What’s happening this week in economics? Deloitte’s team of economists examines news and trends from around the world.
The European Union (EU) has formally rejected the budget proposed by the Italian government. Italy’s budget plan, which is meant to produce a deficit of 2.4 percent1 of gross domestic product (GDP, although probably higher if the economy grows more slowly than the government anticipates), is not seen as acceptable to the EU. Rather, the EU says that Italy should keep its deficit under 0.8 percent of GDP in order to reduce its alarmingly high debt/GDP ratio and restore fiscal probity. This is the first time that the EU has rejected the budget plan of a member country.2 As a member of the eurozone, Italy is obligated to abide by the fiscal rules set by the Union. The Italian government refused to make changes to its budget plans, despite pressure from the EU. Meanwhile, Italian bond yields are up substantially on fears that the budgetary situation will worsen, potentially leading to a crisis in which Italy has trouble selling bonds and the EU is called upon to bail out Italy’s government. Such a scenario is reminiscent of what happened several years ago to Greece. Italy’s prime minister, however, says that the elevated bond yields reflect investor fears that Italy will exit the Eurozone. He says that this will not happen, and that his future grandchildren will one day use the euro as their currency.
Italy is not the first country to violate EU fiscal rules, but is the first to be rejected by the EU. What is different now? There are several differences. First, the last Italian government had agreed on a plan that the new government is now rejecting. Second, other countries have violated the rules during periods of economic downturn, when revenues declined sharply and governments were unable to cut their deficits without doing serious damage to their economies. In this case, Italy has chosen to violate the rules despite a relatively strong economy. Thus, the Italian fiscal decision is seen as especially egregious. A senior EU official noted that “the Italian government is openly and consciously going against commitments made. Europe is built on cooperation. The euro area is built on strong bonds of trust.”3 For its part, the Italian government argues that austerity will only worsen the debt trap in which Italy finds itself. It believes that fiscal expansion will boost economic growth, thus allowing the government to eventually improve its finances.4 That argument might make sense depending on how the money is spent. Meanwhile, the EU has the option of imposing sanctions on Italy. This is not expected to happen any time soon, if at all. Rather, it is more likely that Italy and the EU will continue to talk with the goal of finding a solution.
Interestingly, nearby Spain, with a Socialist government, intends to boost the size of its budget deficit, although still remaining within the EU strictures.5 Spain wants to boost spending and taxes at the same time, and is evidently intent on staying within EU rules. Moreover, with an economy that is performing better than that of Italy,6 Spain clearly has more wiggle room. It has also engendered greater investor confidence as evidenced by the much lower bond yields in Spain than in Italy.
The European Central Bank (ECB) held interest rates steady and low, but indicated that it intends to end asset purchases (quantitative easing) by the end of the year.7 None of this was unexpected, but it is important nonetheless. The end of the asset purchase program, which currently entails purchases of 15 billion euros of government bonds each month, will likely create some upward pressure on bond yields. The continued historically low interest rates, however, reflect a belief that inflation may remain subdued, likely because of the still-high level of unemployment in several eurozone countries.
ECB President Mario Draghi said that the risks to the eurozone economy are “balanced.” As for risks, he noted the crisis in Italian government finances, the burgeoning trade wars, and the currency crisis in emerging countries. With respect to Italy, however, he expressed confidence that the Italian government and the EU will reach an agreement.
At the same time, results of a survey of business leaders conducted by Bloomberg revealed that the situation in Italy is seen as the biggest risk to the eurozone economy.8 The second-biggest risk is the trade war. Draghi said that “incoming information, while somewhat weaker than expected, remains consistent with the base case scenario of ongoing broad-based expansion” and that the “underlying strength of the economy continues to support our confidence.” However, the latest purchasing managers’ indices (PMIs) for the eurozone are at their lowest level in two years. IHS Markit, which compiles the data, said that the latest PMIs “would historically be consistent with a bias toward loosening monetary policy.”
In the third quarter of this year, the US economy grew at a strong pace, but equity investors were not impressed, sending prices down to the point where the gains made during 2018 were almost wiped out.9 Perhaps investors were concerned that, although economic growth was strong, it did not stem from sources that are likely to be sustainable. Here is what happened: real GDP increased at an annualized rate of 3.5 percent from the second to the third quarter, after having grown at a rate of 4.2 percent in the second quarter.10 Real GDP was up 3.0 percent from a year earlier. The two most recent quarters saw the fastest growth of the US economy since 2014.
