Weekly global economic update

What’s happening this week in economics? Deloitte’s team of economists examines news and trends from around the world.

Ira Kalish

United States

The Fed holds rates, but signals elevated rates for longer

  • I was not surprised when the Federal Reserve’s policy committee left the benchmark interest rate unchanged recently, in the range of 5.25% to 5.5%. However, some asset prices reacted sharply to the Fed’s announcement. That is because the Fed offered a new viewpoint on the path of monetary policy, economic growth, and inflation going forward. 

The members of the Federal Open Market Committee (FOMC), which is the principal policy forum for the Fed, were polled and offered their predictions for GDP, inflation, and the Federal Funds rate. All 19 people that either permanently or periodically serve on the FOMC were polled. The median forecasts by the FOMC members have shifted as the Fed has absorbed new information. Specifically, the Fed noted that “economic activity has been expanding at a solid pace. Job gains have slowed in recent months but remain strong, and the unemployment rate has remained low. Inflation remains elevated.” Moreover, although the Fed expects tight credit conditions “to weigh on economic activity, hiring, and inflation,” it recognizes that “the extent of these effects remains uncertain.” What is certain, however, is that the economy remains stronger than many observers had anticipated. 

Moreover, although the Fed is leaving the benchmark rate unchanged, the predictions of the FOMC members suggest a likelihood of one more rate hike this year. However, the predictions also suggest leaving rates elevated for a prolonged period. This means the Fed expects that the current policy could further weaken labor markets, thereby suppressing wage inflation. Moreover, in his press conference, Fed Chair Powell said that an easing of wage pressure could come about if there is an unexpected increase in labor supply, thereby not necessitating tightening of monetary policy. 

As for the FOMC predictions, the median GDP forecast for 2023 increased from 1% in June to 2.1% now. For 2024, the prediction changed from 1.1% in June to 1.5%. Thus, the FOMC members have become significantly more optimistic about economic growth in the last three months. 

The Fed’s predictions on inflation have shifted slightly. The FOMC median prediction for PCE inflation this year increased from 3.2% in June to 3.3% now. However, predicted inflation for 2024 remained unchanged at 2.5%. When volatile food and energy prices are excluded, the prediction for core inflation in 2023 fell from 3.9% in June to 3.7% now. For 2024, the prediction for core inflation remained unchanged at 2.6%. Thus, despite believing that the economy will be stronger than previous expected, the Fed seems to have confidence that underlying inflation is on a favorable path. That suggests no need for further tightening. 

But the larger question is when can the Fed cut rates? The FOMC median prediction for the Federal Funds rate is 5.6% in 2023 (suggesting one further rate hike). In addition, the prediction for 2024 changed from 4.6% in June to 5.1% now. This means that the Fed policymakers may expect the Fed to wait longer before cutting rates, probably late in 2024. 

Even if the economy is strong by late 2024, the Fed might comfortably loosen policy given that real (inflation-adjusted) rates are positive. As Chair Powell said, this is a good thing and helps to suppress inflation. Thus, rates could be cut while leaving real rates positive, so long as inflation remains sufficiently suppressed. 

If, however, inflation decelerates while economic growth remains strong, the Fed could choose to leave rates unchanged. The most likely scenario involving a decline in rates late in 2024 would be a decline in inflation and a significant weakening of the economy. 

In response to last week’s FOMC predictions, short-term bond yields increased sharply while the value of the US dollar increased. These shifts reflect expectations of a stronger economy, persistent high interest rates, and moderate and gradual declines in inflation.  

The outlook for fourth quarter US GDP growth is worrisome

  • I expect that, when third quarter US GDP data is released on October 26, it will reveal relatively strong growth. That is because, in the first two months of the third quarter, we have already seen strong growth of various economic indicators. However, there is a growing consensus that the fourth quarter looks troublesome. There are several reasons for this expectation. They include the continuing lagged impact of the past year’s tightening of monetary policy, the return of student debt servicing by millions of borrowers in October, an increasingly likely shutdown of the Federal government, and the possibility of a prolonged strike by automotive workers. The latter could potentially disrupt supply chains in numerous industries, leading to temporary job dismissals.

