goods has declined, thereby hurting Chinese manufactured exports. Weak Chinese exports are also due to restrictions on trade and cross-border investment imposed by the United States, Japan, and the Netherlands. This, in turn, has led some global companies to shift parts of their supply chains out of China and into other regions such as Southeast Asia. Indeed, inbound foreign direct investment has been weak lately, reducing the development of new capacity to produce exports.
By category, Chinese exports of automobiles, ships, and mobile telephones increased from a year earlier. Most other categories declined, including big drops for computers, steel, apparel and textiles, toys, shoes, and integrated circuits. By destination, Chinese exports to the US were down 23.1%, exports to the European Union were down 20.6%, and exports to Southeast Asia (China’s largest trading partner) were down 21.4%.
The weakness of imports means that the exports of other countries to China have weakened. Several East Asian countries produce inputs that are sent to China for final processing of products that are then exported. Consequently, South Korean exports are down 16.5% from a year earlier, including a 25.1% decline in Korean exports to China. Overall exports from Taiwan are down 10.4%, including a 16.3% decline in Taiwanese exports to China. On the other hand, Taiwanese exports to the United States were down a more modest 3.3%.
The weakness of Chinese trade adds yet another challenge for the Chinese government as it attempts to revive a weaker-than-expected economy. So far, efforts to stimulate domestic demand have not been successful. Also, weak Chinese demand has a negative impact on global exports of commodities. Interestingly, previously clogged supply chains have been unclogged, with the number of ships at ports waiting to ship merchandise down sharply. Yet with weakened global demand, the improvement in supply chain efficiency is not helping to boost activity.
US inflation continues to decelerate
- Although headline inflation rebounded slightly in July, the underlying data suggests that US inflation continues to decelerate. This is good news for the Federal Reserve, which must decide whether to continue interest-rate increases or wait. For the Fed, the current situation is the best of all worlds, with inflation continuing to decline and the economy continuing to grow. It offers the possibility of the much hoped for soft landing. Still, risks exist, especially if the Fed’s tightening leads to financial market turmoil.
Here are the details: In July, consumer prices in the US were up 3.2% from a year earlier, higher than the 3% increase seen in June. However, prices were up only 0.2% from the previous month. In fact, in four of the last five months, monthly inflation was no higher than 0.2%. This bodes well for continued low annual inflation in the months to come.
When volatile food and energy prices are excluded, core prices were up 4.7% in July from a year earlier, down from 4.8% in June. In fact, the July number was the lowest since October 2021. Core inflation had peaked in September 2022 at 6.6%. Moreover, core prices were up only 0.2% from June to July, the same as in the previous month. This continued weakening of underlying inflation is especially good news.
The weakness of inflation is still largely driven by declining energy prices, which were down 12.5% in July from a year earlier and up only 0.1% from the previous month. Also, airline fares were down 18.6% from a year earlier and down 8.1% from the previous month. Prices of mobile telephones were down 17.6% from a year earlier and prices of computers were down 4.9%. On the other hand, food price inflation continues to be elevated, with food prices up 4.9% from a year earlier. Food eaten away from home was up 7.1%, a reflection of strong demand for restaurant meals at a time when restaurants are struggling to find scarce labor.
Another source of underlying inflation was shelter (housing). This was up 7.7% from a year earlier, which was down from the previous month. Shelter prices were up only 0.4% from the previous month. Shelter prices are driven by house prices with a lag. In the past year, after a period of sharply rising home prices, home prices have stalled and even declined. Over time, this will work its way into the shelter component of the consumer price index (CPI), thereby helping to reduce inflation during the second half of 2023. In fact, excluding shelter prices, the CPI was up only 1% in July from a year earlier. Excluding shelter and food, the CPI was unchanged from a year earlier.
Recall that, early in this era of high inflation, the lion’s share of price increases was due to a surge in the prices of durable goods. That, in turn, was related to the pandemic-driven rise in demand for such goods. Now, after two years of declining demand for durables, prices of durables are declining. They were down 1.4% in July from a year earlier. Prices of nondurable goods were down 0.2% in July from a year earlier. Excluding food, nondurables prices were down 5.3%.