The acceleration this year was likely due, in part, to the stimulation provided by last year’s tax cut. This is reflected in the fact that real consumer spending grew at a rate of 4.0 percent in the third quarter, after having grown at a rate of 3.8 percent in the second quarter. Yet the tax cut alone does not explain this. Consider the fact that, in both the second and third quarters, real disposable personal income (which is household income after taxes) grew at a rate of 2.5 percent. Thus, consumer spending grew faster than income, as households dipped into their savings, saved less, and borrowed more. Indeed, the personal savings rate has fallen from 7.2 percent in the first quarter to 6.4 percent in the third quarter. This can continue for a while, but cannot go on forever—and won’t. Thus, there is reason to expect a slowdown in the growth of consumer spending sometime in the near future.
Other important areas of economic activity did not experience significant growth in the third quarter. Real business investment grew at a rate of only 0.8 percent, with investment in structures falling sharply and investment in equipment rising marginally. Only investment in intellectual property grew at a robust rate. The weakness of business investment might be surprising given that there was a substantial cut in the corporate income tax rate which was meant to stimulate more business investment. There was, in fact relatively strong growth of investment in the second quarter. Yet the reality is that, at the time of the tax cut, businesses were already laden with cash and faced historically low borrowing costs. Moreover, their profitability was already quite high. Thus, the added after-tax profits were not likely to have a big impact on investment. Rather, they were used for share repurchases and retained earnings, and contributed to the rise in equity prices. It is possible that the weakness of investment growth was also related to the uncertainty regarding trade. If business investment doesn’t accelerate, then there will likely not be the additions to productive capacity needed to cause a permanent acceleration in growth. The fast growth in 2018 can, consequently, be seen as temporary. Also, with the Federal Reserve raising interest rates, it is likely that interest-sensitive areas of economic activity, such as housing and investment by small- and medium-sized businesses, will be negatively affected.
Speaking of housing, residential investment declined in the third quarter, not surprising given the weak housing activity numbers we’ve seen and the rise in mortgage interest rates. Also, exports declined in the third quarter, clearly part of a global trend as uncertainty about global trading rules undermines growth in trade. Also, exports had grown artificially rapidly in the previous quarter as exporters sought to move soybeans quickly before they faced Chinese tariffs. Thus, it is not surprising that exports fell in the third quarter. Aside from consumer spending, the only other areas of economic activity to experience strong growth were inventory accumulation and government spending on defense. Inventory accumulation actually accounted for roughly 60 percent of the increase in real GDP in the third quarter. This cannot be sustained for long. As inventories pile up due to production exceeding demand, businesses will likely cut back on production in order to wind down inventories. That suggests slower overall growth in the quarters to come. Absent inventory growth, real GDP would have grown at a rate of only 1.5 percent in the third quarter.
IHS Markit has released its flash, or preliminary, PMIs for the eurozone, the United States, and Japan. There are PMIs for manufacturing and services. Each PMI is a forward-looking indicator meant to signal the direction of activity in the economy. It is composed of sub-indices such as output, new orders, export orders, employment, input and output prices, inventories, pipelines, and sentiment. A reading above 50.0 indicates growing activity; the higher the number, the faster the growth—and vice versa.
The latest results for the eurozone indicate a deceleration in economic activity.11 The PMI for manufacturing fell from 53.2 in September to 52.1 in October, a 26-month low and a level consistent with only modest growth in activity. The separate services PMI similarly fell to a 24-month low. For the manufacturing PMI, the sub-indices for output and sentiment both fell to a four-year low. Meanwhile, the sub-index for export orders fell into negative territory for the first time in five years. Markit commented that the weak PMI is “being led by a drop in exports, linked in turn by many survey respondents to trade wars and tariffs, which appears to have darkened the global economic environment and led to increased risk aversion.”
The latest PMIs for the United States suggest continued economic strength.12 The PMI for manufacturing increased from 55.6 in September to 55.9 in October, a five-month high and a level consistent with strong growth of activity. The separate PMI for services also rose to a two-month high. Sub-indices for output, new orders, and employment were all strong. However, input price inflation accelerated and output price inflation matched the high level seen in the previous month. Thus, it appears that bottlenecks persist. Markit commented that the PMIs are consistent with annualized growth of 2.5 percent. It said, however, that “growth is being constrained by a lack of capacity, with skill shortages widely reported and supplier delays remaining commonplace. Companies consequently reported yet another rise in backlogs of work as, measured overall, order book inflows once again exceeded output growth.” Markit said that this situation is consistent with a decision by the Fed to continue tightening monetary policy. That is, the economy is being pushed to perform beyond capacity, thereby creating inflationary pressures. Finally, Markit also said that domestic demand is driving growth while export growth is weak, with “trade being subdued by tariffs.”
The latest PMI for Japanese manufacturing indicated an improvement in performance.13 The PMI increased from 52.5 in September to 53.1 in October. Most major sub-indices indicated accelerating growth. Indeed, the sub-index for exports pointed to growing activity for the first time in five months. The rebound in Japanese manufacturing is welcome, but it is not clear if it can be sustained.
