What’s happening this week in economics? Deloitte’s team of economists examines news and trends from around the world.
There appears to be a growing likelihood that the US Federal Reserve will shift gears and take a more cautious approach to monetary policy. This view is based on comments made by several Fed officials. First, a word on how the Fed is organized: The US Federal Reserve system is made up of a national Board of seven members as well as the presidents of twelve regional Federal Reserve banks. At any given time, five of those 12, along with the seven Board members, serve on the Federal Open Market Committee (FOMC) that decides monetary policy. Thus, the views expressed by the regional bank presidents is of interest to investors as they attempt to glean the likely path taken by the Fed. In recent days, several regional bank presidents have offered their thoughts, and a consensus appears to be building that the Fed ought to hold off on further action until there is greater clarity about the economic situation.1 This comes after three years of rate hikes that have lately contributed to financial-market volatility.
The president of the Chicago Fed, Charles Evans, says that the Fed ought to take its time before acting. He said, “Because inflation is not showing any meaningful sign of heading above 2% in a way that would be inconsistent with our symmetric inflation objective, I feel we have good capacity to wait and carefully take stock of the incoming data and other developments.”2 He added that “recent financial market developments and uncertainties regarding growth abroad, trade policy, and possible fiscal headwinds have cumulated to increase the downside risks.” Meanwhile, Eric Rosengren, president of the Boston Fed, said that he sees “reduced certainty” but remains optimistic about the outlook. Still, he said that “the appropriate stance for monetary policy is, for now, to not have a bias on moving policy in either direction until there is greater clarity around economic trends here and abroad.”3 He noted uncertainty about China, trade, and asset values as creating the conditions that warrant a policy pause. In addition, Raphael Bostic, president of the Atlanta Fed, said that “a patient approach to monetary policy adjustments in the coming year is fully warranted in light of the uncertainties about the state of the economy and about what level of policy rates is consistent with a neutral stance.”4 Finally, St. Louis Fed president James Bullard said that further rate hikes could cause a recession. He said that the recent decline in bond yields is “signaling that there might be some recession risk ahead” if the Fed raises rates.5 He added that the Fed is “bordering on going too far and possibly tipping the economy into recession.” He said that he believes the other members of the FOMC are moving in the direction of his thinking.
Meanwhile, the Fed itself released the minutes of the FOMC’s last meeting, which was held in December. The minutes state that “Many participants expressed the view that, especially in an environment of muted inflation pressures, the Committee could afford to be patient about further policy firming.”6 In addition, it said that “a relatively limited amount of additional tightening” is likely to be needed. However, the latest comments from Fed officials, noted above, suggest that FOMC members have since moved toward the view that no tightening is needed at the present time. The minutes indicate that Fed leaders are concerned about trade, especially in agriculture, and are also concerned about stress in financial markets. Although leaders expressed the view that the US economy remains strong, they also see downside risk emanating from these factors and, consequently, contributing to a possible pause in monetary tightening.
There are reports that the United States and China are making progress in trade talks aimed at averting new tariffs when a 90-day cooling off period ends on March 1.7 In fact, after two days of scheduled talks, the two sides agreed to extend the meeting to a third day. The Chinese seem eager to avoid new US tariffs, especially given evidence that the Chinese economy is already experiencing significant negative effects of the existing trade war. The US side also seems keen to avoid tariffs given that the drop in equity prices in recent months is seen as being related to investor worries about the trade war. Moreover, the weak performance of some US companies in China has attracted the attention of US officials. Kevin Hassett, the US administration’s chief economist, said recently that many US companies are going to see weakened performance because of the slowdown in China.8 He said that “there are a heck of a lot of US companies that have a lot of sales in China that are basically going to be watching their earnings be downgraded until we get a deal with China.” For its part, China has already boosted imports of soybeans from the United States and has pledged to take several other actions meant to assuage US concerns. These include boosting imports from the United States and not forcing US companies to transfer technology to Chinese companies. The United States wants China to reduce subsidies to state-run companies and to do more to protect intellectual property.9 Of course, the devil is in the details, and the United States is seeking greater specificity from the Chinese. Meanwhile, the US side has designated trade negotiator Robert Lighthizer as the point man for these talks. In the past, other administration officials have taken the mantle, including Commerce Secretary Ross and Treasury Secretary Mnuchin. But internal disputes within the administration and uncertainty about the president’s views hindered progress.10 The hope is that, given Lighthizer’s good relationship with the president, these talks will more likely be successful. At the same time, Lighthizer is said to be averse to an agreement that lacks teeth and is worried that others in the administration will be too eager to accept vague proposals from the Chinese.11 Meanwhile, others in the administration are said to be concerned that failure to strike a deal will likely mean a further decline in US equity prices.