Services, on the other hand, account for plenty of inflation. Service prices were up 5.7% in July from a year earlier, heavily driven by shelter. The problem with service inflation is that the provision of services is highly labor-intensive. With wages now rising faster than inflation, the danger is that the cost of providing services will continue to rise rapidly, thereby requiring companies to boost prices absent offsetting increases in productivity. The tightness of the labor market is one of the reasons for rising wages. Thus, from the perspective of the Federal Reserve, there is a need to loosen the labor market to suppress wage inflation. That is seen as the only path toward bringing inflation down to its target level of 2%. This calculus will inform what the Fed does in the months ahead.
Finally, although the Fed wants to loosen the labor market, the question remains as to whether they have already done enough to accomplish this goal. After all, monetary policy is known to act with a lag. It is possible that the Fed’s actions so far are sufficient. It is also possible that the Fed ought to do more. No one knows. As I’ve written previously, managing monetary policy is like driving a car while facing backwards. It requires a degree of finesse (and luck) that may or may not be present.
US household financial conditions remain good despite rising debt
- A new report from the Federal Reserve Bank of New York indicates that, although household debt in the United States continues to grow, the financial condition of US households remains favorable. That is, household ability to service debts is strong and household balance sheets do not represent a systemic threat to the financial system—unlike in the period 2007–2009.
Here are the details: The total volume of household debt, including home mortgages, increased only 0.1% from the first to the second quarter, hitting a record high of US$17.06 trillion. This was up US$2.9 trillion since the start of the pandemic. Indeed, debt accelerated during the pandemic. Yet assets increased even more due to a sharp rise in household bank deposits and an increase in home values. The result was an improvement in consumer balance sheets.
Credit card debt increased 4.6% from the first to the second quarter. Meanwhile, the rate of delinquency on credit card debt has increased since 2021. Still, by Q1 of this year, the rate of delinquency was only 2.4% of balances, down from 2.7% just prior to the pandemic and down from 6.8% at the height of the financial crisis in 2009. Thus, credit card debt, although having risen, remains manageable.
Meanwhile, mortgage debt was largely unchanged from the first to the second quarter as housing-market activity remained moribund. The delinquency rate on mortgages continued its long-term decline, hitting a low rate not seen since 2007. Home equity loans were also largely unchanged—not surprising given the recent rise in borrowing costs. Automotive loans increased sharply, and the delinquency rate increased as well. Yet the delinquency rate remained below the prepandemic level.
On the other hand, Federal student loan payments remain suspended until October. The Biden Administration had attempted to forgive most student debt, but this was deemed illegal by the Supreme Court. Consequently, debt payments will resume after October. After that, the overall delinquency rate will likely increase. Still, the overall rate at 2.7% of all debt is historically low—especially on mortgage debt. Thus, consumer debt is not currently a systemic threat to the financial system. For companies that sell consumer goods and services, the debt situation is not particularly onerous.
After debt-rating downgrade, what is the outlook for US fiscal policy?
- In 2011, after a protracted standoff between President Obama and a Republican Congress, a debt-ceiling agreement was reached at the eleventh hour. After that, S&P downgraded US government debt, citing political dysfunction and the risk of default. Investors barely noticed, with bond yields declining over the next year. Why? The answer is that a bond rating by one of the ratings agencies is meant to reflect the probability of default. Yet the reality is that there is essentially zero probability that the US government will default on its debts, at least not for more than a few days—and even that has never happened. Some countries or companies are at risk of running out of funds and being unable to service their debts. That is not true of the US government.
Fast forward to 2023. Recently, rating agency Fitch downgraded US government debt. This followed the recent debt-ceiling crisis that ended more quickly than expected. Still, Fitch cited the crisis, saying that “repeated debt limit standoffs and last-minute resolutions” are a concern. It also expressed concern that the insurrection on January 6, 2021 reflected increased political division that could undermine the ability of Congress to act in the future. In addition, Fitch cited the long-term trajectory of US deficits. It noted that the cost of Social Security and Medicare is set to rise as the population ages.
Following the Fitch action, bond yields increased, but mostly due to factors unrelated to the Fitch decision, such as news about the resilience of the economy. Again, investors don’t seem to focus on ratings of government bonds. Still, the question arises as to whether investors or voters should be concerned about the outlook for US sovereign debt.
Two possible reasons to worry about government debt include that if the government borrows too much in competition with the private sector, borrowing costs could rise and private sector investment could be curtailed. This is known as crowding out. The other reason is that, if increased debt is funded by central bank money creation, it could lead to much higher inflation. For now, borrowing costs are historically low and inflation is declining rapidly. Evidently, current levels of borrowing are not having an onerous impact. Moreover, borrowing levels have declined sharply since the pandemic.