It is worth noting that China’s GDP figures, when mapped on a graph, show a very smooth line that is not consistent with the experience of any other major economy. For this reason, many analysts, and even Chinese government leaders, are suspicious of the veracity of the data.15 Rather, they look at it not for its accuracy but for the direction that it indicates. There is other data that confirms that the economy is slowing.
The recent easing of monetary policy by the central bank is meant to stimulate more credit activity in order to fund investment. It comes after a period during which tighter monetary policy had a negative impact on credit creation. In fact, outstanding credit in China grew only 10.6 percent in September versus a year earlier, the slowest rate of growth on record.17 This came about even though bank credit accelerated. The slowdown in overall credit growth reflected a sharp decline in growth of shadow banking. This likely had a negative impact on businesses that have come to depend on non-traditional sources of funding.
A debate now rages as to the future direction of the Chinese economy. The government has attempted to boost confidence, with a leading official saying, “If you analyze China’s economy by focusing only on one thing or one period, you might feel it faces difficulty. But if you look at it from a larger historical perspective, the outlook is very bright.”20Then again , a leading Chinese government think tank has noted that “rising US interest rates, the intensifying trade war, and increasing risks in emerging markets will negatively affect China.”21 The big unknown is the impact of the trade dispute between the United States and China. It is not yet clear what level of tariffs will exist next year, nor is it clear if the United States and China will reach an accord on future trading relations.
Indeed, the opposite was likely the case. That is, China’s central bank has probably sold reserves in order to prop up the renminbi and prevent it from declining more rapidly. However, the Treasury did say that “of particular concern are China’s lack of currency transparency and the recent weakness in its currency. These pose major challenges to achieving fairer and more balanced trade, and we will continue to monitor and review China’s currency practices, including through ongoing discussions with the People’s Bank of China.” Indeed, Treasury Secretary Mnuchin had previously said that the exchange rate ought to be a topic of discussion between the United States and China when attempting to find common ground on trade. The US administration has been concerned that the 7 percent depreciation of the renminbi this year almost offsets the impact of the 10 percent tariff that the US has imposed on a large volume of Chinese imports. In fact, the US intends to boost the tariff to 25 percent in 2019, if a new trade deal cannot be reached.
Our clients often ask whether the dominant role of the US dollar is under threat. The standard answer is usually that the major role of the dollar is not likely to change anytime soon for several reasons. These include the fact that there remains a vast and liquid market for dollars; the value of the dollar is reasonably stable; the US financial system is sound and reasonably transparent; and that there is a lack of a good substitute given the fragmented nature of the eurozone and the lack of transparency and openness regarding the Chinese renminbi.
However, a new analysis by Barry Eichengreen, a professor at Berkeley and one of the world’s leading experts on the role of the dollar, casts doubt on this argument. Specifically, Eichengreen says that the US administration’s threat to penalize companies that do business with Iran “could hasten the dollar’s demise as the main global currency.”25 He notes that US-based banks are the principal source of dollars used in international transactions, and that dollars make up roughly half of all such transactions. The US administration, having pulled out of the Iran nuclear deal, is now threatening to cut off companies that trade with Iran from access to dollars. In response, the other signatories to the Iran deal (Germany, the United Kingdom, France, Russia, and China) have said that they intend to create an entity that will facilitate transactions with Iran in other currencies— most likely the euro. This will enable non-US companies to trade with Iran and avoid US government scrutiny.
If successful, it could snowball into a major vehicle for funding trade. Eichengreen recalls that the British pound was the world’s dominant currency as late as 1914 and that, due to the impact of the First World War, the US dollar had become dominant by the early 1920s—a fairly quick downfall for the pound. He says something similar could happen to the dollar, and quite quickly. If that were to happen, the United States would lose the “exorbitant privilege” it now enjoys, which entails issuing debt in its own currency and being able to run a large external deficit with relative impunity. If the euro were to take a more dominant role, it could have a big impact on global commodity markets, global trade flows, global asset management, and the geopolitical power of the United States, Europe, and China.
Rebecca Porter, an economist with Deloitte UK, provides an update on Brexit.
Last week, the EU 27 leaders gathered for their latest summit in Brussels in what was dubbed the “moment of truth” for Brexit negotiations.26 The talks are in deadlock over the so-called “backstop” to avoid a hard border between Northern Ireland and the Republic of Ireland. The Good Friday Agreement in 1998 helped bring peace to Northern Ireland and enabled free movement of goods and people across the border; all parties wish to maintain this “borderless border.” However, for the whole of the United Kingdom, including Northern Ireland, to leave the European Union’s (EU’s) customs union could, in the EU’s assessment, require border infrastructure to monitor trade.