As the US and China continue to seek agreement on trading arrangements, it is worth considering the impact of trade liberalization in this century. The US administration complains that cheap imports from China have led to job losses among US manufacturing workers. This is true. Yet there is another side to the story. About 40 percent of imports from China to the United States are components used to assemble final products. The surge of these relatively cheap imports following China’s accession to the World Trade Organization (WTO) two decades ago enabled US companies to reduce costs, thereby improving their global competitiveness. An analysis by a leading economist found that the US jobs created through this channel exceeded the number lost due to direct competition from Chinese imports.12 This helps to explain why many US manufacturing companies are complaining about tariffs on Chinese imports. Meanwhile, China’s accession to the WTO led to a unilateral dismantling of many trade barriers. Today, about half of China’s imports are tariff-free in those cases where the imports are components used to produce exportable products. This fact has helped to boost exports from the United States to China, which increased over 500 percent in the last two decades.
An analysis by a leading China expert found that the share of inbound investment into China that is subject to joint venture requirements has declined considerably in recent years.13 This means that a declining share of technology brought into China by foreign companies is subject to transfer to Chinese companies. The analysis finds that there remain a number of industries where forced technology transfer still takes place, but that the problem is far less onerous than in the past. Foreign ownership restrictions have been reduced substantially, especially in manufacturing. As the United States and China negotiate, one of the sticking points is the US insistence that China stop forcing US companies to transfer intellectual property to their Chinese partners. The latest analysis suggests that the problem is less acute than previously thought.
An analysis by the Federal Reserve Bank of New York found that the tariffs that have been imposed in the past year by the US government have increased the average effective tariff rate from 1.6 percent to 3.3 percent.14 The effect of this was to raise the average price of all consumer goods and services by 0.3 percent. That is the short-term effect. The longer-term effect could be greater, especially if tariffs are increased further if and when US/China negotiations fail. At the same time, the longer-term effect could involve companies shifting the location of production in order to avert tariffs. The analysis found that 12 percent of total US imports were affected by the new tariffs and that 10 percent of imports are now subject to tariffs in excess of 10 percent. Previously, only 4 percent of imports were taxed at more than 10 percent. The larger impact of tariffs, however, has likely been the chilling effect they have had on business investment, especially due to uncertainty about future trading arrangements.
They say that demographics is destiny. If so, the latest fertility data for the US could suggest a troubled destiny. The US birth rate has fallen to the lowest level since 1950 and, since 2008, has been below replacement level.15 That means that, in the absence of immigration, the population will ultimately decline as it gets older. Moreover, the US birth rate is now below those of France and Russia. What is especially interesting is the ethnic mix of birth rates. Since the early 1980s, the birth rates of most racial categories have been lower than the replacement rate. The one glaring exception was the birth rate for Hispanic women, which was relatively high. That has changed, dramatically. In recent years, the birth rate for Hispanic women fell sharply, to below the replacement level. Thus, birth rates for white, black, Asian, and Hispanic women are all now below replacement level. What does a low birth rate imply? First, the birth rate is now below the most pessimistic scenario of the Social Security Trust Fund. In other words, in the absence of a surge in immigration, America’s system of providing pensions for the elderly will face severe stress in the not-too-distant future. Second, without a surge in immigration or productivity, the economy will likely grow more slowly in the future than previously expected. As of this writing, the US government is shut down because of a dispute about immigration. Thus, it is worth considering the larger consequences of the immigration policy.
The year 2018 was rough for investors, especially during the month of December. In fact, US equities fell more in December 2018 than in any December since 1931 during the Great Depression. For all of 2018, investors made little money, with markets performing worse than at any time in the last decade.16 Yet equities and commodities had actually started the year on a positive note. Rising asset prices reflected optimism about the global economy, especially after the US tax cut. Investors expected that the US fiscal stimulus would cause a boost to US economic growth, add to US corporate profits, and stimulate US demand for the world’s exports. Moreover, they expected that easy monetary policy in major markets would keep economies humming. Yet as the year progressed, something went wrong, leading to a decline in equities and commodities. At the same time, a decline in expectations of inflation in the United States led to a drop in bond yields and a commensurate rise in bond prices. What led to the sharp change in the direction of asset prices?
