Weekly global economic update
What’s happening this week in economics? Deloitte’s team of economists examines news and trends from around the world.
Financial markets react to the latest US trade policy decisions
- Following the US election in November, US equity prices soared on expectations that a combination of tax cuts and deregulation would boost US economic growth, thereby increasing corporate profits. Yet, since that time, most of the economic news has focused on tariffs rather than taxes. Tariff increases are expected to be inflationary and potentially lead to tighter monetary policy. In addition, tariff increases are expected to subdue aggregate demand by reducing consumer purchasing power. Finally, tariffs are expected to hurt the competitiveness of US manufacturers by boosting the cost of imported inputs. Thus, it is not surprising that US equity price indices have fallen back toward the pre-election level. Plus, it is not surprising that equity prices in other markets have fallen on fears of the potential impact of tariffs. There have been especially sharp declines in equity prices for automotive companies in anticipation of massive supply chain disruption due to trade restrictions.
What is surprising, however, is that investor expectations about monetary policy have shifted. Following the election, an expectation of lower taxes, less regulation, higher tariffs, and less immigration led to expectations of higher inflation. This, in turn, led futures markets’ implied probability that the Fed would cut rates several times in 2025 to decline sharply. It became conventional wisdom that the Fed would engage in a wait and see policy for much of 2025, possibly cutting rates only once if at all. Yet lately, expectations have changed, and the futures markets are now predicting as many as three rate cuts in 2025. What happened?
The answer is that the policy of tariffs, combined with uncertainty about tariffs, have led to increased angst on the part of many business leaders. Indeed, the composite purchasing manager’s index (PMI) for the United States fell sharply in February from the previous month, hitting a 17-month low, suggesting an expectation that the US economy will soon start to decelerate if not contract. If the US economy slows down or contracts, that would likely necessitate an easing of monetary policy. Recall that the Fed has a dual mandate from the US Congress: It must minimize inflation while maximizing employment.
Also, it is notable that once the tariffs were implemented the value of the dollar did not rise sharply as normally expected. Here is why the dollar ought to rise: The trade deficit is due to an excess of investment over savings. When a country invests more than it saves, it must experience an inflow of foreign capital to make up the difference. This requires that foreigners accumulate excess dollars. This happens when foreigners sell more to the United States than they purchase (a trade surplus for the foreigners). Thus, if tariffs are introduced, which initially cut demand for imports, there is a drop in demand for foreign currency, thereby boosting the dollar. In addition, something must happen to maintain the trade deficit so long as the gap between investment and savings endures. A rise in the value of the dollar will boost imports and reduce exports, thereby preserving the trade deficit.
The recent experience, however, is troubling. Although the dollar rose sharply against the Mexican peso when the tariffs were introduced, the dollar movement against other major currencies was more muted than expected. Why?
One reason for dollar softness is that investors now see a significant likelihood of a slowdown in the US economy. All other things being equal, a weaker economy means a weaker currency. Plus, the expectation of a weaker economy has led to an expectation of an easier monetary policy. That, too, implies a weaker currency. Thus, the future trajectory of the dollar could be different than previously anticipated.
Another factor driving down the dollar could be the decision by Germany’s two largest parties to engage in massive borrowing to fund defense and infrastructure. This has led to a rise in European bond yields, thereby boosting the value of the euro. Also, investor expectations regarding actions by both the US Federal Reserve and the European Central Bank have shifted substantially in the past few months.
One possibility is that investors are becoming worried that the dominant role of the dollar will decline amid a weakening of the global trading system. Previously, the United States was one of the world’s most open economies, playing a role as the market of last resort for the world’s producers. It also provided a safe haven for investors experiencing risk elsewhere. Yet now, some investors worry that a world in which large trade barriers are erected might become a world in which the dollar is far less attractive.
On the other hand, there is no currency that can easily substitute the role currently played by the US dollar. The United States has a massive, deep, and liquid market for easily substitutable government securities, something the euro lacks. China has capital controls, which makes it nearly impossible for the renminbi to play a major role. No other currency has sufficient scale to challenge the US dollar.
- Investors have been shifting funds toward lower-risk assets as uncertainty, especially regarding tariffs, undermines confidence. Equity prices have been falling, with the Magnificent Seven down 16% from its peak. The tech-heavy NASDAQ index is down 10%. Meanwhile, funds have been pouring into money market funds, which hit a record high volume this week.