The EU has proposed that Northern Ireland stays in the customs union, large parts of the single market, and the EU value added tax system.27 The UK has rejected this on the basis that it could create a border between Northern Ireland and the rest of the United Kingdom; the proposal is also anathema to the pro-UK Democratic Unionist Party in Northern Ireland whose nine Members of Parliament provide the Conservatives with an overall Parliamentary majority. The United Kingdom has proposed a backstop that would effectively keep the whole of the United Kingdom in the EU customs union for a limited period. The UK and EU leaders also confirmed that they are considering a one-year extension to the 21-month Brexit transition period to keep the United Kingdom in the customs union and the single market until the end of 2021. The hope is that the need to trigger the Northern Irish backstop will be avoided with more time to agree a future trade deal.
The EU had been considering announcing a special summit in November to finalize the terms of the United Kingdom’s planned exit from the EU in less than six months. However, EU 27 leaders have since said that there has not been enough progress in talks meaning that the last conceivable date for the EU and the United Kingdom to agree a deal is at the next EU summit in December. Despite EU officials warning that a no-deal is “more likely than ever before,”28 UK betting markets are still placing 65% probability of a deal by 29 March 2019.
Last week there was a sharp drop in equity prices in major markets around the world.29 It began in the United States on Wednesday when equity prices fell more than 3 percent in one day, with shares on the technology-heavy Nasdaq exchange falling more than 4 percent. By Thursday, prices were falling sharply in Asia and Europe, with shares down 5 percent in China and almost 4 percent in Japan. Prices in the United States continued to fall on Thursday, but at a more moderate pace. On Friday, however, prices rebounded somewhat as investors took profits. What happened? There are a number of possible explanations.
Meanwhile, there are some interesting aspects to what is happening in financial markets.
However, saying so does not make it so. Moreover, in the last month, the PBOC’s foreign currency reserves fell by US$22 billion,36 indicating that the central bank probably sold reserves in order to prevent a further decline in the value of the renminbi. Thus, it appears that there is already downward pressure on the currency. And from China’s perspective, that is not necessarily a bad thing. A modest depreciation will help to offset the impact of tariffs imposed by the United States. Indeed, Chinese exports of aluminum to the United States are soaring despite a 10 percent tariff.37 This may be due to the 7 percent drop in the value of the renminbi against the US dollar in the past year. Nonetheless, too large a depreciation would be inflationary and would inflame already fraught relations with the United States. Meanwhile, China retains capital controls meant to suppress outbound flows of capital that can cause downward pressure on the currency. The capital controls are intended to prevent a sharp drop in the renminbi.
Why does China want to be paid in renminbi rather than dollars? The answer is that China is increasingly vulnerable to the trade policy of the United States. The United States wants to reduce its trade deficit with China by limiting Chinese imports. This might work, although the overall US trade deficit will not be influenced by such policies. Meanwhile, China’s surplus with the United States is partly offset by a deficit with the rest of the world. China accumulates dollars by exporting to the United States, and then spends some of those dollars on imports from other countries, especially commodities from emerging countries. If China’s surplus with the United States falls, it will have to borrow dollars in order to pay for commodity imports. If the renminbi becomes a global trading currency, then China will no longer have this problem. It will possess what the United States already has—the “exorbitant privilege” that comes from having a widely traded currency.
Meanwhile, as the Chinese renminbi has fallen relatively sharply against the US dollar, US Treasury Secretary Mnuchin has expressed concern, suggesting that the Chinese government’s economic policy might be contributing to the decline. He also said that the value of the currency must be part of any trade discussion between the United States and China. He said, “We are going to absolutely want to make sure that as part of any trade understanding we come to that currency has to be part of that.”39 Given that governments cannot target exchange rates without giving up monetary autonomy, it is unlikely that China’s government will agree to any exchange rate mandate.
Rebecca Porter, an economist at Deloitte in London, explains the results of “Deloitte CFO Survey: 2018 Q3,” which is Deloitte’s latest survey of British chief financial officers (CFOs).40
The results of Deloitte’s latest survey of British CFOs, released today, show that mounting concern over a “no-deal” Brexit is weighing heavily on business sentiment. Brexit was rated by CFOs to be by far the biggest threat to their business over the next 12 months, ahead of weak UK demand, trade wars, and geopolitics. Their negativity about the effects of the United Kingdom’s departure from the European Union (EU) is at a higher level today than at any time since the EU referendum in 2016. They have also become more pessimistic about the long-term effect of Brexit, with 79 percent expecting it to lead to a deterioration in the business environment, up from 60 percent a year earlier.