However, the most onerous factor that could curtail economic growth is the rebound in oil and gas prices. We already know that, in August, the surge in gasoline prices stifled retail spending on nongasoline goods. If prices rise further, it could further suppress real consumer spending. Moreover, more increases in oil prices could cause a rebound in inflation, leading the Federal Reserve to tighten monetary policy more than currently anticipated. 

Meanwhile, there is debate about the potential impact of the return of student debt payments. Recall that, during the pandemic, debt service payments on Federally funded student debt were halted. When they were scheduled to resume, President Biden initiated a loan forgiveness program, which the Supreme Court later invalidated. Consequently, loan repayment begins October 1. For debtors, average monthly payments will be between US$200 and US$300. For an entire year, the resumption of payments will reduce discretionary income by US$100 billion. While that seems like quite a lot, it pales in comparison to the US$18 trillion in annual consumer spending. 

Will this have a big impact on the economy? The answer is that, if all debtors make full payments on time, and if there is no significant shift in the personal savings rate, it will subtract about 0.5% from consumer spending. However, based on past experience, roughly half of debtors will not make timely payments. Moreover, the Biden Administration has initiated a new program called Saving on a Valuable Education, or SAVE, that allows debtors to make monthly payments based on their income. For lower- to middle-income debtors, this could result in a substantial reduction in monthly payments. Moreover, continued strong job growth and rising real (inflation-adjusted) wages will likely offset the impact of new student debt payments.  

British inflation eases and the Bank of England takes a break

  • Inflation in the United Kingdom has fallen, but core inflation, although down, remains persistent and high. Still, the fact that inflation is lower than previously anticipated is informing investor expectations for future actions by the Bank of England (BOE).

The British government reports that, in August, consumer prices were up 6.7% from a year earlier, down from 6.8% in July. This was the lowest rate of annual inflation since February 2022. Recall that inflation peaked at 11.1% in October 2022. Thus, significant progress has been made, although the progress slowed in August. Prices were up 0.3% from the previous month.

When volatile food and energy prices are excluded, core prices were up 6.1% from a year earlier, down sharply from 6.9% in July and the lowest level since March 2023. Still, core inflation has been relatively stable since early 2022. Thus, there has not been significant progress on underlying inflation. On the positive side, core prices were up only 0.1% from the previous month. The big difference between the change in headline versus core inflation reflects the impact of rising petrol prices in August.

The progress on inflation, and the evident weakness of core inflation, led investors to reevaluate their expectations for BOE policy. Bond yields and the pound initially fell in value on expectations that the BOE will not tighten monetary policy as much as previously expected.  

Two days after the release of inflation data, the BOE chose to keep its benchmark interest rate unchanged at 5.25%. The vote of the nine-member policy committee was a close five to four, with BOE Governor Andrew Bailey casting the deciding vote to keep rates steady. After two years of rising rates, some observers wonder if this signals the end of monetary tightening.  

In addition, the BOE decision comes just two days after the US Federal Reserve made a similar decision. In the case of the Fed, it is expected that it will raise rates again before the end of this year. Yet many observers expect that the BOE will now keep rates on hold. In its commentary, the policy committee suggested that the current stance of monetary policy be “maintained” until there is further progress on inflation. On the other hand, the swaps market is pricing in a 70% probability of another rate hike this year. This is down from 80% just prior to the recent release of inflation data. 

In response to the BOE inaction, the value of the pound fell further, having already fallen following release of the inflation data. The pound has been falling since mid-July when it reached US$1.31 per pound. Now it is slightly above US$1.22. The decline reflects the view that the interest-rate gap between the United States and the United Kingdom is likely to widen, or at least not diminish. Moreover, the decline likely reflects an expectation that the US economy will grow faster than the UK economy in the near term.  