The decline in equities reflects not only concern about the potential economic cost of tariffs, but the chilling effect of tariff uncertainty. Consider that, in recent weeks, large tariffs were imposed on Mexico and Canada and then mostly removed, but only for 30 days. There have been several policy reversals on tariffs. Plus, there have been several tariff proposals that have not been implemented. And there have been multiple reasons offered for imposing tariffs. As such, businesses don’t know what to expect and might fear making the wrong long-term decision about allocating capital. This is especially true for companies that must make large, long-term bets such as those in the automotive industry.
Europe shifts gears
- Faced with a dramatic shift in the policy of the United States toward Europe and Ukraine, European governments and the European Union (EU) are engaged in a dramatic shift as well, one that could have significant economic implications. Recent statements by senior US officials about the US role in Europe and its policy toward Ukraine have been a shock to senior European officials. The consequence of this has been a radical shift in European official views about spending on defense.
First, Germany’s two major political parties, the center-right CDU/CSU and the center-left Social Democrats, which will likely form a government together, endorsed a major increase in spending on defense and infrastructure. The former is meant to deal with the Russian threat, the latter to address a shortage of investment that has held back economic growth. The plan calls for creation of two funds worth roughly 900 billion euros. This is a massive shift in policy.
There remain political hurdles to passing the necessary legislation. Specifically, the constitution must be changed to allow a much higher level of government borrowing. This will likely be done by the current Parliament before the newly elected one is seated.
Still, investors evidently expect that the German reforms will take place, given the sharp reaction in financial markets to the plan. Since the announcement recently, the yield on Germany’s 10-year government bond increased by 38 basis points, the biggest short-term rise in nearly 30 years. In addition, the euro surged against the dollar, reflecting a shift in the interest differential between Germany and the United States. Also, it is notable that, since early January, German equity prices have significantly outperformed US equities, evidence that investors had already anticipated some form of German fiscal stimulus. Plus, investors were likely disappointed that the focus of US policy has been tariffs rather than tax cuts and deregulation.
If the German plan is implemented, it is expected to do four important things. First, it will likely be a fiscal stimulus to the German economy that has suffered from sub-par growth. Second, it could kickstart public investment, helping Germany to catch up after a period of inadequate investment. Third, the stimulus to Germany’s economy will likely have a positive spillover impact on the rest of Europe, helping to boost growth while, at the same time, rendering higher borrowing costs (this is already happening). Finally, the surge in spending on defense will potentially play a role in supplying Ukraine at a time when US support is in question.
Second, European Commission President Ursula von der Leyen has urged a large increase in region-wide spending on defense, funded by releasing the cap on borrowing. Specifically, she wants to allow EU members to violate the current rule governing the share of GDP that can be borrowed each year, so long as the increased borrowing is meant for increased defensive capabilities.
In addition, von der Leyen foresees increasing overall European defense spending by 800 billion euros, part of which would be used to buttress Ukrainian defenses. If this happens, it could provide a region-wide fiscal stimulus while, at the same time, boosting the level and cost of government debt.
Notably, European defense company equity prices have lately soared on expectations of increased government spending. Meanwhile, some European leaders have talked about using increased funds to purchase US-made weapons for Ukraine. In doing this, Europe would assure Ukrainian defenses while, at the same time, boosting imports from the United States. The latter would be meant to discourage the United States from imposing tariffs on imports from Europe.
US job growth decelerates
- In the United States, employment continued to grow at a healthy pace in February, although slower than investors had anticipated. Meanwhile, the unemployment rate inched up slightly. The US government releases an employment report that is based on two surveys: One is a survey of establishments; the other is a survey of households. First, we look at the establishment survey results:
In February, the US economy generated 151,000 new non-farm jobs, of which 140,000 were in the private sector. There was strong growth in construction and modest growth in manufacturing. In the realm of services, employment declined for retailing, professional services, leisure and hospitality, and the Federal government. On the other hand, there was strong growth for transportation and warehousing, health care, and local government. In other categories, there was modest growth. Equity prices continued their decline following release of the jobs report. Evidently, investors interpreted the report as signaling slower economic growth than previously believed.
The establishment survey also included data on wages. The report said that average hourly earnings of all non-farm workers were up 4% in February from a year earlier and were up 0.3% from the previous month. These numbers indicate moderate tightness of the labor market, with wages rising modestly faster than inflation. Yet with labor productivity likely rising, the rise in wages is probably not contributing to inflation. Indeed, this is the view of the Federal Reserve.
The separate survey of households found a sharp decline in the number of people participating in the labor force. In part, this could reflect the fact that the number of immigrants entering the United States has dropped sharply since the end of 2024. Indeed, the government reported a 93% decline in the number of daily border encounters since the start of the new administration. The result was a decline in employment (including self-employment) and a modest increase in the unemployment rate from 4% in January to 4.1% in February.