The International Monetary Fund (IMF) warned that protectionist policies will cause a slowdown in economic growth around the world. It also said that efforts to offset this through fiscal expansion could create new risks. Regarding the impact of trade restrictions, the IMF’s World Economic Outlook said that “escalating trade tensions and the potential shift away from a multilateral, rules-based trading system are key threats to the global outlook. Since the April 2018 forecast, protectionist rhetoric has increasingly turned into action, with the United States imposing tariffs on a variety of imports, including on US$200 billion of imports from China, and trading partners undertaking or promising retaliatory and other protective measures. An intensification of trade tensions, and the associated rise in policy uncertainty, could dent business and financial market sentiment, trigger financial market volatility, and slow investment and trade.”
The IMF was particularly critical of the United States, saying that, if the United States follows through on various threatened tariffs, long-term growth will decline by 1 percentage point per year in the United States and by 0.5 percentage point globally. On the issue of government spending, the report said that “fiscal policy should aim to rebuild buffers for the next downturn. In countries at or close to full employment, with an excess current account deficit and an unsustainable fiscal position (notably the United States), public debt needs to be stabilized and eventually reduced.”41
Indeed, the United States was targeted on this issue, with the Fund calling US fiscal policy “unsustainable.” It said that pro-cyclical fiscal policies, like that of the United States, create imbalances in the global economy. Although the Fund warned against increased spending, it made an exception for Germany which it said ought to invest more in infrastructure. Germany has a budget surplus. The IMF downgraded its economic growth forecast for the global economy as well as for growth in the United States, Eurozone, UK, and Latin America.42 It upgraded forecasts for oil exporting countries such as Saudi Arabia and Russia. Other emerging markets, such as Argentina and Turkey, saw a sharp downgrade, not surprising given their recent crises. The Fund said that, although the global economy is currently growing at a healthy pace, there are increasing risks. It noted that the world is in “an environment where financial conditions could tighten suddenly and sharply.”
At the start of 2016, consumer price inflation in Mexico was running in the range of 2 to 3 percent. Then, following the dramatic drop in the value of the peso, which was related to fears about the future of North American Free Trade Agreement, inflation soared to more than 6 percent during 2017, peaking at a 17-year high of 6.8 percent. Then the central bank tightened monetary policy, the peso stabilized, and inflation fell to 4.5 percent by May of this year. Since then, however, inflation has gradually accelerated once again.
The government reports that consumer prices were up 5.0 percent in September versus a year earlier.43 This was the highest rate of inflation since March and well above the central bank’s target of 3.0 percent. The good news is that the central bank, which is responsible for fighting inflation, retains its independence and that incoming President Lopez Obrador intends to appoint a fiercely independent economist to the central bank’s board.44 This suggests that the new president wants to inspire investor confidence and avoid the kind of financial turmoil that sometimes greets the ascension of a leftist government.
The central bank left the benchmark interest rate unchanged recently, despite the fact that inflation is accelerating. The board evidently believes that, with the currency stable, there is reason to expect inflation to ultimately abate. Moreover, given the uncertainty as to whether and when the US Congress will approve the new trade deal, the central bank might have decided to wait until this issue is resolved before taking any action that might inhibit growth.
The latest employment data from the US government confirms that the economy remains strong, yet the data also indicates a slowdown in employment growth.45 The headlines last week were focused on the fact that the unemployment rate fell to the lowest level since 1969. That was based on a survey of households. Yet the establishment survey found that there were 134,000 new jobs created in September,46 far below the 270,000 new jobs growth in August and the slowest job growth in 12 months. However, the government noted that Hurricane Florence had a negative impact on employment in the leisure and hospitality industry, which lost 17,000 jobs in September after having gained 21,000 in the previous month. The report also indicated continued strong wage growth, with average hourly earnings up 2.8 percent from a year earlier. This was only slightly lower than the 2.9 percent growth seen in August, which was the strongest since 2009. Yet wage growth was only marginally higher than the rate of inflation. As such, consumers did not see a meaningful gain in purchasing power. The separate survey of households found that the unemployment rate fell from 3.9 percent in August to 3.7 percent in September,47 the lowest in almost half a century. The participation rate remained unchanged.
Investors interpreted the report as indicating continued strong job growth. Even though employment growth decelerated, it remained above the level needed to absorb new entrants into the labor force. The result was that bond yields continued their ascent and equity prices fell. The yield on the 10-year US government bond hit the highest level since 2011.48 The rise in Treasury yields could be due to either expectations of higher inflation or expectations that the expected sharp increase in the supply of government bonds will mean that the government will face more competition from a robust private sector in the market for loanable funds. Interestingly, the 10-year breakeven rate, which is an excellent proxy for inflation expectations, has been relatively flat. Thus, it appears that inflation expectations are not yet changing. At the same time, the yield on Treasury Inflation Protected Securities (TIPS) has increased considerably. The principal on TIPS moves in line with inflation. Consequently, the yield is an after-inflation, or real, yield that reflects expected supply and demand conditions in the bond market. If investors expect businesses to borrow more in competition with a government that is already borrowing with abandon, then they will likely bid up yields. That appears to be what is happening. Yet if investors got this idea from the latest job market figures, they may be missing the bigger picture. After all, the US government reports that new orders for non-defense, non-aircraft capital goods actually declined in August.49 That probably bodes poorly for growth of business investment. In addition, new orders for computers and for information technology declined as well, suggesting weak growth of industrial output.