Yet what is considered worrisome is that government programs for the elderly (Social Security, Medicare) as well as debt-servicing costs are set to rise in the coming years. Absent offsetting spending cuts or increased taxes, and absent an acceleration in economic growth, this implies increased deficits and an increase in the volume of debt. At what point does this have a negative impact? In Japan, debt as a share of GDP is much higher than in the United States, and yet borrowing costs and inflation remain very low. This implies that the United States can go much further. Still, the ability to issue debt is not unlimited, as evidenced by those countries that have defaulted or experienced hyperinflation.
What can be done to restrain US government debt? There are some solutions that, however, could face political resistance. Taxes could be increased; spending on non–Social Security and non-Medicare programs could be cut; pension and health care benefits could be reduced; the age at which people become eligible for benefits could be increased (this was done in the 1980s); and immigration could be increased, thereby increasing the ratio of taxpaying workers to retirees. Some combination of these actions would likely constrain the increase in debt. Yet given the political division in the United States, this seems unlikely.
US job growth slows, productivity accelerates, unit labor costs decelerate
- The US job market continued to grow in July, but at a more modest pace than previously. This signals that the overall economy is decelerating in response to the monetary tightening implemented by the Federal Reserve. The US government publishes two employment reports: one based on a survey of establishments; the other based on a survey of households. Let’s consider both.
First, the establishment survey indicated that 187,000 new jobs were created in July, roughly similar to the growth seen in June. Growth in June and July was the slowest since December 2020. There was good growth in construction, wholesale trade, financial services, and health care. Most other industries experienced weak or negative growth. Notably, there was almost no growth for restaurants and hotels, a category that had been a major driver of job growth since the pandemic receded. In addition, there was no growth for professional services, which had previously been growing rapidly.
Average weekly hours, which soared at the start of the pandemic and has been declining ever since, fell again in July, hitting the lowest level since the start of the pandemic. However, weekly hours worked are now comparable to what was seen during the decade prior to the pandemic. In that sense, the labor market is returning to normal. The continuing decline in weekly hours worked suggests that many employers chose to reduce hours rather than dismiss workers, especially given the intense shortage of labor.
Also, the government reported that average hourly earnings were up 4.4% in July versus a year earlier. This was the same for the past four months. Earnings are now rising faster than prices, meaning that households are seeing an increase in real (inflation-adjusted) income. That will be good news for consumer spending. However, the persistence of wage gains is likely a worry for the Federal Reserve, which wants to weaken the job market sufficiently to bring down wage inflation. Indeed, if productivity fails to accelerate, strong wage gains may compel companies to continue raising prices, thereby potentially limiting the Fed’s ability to suppress inflation. Further Fed tightening, therefore, is meant to avoid a wage-price spiral in which companies pass on increased employment costs to consumers in the form of higher prices.
The separate survey of households, which includes self-employment, indicated that employment grew slightly faster than the labor force while the participation rate remained steady. The unemployment rate fell from 3.6% in June to 3.5% in July, one of the lowest rates in the past half century. Participation among prime-age workers is up sharply in the past two years, and yet unemployment remains historically low. This is indicative of a job market that remains very tight.
- In the years leading up to the pandemic, productivity in the United States (output per hour worked) was rising at a modest pace. Then, with the pandemic and its aftermath, productivity became quite volatile, rising rapidly in 2020, stagnating in 2021, and declining in 2022. Now, it appears that productivity is rebounding as output continues to rise while employment growth is decelerating. Specifically, labor productivity was up 3.7% from the first to the second quarter and was up 1.3% from a year earlier. It was the first annual rise since the fourth quarter of 2021.
Economies grow either because more workers are added or because more output is generated by each worker (productivity). Thus, given the outlook for US demographics, faster productivity growth will be needed to maintain strong economic growth.
In addition, productivity plays a role in boosting or suppressing inflation. That is, when productivity rises, it offsets the cost to employers of paying higher wages, thereby reducing the need to raise prices. Specifically, if wages rise faster than productivity, it represents an increase in unit labor costs (ULC), which is a measure of the labor cost of producing an additional unit of output.