Japanese inflation remains elevated, but the Bank of Japan stays the course

  • Core prices, the most common measure of consumer prices in Japan, which excludes the impact of fresh foods but includes energy, were up 3.1% in August versus a year earlier. This was the same as in four of the last seven months. In other words, inflation has stabilized at a level significantly above the prepandemic level but below the levels seen in late 2022. When energy is excluded, core-core prices were up 4.3% from a year earlier, the same as in three of the last four months. Thus, underlying inflation appears to have stabilized at a level far higher than at any time since the early 1980s. As such, it can be argued that Japan has an inflation problem.

Japanese inflation, unlike in the United States, is largely related to goods. In August, goods prices were up 4.2% while prices of services were up a more modest 2%. Also, wages are rising more slowly than prices. In each of the past 16 months, households have experienced a decline in real (inflation-adjusted) earnings. 

The Bank of Japan (BOJ) has long maintained that the inflation is supply driven rather than demand driven. Consequently, it has argued that a tightening of monetary policy is not needed because the supply factors that drove inflation have abated. Yet the inflation itself has not abated, suggesting that it has become embedded in the expectations of participants in the market economy. Historically, the best way to undermine those expectations is to tighten monetary policy. Yet BOJ Governor Ueda said recently that the policy of low interest rates will remain in place. 

Not surprisingly, the value of the yen has fallen as investors have lost confidence that the BOJ will tighten monetary policy any time soon. In fact, as of August, the real effective value of the yen, which reflects the actual purchasing power of the yen versus a basket of other currencies, hit the lowest level since 1970. This means that the relative cost of imports to Japan, or the cost that Japanese citizens face when they travel overseas, is now relatively high. It means a decline in true purchasing power for Japanese. Moreover, the process of currency depreciation can be inflationary. On the other hand, a weak yen is helpful for the competitiveness of Japanese exports.

Meanwhile, the latest purchasing managers’ indices (PMIs) for Japan were relatively good in September, although indicative of deceleration. The services PMI fell slightly to 53.3 in September while the manufacturing PMI was relatively steady at 48.6. The composite PMI fell from 52.6 in August to 51.8 in September, indicating modest economic growth. S&P Global commented that “the rate of growth was only modest and the slowest recorded since February.” It also noted that “forward-looking indicators from the survey suggest the potential for softening demand and activity over the coming months.” Perhaps this explains the BOJ’s reluctance to tighten monetary policy.

China’s strength in electric vehicles leads to potential EU retaliation

  • Amidst debate about the stagnating Chinese economy, one area of strength for China’s economy is attracting global attention. That is the automotive sector. China is about to become the world’s largest exporter of cars, with a substantial share of those cars being electric. The number of cars exported from China each month has quadrupled since the start of 2021. 

Export strength comes at the same time that domestic demand for automobiles in China is weak. In addition, it is reported that there is huge excess capacity in China. In part this stems from an excessive number of producers. There had been an expectation that the number of producers would shrink as some companies fail and others are absorbed into larger companies through market consolidation. Yet many unprofitable producers are staying afloat through support from local governments and state-run banks. Exporting, therefore, has become an important ingredient in success given the weak domestic market.

Europe is the key, with China making huge inroads into a region that is required to end sales of internal combustion engine cars by 2035. In Europe, about 20% of all electric vehicles (EVs) sold are assembled in China. While European producers are working hard to build up capacity, it is reported that they face intense price competition from their Chinese peers. 

Chinese producers are said to benefit from government support as well as access to domestic mineral sources for production of EV batteries. In Europe, a debate has emerged about how much support the EU ought to provide for clean technology production, especially given the significant support offered in the United States. The EU is allowing member states to match subsidies offered by other countries. In France, the government intends to subsidize EVs based on the emissions of their producers. This is meant to hurt Chinese producers who rely on electricity fueled by coal. In France, on the other hand, clean nuclear energy fuels much electricity production. 

The global fight over the future of the automotive industry reflects both China’s strengths and weaknesses. The strength is in the development of sophisticated EV capacity, fueled by access to key minerals. The weakness is in the excess capacity, driven by massive subsidies through local governments and state-run banks, effectively keeping poor performers on life-support. Meanwhile, subsidies in the United States and Europe threaten to create global excess capacity. 