Meanwhile, US equity prices plummeted as bond yields rose.50 Equity investors are likely recalculating valuations based on an expectation that the present value of future profit streams will be lower due to a higher interest rate at which such future profits are discounted. Also, many investors might expect that Federal Reserve tightening will have a negative impact on profitability.
What does all of this mean for Federal Reserve policy? The Fed is already on a path of boosting short-term interest rates in order to avert a sharp increase in inflation. If new data suggests that the economy is stronger and likely to face more bottlenecks, it could lead the Fed to tighten faster. If investors are confident that the Fed will be successful in holding down inflation, then bond yields will not rise very sharply. In that case, we could wind up with an inversion of the yield curve in which case short term rates exceed long term rates. When that happens, banks have less incentive to lend money. At the same time, Fed Chairman Powell recently said that he sees no evidence that the tight labor market is fueling inflation risk.51 In a speech, he said, “Removing accommodation too quickly could needlessly foreshorten the expansion.”52 Thus, it is possible that the Fed will be cautious about raising interest rates.
The price of oil has hit the highest level since 2014, with Brent crude rising above $80 per barrel. Some analysts are now talking about oil hitting $100 in the near future. The rise in the price reflects the decision by Saudi Arabia and others to not boost production as previously expected. It also reflects a sizable drop in Iranian production following the re-imposition of US sanctions. Reports suggest that Iranian exports are down by about a third since June.53 However, there remain reasons to believe that the current surge in prices will be only temporary and that there could soon be downward pressure on oil prices. Here is why:
In Italy, the yield on the 10-year government bond has reached a level not seen since 2014.55 This is due to investor concern about Italy’s plans to run a budget deficit larger than the European Union (EU) would prefer. Indeed, EU officials have expressed concern, especially given that the leaders of the two main coalition parties say that they intend to stick by their fiscal plans. The government plans to run a budget deficit of 2.4 percent of gross domestic product (GDP) next year. This is based on a forecast of 1.6 percent economic growth, considerably more than the 1.0 percent growth recently seen or the 1.1 percent forecast of the European Commission.
Thus, many analysts are concerned that the expansive spending plans of the government will actually lead to a deficit in excess of the EU’s cap of 3.0 percent of GDP. Italy’s constitution requires a balanced budget and the president has the power to reject a budget proposed by the government. However, if the current president, Sergio Mattarella, rejects the budget, it could provoke a constitutional crisis. Mattarella has criticized the government’s spending plans. Another possibility is that the European Commission could reject Italy’s budget—something that has never happened before. Such action could lead to the EU imposing sanctions on Italy for violating fiscal rules. Yet politically this would be troubling, especially given that the EU did not sanction Germany or France when their budget deficits previously exceeded the cap.
However, that was in the context of a weak economy. Italy’s fiscal policy comes at a time of economic strength in Europe. This is when governments are meant to be fiscally responsible. Many investors worry that conflict between the EU and Italy could lead to a crisis similar to what transpired several years ago with Greece, at which time Greece just barely avoided default. Still, it is worth keeping in mind that, at 3.4 percent, the yield on Italy’s 10-year bond remains far below the peak of 7.5 percent reached in Italy during the Greek debt crisis in 2012.56
Chinese direct investment in the United States has plummeted. According to data from Mergermarket, Chinese outbound investment in the United States fell 92 percent in the first nine months of 2018 from its peak two years earlier, and fell 55 percent from a year earlier.57 Why was there such a large decline? There are several possible explanations.
Meanwhile, inbound direct investment in China has fallen as well in recent months.58 This reflects the fact that much inbound investment is related to building export capacity. In any event, while outbound investment in the United States has fallen sharply, outbound investment in Canada has risen sharply, Chinese investment in Canada’s key energy sector was up six-fold in the first nine months of 2018 versus a year earlier.
The managing director of the International Monetary Fund (IMF), Christine Lagarde, says that “there has to be a fresh look at Abenomics,”59 the economic policy of Japanese Prime Minister Abe. The policy was meant to entail fiscal and monetary stimulus as well as structural reforms, such as market liberalization and new free trade agreements. Yet the reality is that, for the most part, Abenomics has mainly entailed an expansionary monetary policy, which has suppressed the yen and boosted inflation.