As the pandemic faded, there was a surge in ULC due to a sharp rise in wages combined with a decline in productivity. Now, as productivity recovers and wage increases abate, ULC is rising more slowly. Specifically, ULC increased 1.6% from the first to the second quarter and was up 2.4% from a year earlier. The latter figure was the lowest since the second quarter of 2021. This is good news in that it implies less inflationary pressure.
In the Eurozone, inflation eases and growth resumes
- The latest report on inflation in the Eurozone offers mixed signals. On the one hand, headline inflation in July fell to the lowest level since January 2022. Even core, or underlying, inflation appears to have peaked. On the other hand, inflation for services hit a record high in July. Moreover, all measures of inflation remain above 5% at a time when inflation in the United States has fallen much farther. For the European Central Bank (ECB), this suggests that the most recent decision to raise interest rates was warranted.
Let’s look at the details. First, consumer prices in the 20-member Eurozone were up 5.3% in July versus a year earlier, the highest since January 2022. Inflation had peaked in October 2022 at 10.6%. In addition, prices were down 0.1% from the previous month, the first monthly decline since January 2023. The continued decline in inflation has much to do with energy prices, which in July were down 6.1% from a year earlier and down 0.3% from the previous month. On the other hand, food prices continued to soar, up 10.8% in July versus a year earlier and up 0.2% from the previous month.
When volatile food and energy prices are excluded, core prices were up 5.5% in July versus a year earlier, barely down from the peak of 5.7% in March. Still, core prices fell 0.1% from the previous month, which bodes well for further reductions in annual core inflation.
The most worrisome aspect of the report is that prices of services were up 5.6% in July from a year earlier, a record high, and up 1.4% from the previous month. This could signal that the tight labor market is wreaking havoc with prices, especially given that many services are highly labor-intensive. Wages have been rising in the Eurozone, evidently feeding into the prices of services. The ECB has indicated a desire to weaken the tight labor market to reduce wage pressure.
By country, inflation varied significantly in July. From a year earlier, prices were up 6.5% in Germany, 5% in France, 6.4% in Italy, 2.1% in Spain, 5.3% in Netherlands, 1.6% in Belgium, 4.6% in Ireland, 4.3% in Portugal, 3.4% in Greece, and 7% in Austria.
- The European Union reported that Eurozone real GDP growth resumed in the second quarter following two consecutive quarters with no growth. However, four Eurozone countries had either zero or negative GDP growth in the second quarter. Germany and Portugal had zero growth while Italy and Austria had negative growth. Meanwhile, Latvia and Sweden, both members of the European Union (EU), also had negative growth. Thus, the European economy appears to have remained weak in the second quarter.
Here are the details. In the second quarter, real GDP in the 20-member Eurozone was up 0.3% from the previous quarter while real GDP in the larger EU was unchanged from the previous quarter. Real GDP in the Eurozone is now well above the prepandemic level, but below the prepandemic trend. From the first to the second quarter, real GDP was unchanged in Germany, up 0.5% in France, down 0.3% in Italy, and up 0.4% in Spain.
The Eurozone economy had shrunk in the last quarter of 2022 and was unchanged in the first quarter of 2023. Thus, growth in the second quarter is certainly welcome. However, there are some caveats. First, France’s strong growth was mainly due to the sale of a cruise ship. Second, Ireland’s growth, which tends to be volatile owing to swings in intellectual property revenue for US-based pharma and tech companies, was exceptionally strong in the second quarter. Absent Ireland, Eurozone growth would have been half as strong as reported. Moreover, given the weak credit market report recently issued by the ECB, it seems likely that economic activity will weaken further. Thus, the second-quarter growth could be a one-off event.
Finally, the heatwave this summer will likely take a toll on the important tourist industries in southern Europe. This, too, could have a negative impact on economic growth in the third quarter.
Why is Germany the Eurozone’s laggard?
- Germany’s economy is one of the laggards of Europe, likely the only major economy in Europe that has fallen into recession. Why? In part, it has to do with the heavy reliance on industry (defined as manufacturing, construction, mining, and utilities). Industry as a share of GDP in Germany, at 26.7%, is much higher than any other major economy in Europe or the United States. By comparison, the figures are 22.5% for Italy, 20.4% for Spain, 16.7% for France, 17.5% for the United Kingdom, and 17.9% for the United States.