First, the US administration launched a trade war in March, starting with tariffs on imports of steel and aluminum. In addition, the United States imposed significant tariffs on imports from China, threatened tariffs on imported automobiles, and engaged in a lengthy and uncertain negotiation to revise the North American Free Trade Agreement. The trade war, and the consequent uncertainty, had a chilling effect on investment and, ultimately, on trade flows. This led to investor pessimism about the outlook for globally oriented companies and for the demand for traded goods as a consequence of tariffs.
Second, the global economy appeared to decelerate in 2018. Growth in Europe, China, and several key emerging markets slowed.12 In Europe, political fragmentation created fears about the future of the Eurozone. In Britain, investors worried about the consequences of a no-deal Brexit. Meanwhile, the Japanese economy appeared to stall. Currency crises in Argentina and Turkey are causing recession in these countries, and policy responses to currency depreciation in other countries caused investors to expect a slowdown in growth.
Third, although the massive US economy did accelerate initially after the tax cut, it was likely short lived. By the third quarter, growth remained strong, but largely due to consumer spending and inventory accumulation. Meanwhile, business investment and exports stagnated.18 In addition, a rise in bond yields weakened the housing market and rising short-term interest rates alarmed investors, leading to weaker credit market conditions.
So, what happens next? I always say that, if I could accurately and consistently predict asset markets, then I’d probably own a private island in the Bahamas. Therefore, rather than offer a firm prediction I’ll provide the points of view of optimists and pessimists.
The pessimistic view is that the global economy has peaked and is now heading south. The slowdown in Europe and China will not soon be reversed, despite easy monetary policy, especially as trade concerns continue to stifle investment. Moreover, the United States has peaked and, with a likely further tightening of monetary policy and an imminent reversal of fiscal stimulus, is likely to see much slower economic growth. The recent sharp decline in inflation expectations suggests investors expect slower growth. The pessimistic view is also that the trade war will worsen, with the United States and China failing to find common ground. This view is that, with the US trade deficit actually rising due to strong domestic demand, the US administration will be frustrated at a lack of progress and will, likely impose new tariffs on China, thereby reducing consumer purchasing power and stymying growth of trade. Finally, the drop in energy prices, combined with higher interest rates, will likely create credit market problems in rich countries and more currency crises in poorer countries. The pessimistic view suggests the possibility of a further drop in asset prices.
The optimistic view, on the other hand, is that policymakers will respond to changed circumstances and avoid a downturn. The fact that inflation expectations in the United States have fallen sharply means that the Federal Reserve might choose to delay further interest rate increases, thereby giving the economy some breathing room. Indeed, the futures markets now say that investors see a 90 percent chance of no interest rate increases in 2019.19 Moreover, the US Congress could choose to avert an impending tightening of fiscal policy. The trade war might not worsen, especially if the US administration chooses to accept a modest deal with China and declare victory. Indeed, it has been reported that the US trade negotiator, Robert Lighthizer, is actually worried that this will happen.20 Finally, the optimistic view is that Europe’s economy will be stable amidst continued easy monetary policy and easing fiscal policy. The view is also that China’s authorities, through the use of monetary and fiscal policy, will be successful at stabilizing the Chinese economy and avoiding a further slowdown. The optimistic view suggests that assets might currently be undervalued.
Shares in major global consumer-oriented companies took a beating last week when some companies announced weak performance in the massive Chinese market. Global companies in such industries as telecoms, automobiles, and luxury fashion all announced weak results.21 Moreover, the weakness of these companies is consistent with other information suggesting a weakening Chinese economy. Official retail sales statistics have been especially poor, with November sales increasing at the slowest pace since 2003.22 However, many observers, including some of China’s leaders, are often suspicious of official data.23 So they look to private sector data in order to glean trends in the economy. For example, the automotive industry reports weak demand in China, with sales down roughly 15 percent in November versus a year earlier.24 It appears that Chinese consumers are increasingly averse to big ticket purchases.
Meanwhile, shares in Asian companies that supply US-based companies also took a beating. In addition, the latest purchasing manager’s index (PMI) for Chinese manufacturing indicated declining activity. Similarly, PMIs for South Korea, Taiwan, and Singapore also signaled declining activity.25 Many observers said that the trade war between the United States and China was, in part, responsible. The argument has been made that the uncertainty engendered by the trade war has affected consumer willingness to spend. It has certainly had an impact on business investment on both sides of the Pacific Ocean.
Other factors have also had a negative impact on consumer spending in China. These included the lagged effect of Chinese official efforts to stem a housing market bubble by tightening credit conditions, as well as efforts to stem the rise of private sector debt.26 Lately, however, China’s authorities have eased credit market conditions and boosted infrastructure spending, in part due to concerns about the negative impact of the trade war. Despite these efforts, the economy has not yet rebounded.