Moreover, on fiscal policy the government is now committed to raising the national sales tax in 2019 after having twice postponed an increase. Lagarde, however, worries that this will cause a recession (which is what happened the last time the tax was increased). She said, “We believe that the fiscal stance should remain neutral, at least for the next two years.” Prime Minister Abe says he intends to go ahead with the tax increase. Lagarde says that, at the least, this should be offset by a temporary increase in spending. The tax increase is widely seen as necessary in order to preserve the solvency of the nation’s pension system at a time when the population is rapidly aging. Lagarde agrees that, in the long run, the tax must be increased. The IMF has also called on Japan to increase the availability of childcare in order to encourage more women to enter the labor force. This would help to boost the ratio of workers to retirees.
Many analysts criticized the RBI, saying that the decision will make it harder to act decisively later. Yet RBI Governor Urji Patel said, “We are not bound to increase rates at every meeting. That is not required given our inflation outlook and forecasts at this point in time.” He noted that the RBI had increased rates at its last two meetings, the first time this had happened since 2014. Patel also said that the 15 percent drop in the value of the rupee over the past year was relatively “moderate” compared to some other currencies. He noted, “There is no target or band around any particular level of exchange rate, which is determined by market forces.” It appears that Patel is more concerned with maintaining strong growth than with stabilizing the value of the currency. The problem is that, if investors push the rupee down further, it will exacerbate inflation and boost the cost of imports such as oil. In fact, the government lately imposed tariffs on “nonessential” imports in order to suppress imports. At the same time, a weak currency will likely be helpful for export competitiveness.
If US President Trump were to announce that he intends to raise taxes by about US$80 billion in 2019, there would likely be loud protest, especially from his own party. But that is precisely what he is doing. Referring to China, Trump has said, “We’ve taxed them US$50 billion—that’s on technology. Now, we’ve added another US$200 billion.”65 However, the United States is not actually taxing China. Rather, the US government is taxing its own people. When a US retailer buys a wireless modem from a Chinese company to sell in the United States, the imposition of new tariffs means that it will now pay a tax to the US government on that product. It can choose to raise the prices it charges consumers, or it can take a hit to its profit margin. Either way, it is a tax increase. The United States has already imposed a 25 percent tariff on US$50 billion in imports from China. It added a 10 percent tariff on US$200 billion on September 24, which will automatically rise to 25 percent in January 1 in the absence a new trade agreement.66
In addition, the US administration has taxed imports of aluminum, steel, washing machines, and lumber. The government will collect about US$80 billion from these tariffs, or about 0.4 percent of gross domestic product (GDP). This will likely reduce economic activity from what would otherwise be the case. It can be argued that, because of last year’s tax cut, the economy is likely to grow strongly next year, in which case the negative impact of the tariffs will not be notable. However, if the economy slows in 2020, as many expect, the tariffs could make the difference between modest growth and no growth at all. But that is not all. China has retaliated, imposing tariffs on US$110 billion in imports from the United States, thus likely having a negative impact on the US export growth. In addition, the administration says that it may tax another US$267 billion in imports from China, and it may tax all automotive imports.
Also, there is anecdotal evidence that businesses are potentially delaying major investment plans until there is greater clarity about future trading rules. Indeed, findings of a survey of CEOs by the Business Roundtable in the United States revealed that the new tariffs on China will have a moderately or significantly negative impact on business investment spending in the coming six months.67 In addition, Federal Reserve Chairman Powell has said that the Fed’s discussions with business leaders also indicate that many investment projects are being put on hold. Thus, it is easy to see how the current trade war could significantly harm US economic growth, not to mention growth in China and elsewhere.
Meanwhile, China’s government announced that it will cut tariffs on non-US imports.68 The goal is to relieve Chinese businesses from the higher prices that will come about as a result of new retaliatory tariffs on US imports. This action will partially immunize China’s economy from the trade war. It is also a way to enhance trade liberalization with the rest of the world at a time when the United States appears to be turning inward. Still, the net effect will be relatively modest. The average tariff level for China will, as a result of this action, fall from 9.8 percent to 7.5 percent. The biggest drop in tariffs will apply to machinery, thereby enhancing the ability of Chinese manufacturers to remain globally competitive.
The eleventh hour deal came about after the United States and Mexico agreed on a bilateral deal and encouraged Canada to join.70 Canada resisted some of the provisions, and the final deal involved a compromise in which the United States agreed to retain a dispute resolution process while Canada agreed to open its dairy market to competition. The deal ends the uncertainty about the future of North American trade and, consequently, was greeted with a degree of euphoria, or perhaps relief, by financial markets. However, the deal involves more managed trade rather than free trade. It will likely lead to higher prices of automobiles sold in North America, thereby having a negative impact on overall consumer spending.