In recent years, German industry’s competitiveness stemmed, in part, from its reliance on cheap Russian energy. German wages were relatively high, so cheap energy was critically important. Now, with energy costs significantly higher than before the war in Ukraine, and likely to remain so, industry has lost competitiveness. Moreover, Germany depends heavily on exports of heavy industrial products, especially to China. Global demand (including China) has weakened, thereby hurting Germany’s economy. Also, Germany has been dependent on heavy industry rather than newer high technology products. Investment by German companies has lagged, in part due to companies investing in other countries with cheaper energy.
Aside from the energy issue, there are other obstacles to success for the very large number of small and medium-sized companies that are at the heart of Germany’s economy. These obstacles might include skills shortages, regulation, high taxes, poor infrastructure, poor demographics, and failure to quickly implement digitalization as factors restraining economic success.
Meanwhile, despite disappointing GDP growth in Germany, the labor market remains tight. With the unemployment rate in the Eurozone at an historically low 6.4% in June, the unemployment rate in Germany was 3%, unchanged from a year earlier. This, in part, reflects the shortage of labor. It also means that there is not much room for employment growth. Thus, economic growth will likely have to come from improved productivity. Yet lately, productivity growth has been feeble, in part because much of Germany’s growth has taken place in less productive industries such as the public sector.
As credit conditions worsen in the Eurozone, the European Central Bank tightens again
- On July 26, the US Federal Reserve raised its benchmark interest rate to a 22-year high. The next day, the European Central Bank (ECB) raised its rates to the highest since the euro began 23 years ago. Thus, we are now in a new environment of very high policy rates on both sides of the Atlantic, meant to stifle the highest inflation in 40 years. However, inflation is no longer at a 40-year high. It has come down in both the United States and the Eurozone, raising hopes among investors that this episode of monetary tightening might soon be over.
The ECB said that, although inflation has declined, it is “expected to remain too high for too long.” Consequently, it deemed it necessary to implement yet another increase of 25 basis points (bps). It said that, under current conditions, there is an “expectation that inflation will drop further over the remainder of the year but will stay above target for an extended period.” It expressed particular concern about the persistence of underlying inflation.
Unlike the Federal Reserve, which has a dual mandate to target both inflation and employment, the ECB is mandated to only target inflation. Thus, it is not surprising that the ECB said that “the key ECB interest rates will be set at sufficiently restrictive levels for as long as necessary to achieve a timely return of inflation to the 2% medium-term target.” Its decisions will be based on incoming data and an assessment of the inflation situation and the transmission of monetary policy.
Despite the ECB’s single mandate, it still must consider the impact of its policies on the economic environment, if only because that influences inflation. The ECB noted that the economic outlook has deteriorated, largely due to weaker domestic demand. The latter is due, in part, to tighter financial conditions, the result of monetary tightening. Thus, monetary policy has already taken a toll on the economy, thereby reducing inflationary pressure.
On the other hand, the ECB noted the tightness of the labor market, with a record low regional unemployment rate. However, it said that forward-looking data suggests the possibility that the labor market will weaken. Concerns about the labor market, and especially the impact of rising wages on inflation, have been top of mind for the ECB.
Also, the ECB noted that energy prices have declined, helping to reduce inflation. Yet, in part, this reflects government subsidies that were in response to the war-driven energy crisis. The ECB recommended that governments “roll back” subsidies to “avoid driving up medium-term inflationary pressures.” The government subsidies have been akin to a fiscal stimulus, which has an inflationary impact.
- Meanwhile, the tight monetary policy of the ECB has already had a significant impact on money supply growth and credit expansion, according to data released by the ECB. The Eurozone’s central bank reported that M3, a broad measure of the money supply, was up only 0.6% in June from a year earlier. As recently as early 2022 it had been growing at an annual rate of more than 6%.
Regarding credit, the ECB reported that credit to Eurozone residents increased only 0.3% in June from a year earlier. Credit for the private sector increased a modest 1.5% in June. This was offset by a decline in credit to governments. Bank loans to the private sector were up 2% while bank loans to households were up 1.7%. All these numbers are down substantially from the peak growth seen in 2021. As recently as early 2022, bank loans to the private sector were growing at an annual rate of 7%.
Also, the ECB’s quarterly Bank Lending Survey (BLS) reports that credit standards tightened in the second quarter. Moreover, “the cumulated net tightening since the beginning of 2022 has been substantial, and the BLS results have provided early indications about the significant weakening in lending dynamics observed since last autumn.” In addition, the ECB reported that business demand for loans “fell strongly” in the second quarter, hitting a record low since records began in 2003. There was also a big drop in demand for housing loans. This weakening of credit demand is largely due to the higher interest rates implemented by the ECB. The ECB data points to a likelihood of further weakening of the Eurozone economy.