Meanwhile, the EU is concerned about Chinese competition. It announced that is starting an investigation into Chinese subsidies that, it says, are “distorting” the European market for EVs. Ursula von der Leyen, president of the European Commission, said that “global markets are now flooded with cheaper Chinese electric cars and their prices kept artificially low by huge state subsidies. And as we do not accept this from the inside, we do not accept this from the outside. So, I can announce today that the commission is launching an anti-subsidy investigation into EVs coming from China.” Von der Leyen shared her concerns with Chinese Premier Li at the G20 meeting in India. 

The investigation is the first step in what could potentially lead to punitive tariffs being imposed on Chinese vehicles by the EU. Consequently, shares in Chinese vehicle makers fell following the EU announcement. The EU is reportedly concerned lest its EV industry face the same situation that European solar panel makers previously faced. In that case, the EU imposed punitive tariffs on Chinese makers of photovoltaic cells, only to reduce the tariffs in order to assure a sufficient supply for the European market. 

Aside from government subsidies, Chinese EV producers also benefit from cheaper electricity for factories, lower labor costs, and direct access to critical minerals used to produce electric car batteries. 

In response to the EU action, a senior Chinese official complained that this is “sheer protectionism.” Wang Lutong, who heads European Affairs for China’s government, said that “many EU members subsidize their electric vehicle industries.” He pointed to French and German government programs meant to boost sales of EVs through such incentives as tax exemptions and direct subsidies for households. 

The EU action follows a dramatic increase in sales of Chinese EVs in Europe. It is estimated that, in the first seven months of 2023, sales were up 113% from the same period in 2022 and were up 3205% from 2020. The EU estimates that prices of Chinese EVs sold in Europe are about 20% below prices of European vehicles. While EU member states expressed support for the EU investigation, some business leaders were concerned about potential Chinese retaliation. Meanwhile, a Chinese business organization said that the price competitiveness of Chinese EVs is not due to subsidies. Rather, it reflects having “persistently pushed the boundaries of innovation.”  

China’s economy and inflation rebound modestly, but headwinds remain

  • Some of China’s economic indicators improved in August, suggesting that the economy is rebounding modestly. Retail sales and industrial production accelerated from the previous month. However, the decline in property investment deepened and prices of residential property continued to decline. Overall fixed asset investment continued to decelerate. Trade with the outside world continued to decline, but at a slower pace. Overall, recent reports from the government paint a picture of a weak economy that improved slightly but still faces considerable headwinds.

Let’s look at the details: In August, retail sales in China increased 4.6% from a year earlier, an increase from the 2.5% increase in July. Due to the troubled property market, spending fell at stores selling home appliances and building materials. On the other hand, there were strong increases in spending at stores selling communications equipment, cosmetics, and jewelry. 

Chinese industrial production continued to grow at a moderate pace, rising 4.5% from a year earlier, up from 3.7% growth in July. The manufacturing component of industrial production was up 5.4%. Growth was very strong for chemicals (up 14.8%) and automobiles (up 9.9%). 

On the other hand, there continued to be weakness for fixed asset investment, which was up only 3.2% in the first eight months of the year versus a year earlier. This was the slowest growth since early in the pandemic. This included a 0.7% increase in private sector investment. Investment by the state sector grew relatively strongly. Yet, in the past few decades, a disproportionate share of productivity growth stemmed from the private sector. Meanwhile, inbound foreign direct investment is down 87% from a year earlier. 

Also, there was an 8.8% decline in investment in property in the first eight months of 2023 versus a year earlier. This was worse than the 8.5% decline reported for the first seven months of the year. Meanwhile, the price of residential property for sale continued to fall. The government reports that, in August, prices fell in 52 of 70 major cities, up from 49 cities in July. Sales of new homes fell 1.5% in the first eight months of the year versus a year earlier, worse than the 0.7% decline in the first seven months. 