On September 27, the US Federal Reserve boosted the short-term benchmark interest rate, the federal funds rate, by 25 basis points. The move was not unexpected and is part of what likely to be a steady pattern of rising short-term interest rates. The Fed is acting in order to avert a sharp rise in inflation. Notably, the Fed’s comments no longer used the world “accommodative” to describe policy. At the same time, Chairman Powell suggested that economic conditions are relatively benign, saying, “Our economy is strong, growth is running at a healthy clip, unemployment is low, the number of people working is rising steadily, and wages are up. Inflation is low and stable. All of these are very good signs.”73 So why raise interest rates further? The answer is that there are reasons to expect inflation to accelerate. These include a tightening labor market with rising wages, evidence of bottlenecks in the economy, excessive credit growth, and a fiscal policy that promises to stimulate an already overheated economy. In the absence of a tightening of monetary policy, inflation could become a problem.
The People’s Bank of China, China’s central bank, left interest rates unchanged after the US Federal Reserve raised rates.74 Thus, the gap between US and Chinese rates is increasing. This is likely to stimulate an increase in capital flows from China to the United States, thereby putting downward pressure on the renminbi, all other things being equal. But all other things are not entirely equal. That is, China retains capital controls that reduce investors’ ability to shift funds from China to the rest of the world. Thus, it can prevent a sharp drop in the currency without raising interest rates. China’s authorities have lately eased monetary policy in order to maintain steady growth amidst the threat of a worsening trade war. Thus, it is clear that China is reluctant to take actions meant to stabilize the currency if that means slowing the economy. Of course, a further drop in the value of the renminbi would likely exacerbate tensions with the United States. Plus, an easy monetary policy risks exacerbating the problem of excessive debt.
Regarding debt, much has been written about the sharp rise in debt owed by state-owned companies, local governments, and property developers—debt that is seen as a threat to financial stability. Yet it appears that household debt has risen sharply as well. A report estimates that household debt is now 49.1 percent of GDP, up almost 20 percentage points in the last five years.75 In a country famous for its frugal consumers, this is notable. By contrast, the figure for the United States is about 80 percent. The increase in China was due to both a surge in mortgage debt as well as a surge in non-mortgage consumer debt. The latter was fueled by a sharp rise in online shopping, much of which takes place through credit cards. Despite the rise in debt, consumer spending remains relatively low as a share of GDP, at 39.1 percent compared to nearly 70 percent in the United States and 55 percent in Europe. However, the Chinese figure has risen over the last few years as consumer spending has played a dominant role in driving economic growth. If household debt becomes too onerous, it could stymie further growth in consumer spending.
In the 19-member eurozone, headline inflation remains relatively elevated, but largely due to the lagged effect of the surge in oil prices during the past year. Underlying inflation, however, appears to be decelerating. Here are the details: According to the European Union (EU), consumer prices were up 2.1 percent in September versus a year earlier, slightly higher than in August and the same as in July.76 Overall inflation has not been in this range since early 2012, and the current surge is largely due to oil prices, which were up 9.5 percent in September versus a year earlier. When volatile food and energy prices are excluded, however, core prices were up only 0.9 percent in September versus a year earlier. This is the lowest level since June. This means that the continued aggressive monetary policy of the European Central Bank (ECB) does not yet appear to be causing a boost to underlying inflation.
The policy is, however, having a positive impact on credit creation. The ECB reports that, in August, bank loans to households were up 3.1 percent from a year earlier, the biggest increase since February 2009. Loans to non-financial corporations were up 4.2 percent, also the highest in more than a decade.77 For a long time, easy monetary policy failed to translate into strong credit growth. That was mainly due to the continued troubled balance sheets of many banks.
While those problems have not completely disappeared, the latest data suggest that the problem could be abating. This means that monetary policy is likely having a more positive impact on the economy than at any time since the global financial crisis nearly a decade ago. It also means that the ECB decision to wind down asset purchases makes sense. Such purchases were meant, in part, to circumvent the banking system in order to boost liquidity because the banks were not responding to traditional monetary policy. That has now changed. The ECB still intends to retain very low interest rates as long as underlying inflation remains below the ECB’s target of 2.0 percent. The low inflation reflects continued high unemployment in many eurozone countries.
The strong Japanese economy has generated a tight labor market. In August, the unemployment rate was 2.4 percent, roughly in line with the experience of the past year, and in a range that has not been seen since the 1990s. In addition, the job-openings-to-applicant ratio remained at 1.63 for the second month, the highest ratio since early-1974.78 Moreover, the tightness of the labor market has generated an acceleration in wages due to a shortage of labor. That shortage has led many women to enter the labor market. In fact, the government reports that the share of working age women participating in the labor force has reached an historic high of 70 percent—higher than in the United States. This is up from 61 percent as recently as 2013. The share of both men and women participating in the labor force also reached a record high of 77 percent.