However, the ECB is highly concerned that underlying inflation appears to be stuck at an elevated level. Moreover, it is concerned that a tight labor market, and the consequent sharp rise in wages, will inhibit further reduction of inflation. The argument is made that only a weakening of the labor market will allow inflation to decline further. The fact that core, or underlying, inflation remains steady suggests that the ECB has hit a roadblock. On the other hand, monetary policy acts with a lag. It is possible that the current decline in credit activity will feed its way through the economy, thereby weakening the labor market. The problem is that conducting monetary is like driving car while facing backward.
It is worth noting that, historically, many recessions began because of monetary policy errors. That is, central banks tightened too much because they weren’t sure they had done enough to quell inflationary pressures. Naturally, the ECB and other central banks would prefer to avoid this mistake. On the other hand, the ECB does not want to make the mistake made by many central banks in the mid-1970s by easing policy before inflation had been defeated.
So, what happens next? ECB President Lagarde said that the policy committee has an “open mind” about what it will do in subsequent meetings. She also acknowledged that the language the ECB used to convey policy intentions had changed and that the change was not “irrelevant.” In other words, she appeared to be signaling at least the possibility that the ECB will pause. Indeed, regarding the next meeting in September, she said “there is a possibility of a hike, there is a possibility of a pause.”
The Bank of Japan adjusts policy, shocks investors
- Since a new governor took control of the Bank of Japan (BOJ), there has been speculation as to whether the BOJ would adjust its extraordinarily easy monetary policy in the face of rising inflation. For months, the BOJ said that the surge in inflation is temporary and driven by supply, rather than demand, factors. As such, there was no need for an adjustment. Moreover, there was concern that a tightening of monetary policy might kill the economic recovery in its infancy. Moreover, there was concern that tightening would boost the value of the yen, thereby hurting export competitiveness.
Last Friday, things changed. The BOJ announced that it will implement “greater flexibility” in its yield curve control (YCC) policy. YCC involves not only a negative short-term interest rate (–0.1%), but also targeting of the 10-year bond yield meant to keep the yield spread constant. The target for the 10-year yield was, and remains, 0%. However, the BOJ has a range in which it allows the yield to move. Until today, the upper limit for the 10-year yield had been targeted at 0.5% for the past seven months. The new policy means that the BOJ will tolerate a 10-year yield of 1%. It said that the range would be “references” rather than “rigid limits.”
The BOJ said that “sustaining the 2% inflation target accompanied by wage increases is far from being realized. It is important to patiently continue monetary easing along with the YCC policy. Today's policy tweaks will enhance the sustainability of monetary easing and YCC.” In addition, it said that “the bond market is stable now and we saw uncertainty over the outlook very high. This is a good timing to make tweaks to our policy framework.”
Thus, despite continuing to endorse monetary easing, the BOJ signaled an end to monetary easing, thereby shocking investors. The result was movements in asset prices. The yield on the 10-year Japanese bond quickly increased from 0.45% to 0.57%. The value of the yen increased sharply against both the US dollar and the euro. The euro also fell against the dollar.
What likely concerns investors is that the BOJ’s YCC policy has involved a massive injection of liquidity into the global financial system as the BOJ purchased massive quantities of Japanese bonds. The possibility that this will be significantly reduced, if not ended, has global implications. This could lead to higher bond yields in other countries. It could also mean capital outflows from some emerging markets. Some had benefited from the so-called carry trade in which investors borrowed cheap yen and invested in higher-yield bonds in emerging countries.
The new approach by the BOJ suggests that it now acknowledges the end of a long period of deflationary pressure in Japan. Given the way that central banks often act, it seems likely that today’s modest announcement could be the first step in a move toward a more traditional monetary policy. That could entail positive short-term rates and an end to YCC. The new approach also suggests that the BOJ is confident that the economy can withstand a tighter monetary policy. It also suggests that the BOJ is finally concerned that the rise in inflation might not be temporary.
US Fed tightens monetary policy as economy continues to grow
- As expected, the Federal Reserve’s policy committee voted unanimously to increase the Federal Funds rate by 25-basis points to a range of 5.25% to 5.5%. This is the highest rate in 22 years. Investors barely reacted, with asset prices moving only moderately. However, the Fed left unclear its future intentions, merely saying that it will consider new data. It did note that US inflation remains elevated and that the economy is relatively strong as evidenced by a moderate pace of expansion, a strong labor market, and a sound and resilient banking system.