In response to the relative weakness of the Chinese economy, the government has undertaken a variety of measures including gradually easing monetary policy, reducing down payment requirements for mortgages, removing price restrictions on house purchasing in some cities, and boosting spending on infrastructure investment. In addition, the government has provided subsidies for the completion of stalled residential projects. The easing of monetary policy has paid off in that the volume of bank lending accelerated from July to August. 

Still, China faces many headwinds. These include a declining working-age population, declining internal migration, a big increase in household savings, weak private sector investment, and a trouble external environment given weakening global economic growth and fraught relations with the United States and Europe. 

  • In July, when it was reported that China had succumbed to deflation, with consumer prices down 0.3% from a year earlier, there was concern that China was headed into something akin to what happened in Japan in the 1990s, which would involve deflationary pressure and very slow economic growth. However, it is now reported that, in August, consumer prices were up a very modest 0.1% from a year earlier. Thus, deflation took a break. Meanwhile, core inflation, which excludes the impact of volatile food and energy prices, remained unchanged at 0.8% in August. 

Still, the near absence of any inflation could be seen as worrisome. First, it could reflect the weakness of underlying demand, both domestically and externally. Second, it could imply that real (inflation-adjusted) interest rates are quite high, thereby putting an added burden on borrowers, especially in the property sector. Third, producer prices are falling sharply, which may bode poorly for a rebound in consumer prices.

On the other hand, nonfood prices were up 0.5% in August versus a year earlier. This was offset by a sharp decline in food prices. Yet food prices were up sharply from July to August, causing consumer prices to rise 0.3% from July to August. That is why some analysts are suggesting that the worst may be over. Regardless, inflation is not a serious problem, meaning that the central bank has wiggle room to ease monetary policy further without sparking inflation.

US headline inflation rebounds, but underlying inflation declines

  • Oil prices have been rising in recent months. Thus, it was inevitable that this would feed into inflation. Recently, the US government reported that headline annual inflation rose in August, entirely due to the rebound in energy prices. Consumer prices were up 3.7% in August versus a year earlier, up from 3.2% in July and 3% in June. Prices were up 0.6% from July to August, up from a 0.2% increase in the previous month. The sudden surge was because energy prices were up 5.6% from July to August. 

The acceleration in inflation led the headlines following the government’s announcement of August inflation. There was evident concern that the recent progress in reducing inflation might be over. Yet, when volatile food and energy prices are excluded, core inflation decelerated in August. Specifically, core prices were up 4.3%in August versus a year earlier and up 0.3% from the previous month. The core annual inflation was the lowest since September 2021. Thus, it appears that underlying inflation continues to improve. 

The biggest source of inflation remains shelter (housing), with prices up 7.3% in August versus a year earlier. Yet shelter was up only 0.3% from the previous month, suggesting that annual shelter inflation will likely continue to abate. Indeed, shelter inflation, which accounts for 34.8% of the consumer price index, has fallen from a peak of 8.2% in May, to 7.7% in July and now 7.3% in August. The stabilization of house prices in the past year is gradually feeding into the index, and this process will likely continue in the months to come, thereby reducing inflation. If shelter is excluded from the CPI, consumer prices were up a modest 1.9% from a year earlier. If both shelter and food prices are excluded, then prices were up 1.3%. 

Prices of durable goods were down 2% in August from a year earlier. Prices of nondurable goods were up 2.5%. However, when food (which was up 4.3%) is excluded, nondurable prices were up only 0.6%. Most inflation was due to services, which were up 5.4%. And the largest component of services is shelter. Interestingly, some service prices were down sharply, such as airline fares, which were down 13.3% from a year earlier. This is good news for those of us who travel incessantly. 

The inflation report offers evidence to support different paths for monetary policy. Hawks, intent on further tightening, will point to the rebound in headline inflation. Doves, who want to pause monetary tightening, will point to the deceleration of core inflation. 