As China’s consumer economy decelerates, it could have global implications. China is the largest market in the world for many important products including automobiles, mobile phones, and luxury fashion goods, among others. Weak sales will affect the fortunes of many global companies and will likely have significant spillover effects on suppliers of components and commodities in multiple countries. Weak demand in China could have a negative impact on the exports of other countries. A further intensification of the trade war might worsen the situation. Meanwhile, concern about the state of China’s economy likely played a role in the global decline in equity prices last week. In addition, bond yields in major markets fell, signaling investor belief that inflation is likely to wane and growth is likely to decelerate.
Amidst global concern about the uncertain state of the Chinese economy, China’s central bank, the People’s Bank of China (PBOC), announced last week new measures aimed at reviving the massive Chinese economy.27 Specifically, the PBOC said that it will cut the required reserve ratio for commercial banks by 0.5 percent in mid-January and another 0.5 percent in late January. These actions are expected to pump 1.5 trillion renminbi (about US$210 billion) into the banking system, enabling banks to significantly increase their lending. The PBOC also took steps meant to target increased lending to smaller businesses. This comes following an earlier easing of monetary policy as well as a recent decision by the government to increase the amount of debt that local governments are allowed to issue for the purpose of infrastructure investment. The latter is part of a more aggressive fiscal policy meant to stimulate the economy.
These measures are reminiscent of past actions by the government meant to offset external headwinds. In this case, the headwinds are coming, in part, from the trade dispute with the United States. In response to the latest action, Chinese equities increased strongly. In addition, investors likely reacted positively to news that the United States and China will resume direct trade talks next week. Also, investors were likely pleased by news that the PMI for the Chinese services sector increased in December, indicating faster growth of the services sector.28 This was welcome news at a time when many other indicators suggest a worsening economy.
Markets are now pricing in a 30 percent probability that the US Federal Reserve will actually cut interest rates in 2019.29 This is a dramatic change from just a few months ago when the perceived probability was zero. The probability of no rate change is now 60 percent. This means that investors believe that the Fed will change from its stated intentions due to slowing growth and declining inflation. Indeed, the head of the Federal Reserve Bank of Dallas, Robert Kaplan, referring to uncertainty about the state of the global economy, said, “We should not take any further action on interest rates until these issues are resolved, for better, for worse. So I would be an advocate of taking no action and—for example—in the first couple of quarters this year, if you asked me my base case, my base case would be take no action at all.”30 Although Kaplan is not currently sitting on the policy committee, he is said to be close to Chairman Powell. Meanwhile, the yield on the US government 10-year bond fell to 2.57 percent today, the lowest rate in almost a year. This decline has largely resulted from a sharp drop in measured expectations of inflation. Such expectations have fallen because of declining energy prices and a rising dollar, but also because of concerns about slowing economic growth.
Although investors are concerned about the outlook for the US economy, it is clear that the job market remained exceptionally strong in December. The US government reports that there was very strong job growth, a large increase in the number of people participating in the labor force, and a significant acceleration in wages.31 The government provides two reports; one based on a survey of establishments, the other based on a survey of households. Here is what these surveys revealed.
The establishment survey found that 312,000 new jobs were created in December, the biggest increase since February of 2018. This was far in excess of the number required to absorb new entrants into the labor force. As such, it indicates a further tightening of the labor market, auguring for more job shortages. There was strong job growth in construction, manufacturing, retailing, professional and business services (such as Deloitte), health care, and leisure and hospitality. The tightening of the labor market, not surprisingly, led to a further acceleration in wages. Average hourly earnings were up 3.2 percent from a year earlier, the fastest wage gain since 2009. Wages were up 0.4 percent from the previous month. Still, wage gains are not much higher than the rate of inflation.
The separate survey of households indicated very strong growth in labor force participation, with the participation rate increasing by 0.2 percentage points. Although job growth was strong, it was not as strong as the growth of the labor force. Consequently, the unemployment rate increased from 3.7 percent in November to 3.9 percent in December.
Investors greeted the positive news about job growth by pushing up equity prices substantially, both in the United States and globally. Commodity prices and bond yields also increased. Investors were also pleased by news that China’s government will take new steps to stimulate the Chinese economy. Finally, investors likely approved of a comment made by Federal Reserve Chairman Powell in which he said that the Fed would “watch to see how the economy evolves” as it deliberates on policy.32 This suggests the possibility that the Fed will veer away from its previous plans to gradually raise interest rates.