At its last policy meeting in June, the Fed had hinted that, although it did not raise rates in June, it would likely raise them twice more this year. However, since then there has been new data signaling lower-than-expected inflation as well as a weakening of credit market conditions. This has led to a new expectation among some investors that the July increase announced last week would be the last one for a while. Also, the next Fed policy meeting will be in September, by which time there will be two more months of data on inflation, employment, and credit conditions. That data will inform whatever decision is made by the Fed.
If inflation remains low, and if core (underlying) inflation continues to decelerate, it is likely that the Fed will hold rates steady for the remainder of the year. On the other hand, the Fed leadership has expressed concern that labor-market tightness might work against further reduction in inflation. That is, now that wages are rising faster than inflation, if wage inflation fails to decline further then underlying inflation could get stuck at an elevated level. From the Fed’s perspective, the solution to this problem is to weaken the labor market through further tightening of monetary policy. On the other hand, it is possible that the Fed has already done enough and that the lagged impact of its past actions will be sufficient to weaken the labor market. The challenge is that the Fed simply cannot know whether this is the case.
- The US economy continues to grow at a good pace. The government reported that, in the second quarter, real GDP increased from the previous quarter at an annual rate of 2.4%. This is more than the long-term ability of the economy to grow, which means that the economy is gradually catching up to the prepandemic path. It also means that the economy has not yet succumbed to the tightening of monetary policy by the Federal Reserve (which boosted interest rates again recently).
Growth was fueled by consumer spending on services, nonresidential fixed investment, and spending by local governments. In fact, roughly 1 percentage point of growth was attributable to consumer spending on services, 1% to business fixed investment, and 0.4% to state and local government spending (fueled by infrastructure money). Meanwhile, there was a decline in exports and imports as well as a decline in residential investment.
There were some notable trends in the numbers. First, overall consumer spending grew modestly, slower than in the previous quarter. This could reflect the impact of tighter monetary policy, which has significantly curtailed housing market activity. That, in turn, has an impact on consumer spending for household products. Spending on goods increased at a very modest rate of 0.7%. However, consumers continued to shift toward spending on services, which increased 2.1%—still slower than in the previous quarter. The strength of the job market has sustained consumer spending. If the job market weakens, this will likely have a negative impact on consumer spending.
Second, business fixed investment grew rapidly in the second quarter, rising at an annual rate of 7.7%. This included growth of 9.7% for structures, 10.8% for equipment (especially transport equipment), and 3.9% for intellectual property. It is likely that business investment was fueled, in part, by government spending on infrastructure as well as government subsidies for clean energy and information technology. The latter two were related to the Inflation Reduction Act and the CHIPS Act.
Third, exports of goods declined at a rate of 16.3%. This likely reflects the weakening of the global economy. However, imports fell sharply as well. Thus, trade had only a modest impact on GDP growth. In addition, residential investment fell at a rate of 4.2% in the second quarter. It has not grown since the first quarter of 2021. Finally, government spending at the state and local level grew at a rate of 3.6%, partly fueled by Federal subsidies for infrastructure investment.
What could undermine this growth going forward? First, the job market is critical. If Fed tightening undermines the tightness of the labor market (as is intended), this could have a negative impact on consumer spending. Second, it is possible that there could be further episodes of financial market stress, thereby boosting risk spreads and undermining credit activity. This could hurt business investment as well as investment in housing. Finally, if the global economy weakens further, there could be negative consequences for net exports. In any event, there is a general view that the economy will slow further, but not necessarily dip into recession. Much depends, of course, on what the Federal Reserve does in the coming months.
The GDP report also included a measure of inflation for the broad economy, known as the GDP deflator, which was up at an annual rate of 2.2%. This was the lowest rate since the second quarter of 2020. Also, the PCE deflator, which measures inflation for the consumer sector and is the favorite measure of inflation for the Federal Reserve, came in at 2.6%, also the lowest since the second quarter of 2020. This is yet more evidence that inflation is rapidly abating. That is good news for the Federal Reserve and reduces the likelihood that it will boost interest rates again.
August 2023 updates
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Ira Kalish
Cover image by: Sofia Sergi
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