Still, the rise in energy prices cannot be ignored as, eventually, it could feed into the prices of everything else. The question now is how far energy prices will rise. That depends, in turn, on the degree to which the rise is driven by demand or supply. On the one hand, Saudi Arabia has voluntarily restricted its own output to boost prices. The suppression of supply has probably gone as far as it can go. On the other hand, demand is likely stronger than previously expected given the resilience of the US economy. Yet, given that monetary policy acts with a lag, it is entirely possible that the United States and global economy could decelerate in the coming year, thereby easing demand for energy. In that case, energy prices would likely decline again. 

Meanwhile, it is now widely expected that the US Federal Reserve will raise the benchmark interest rate at least one more time, if not two, before the end of this year—but not necessarily this month. There is also an expectation that, in 2024, the Fed will pause and wait to see the fruits of its labor. For now, both short- and long-term interest rates exceed inflation, meaning that real rates are positive. Over time, this should have a negative impact on interest-sensitive sectors, thereby slowing the economy.

Japanese yen rises in anticipation of shift in monetary policy

  • Since the start of this year, the value of the yen has fallen sharply, from roughly 128 yen per US dollar in mid-January to 147.9 yen on Friday, September 8. This was largely due to the fact that US interest rates were rising while Japanese rates were not. The decline in the yen worried some policymakers. A weaker currency leads to higher import prices, thereby fueling inflation. Japanese inflation, while low compared to other developed economies, has risen sharply in the past year. On the other hand, a cheap yen can boost export competitiveness. In any event, the decline in the yen came as the Bank of Japan (BOJ) continued to insist on retaining a relatively easy monetary policy characterized by negative short-term rates and a policy of yield curve control (YCC), in which the BOJ targets the yield curve, thereby keeping bond yields suppressed.

In recent months, there has been plenty of speculation as to whether the BOJ will adjust policy, especially given the sharp rise in inflation. For a while, the BOJ insisted that the surge in inflation was temporary, driven by supply rather than demand factors. Yet it also hinted at future flexibility. Now, it appears, the future might have arrived. 

First, Japan’s Finance Minister Suzuki said last week that “it is important for currencies to move stably reflecting fundamentals. Excessive moves are undesirable. We will carefully monitor currency market moves with a high sense of urgency. We won’t rule out any options if currency moves become excessive.” Then, BOJ Governor Ueda said that ending the policy of negative interest rates is “an option.” These two statements, although mild, set off a financial storm. The yen increased in value from 147.9 on September 8 to 146.1 on the following trading day. In addition, although the BOJ sets a range for the bond yield to move, the yield on the 10-year bond increased to the highest level since 2014.

Is the BOJ changing policy? The answer is, not yet. One possibility is that the seemingly coordinated statements by the BOJ and the Finance Ministry were meant to stabilize the yen, which had been depreciating. These statements likely gave investors pause before shorting the yen. Whether or not this implies that BOJ policy will change remains uncertain. Meanwhile, it is increasingly expected that the US Federal Reserve will raise its benchmark rate one, and possibly two, more times this year. If so, that will put new downward pressure on the yen.

Why is the US economy so resilient after Fed tightening?

  • The Fed has raised its benchmark interest rate by more than 500 basis points, leading to an inversion of the yield curve. Normally, higher interest rates would stifle interest-sensitive spending by both households and businesses, often leading to a recession. Yet in this cycle, many households are in surprisingly good financial shape, with considerably lower debt as a share of GDP than before the global financial crisis of 2008–09. Moreover, since that crisis, banks have been more cautious about lending to households with poor credit histories. In addition, after a long period of low interest rates, most mortgages today are fixed rather than adjustable. Thus, higher mortgage interest rates don’t immediately affect the borrowing costs of most homeowners. The result is that household debt servicing costs, although rising, remain historically low. This allows consumer spending to continue growing.

As for businesses, many are flush with cash. In addition, in recent years many companies switched from short-term financing through commercial paper and bank loans to issuance of long-term debt at fixed interest rates. The result is that higher borrowing costs don’t immediately influence the cashflow of many borrowers. Moreover, many companies are putting cash into higher-yield short-term instruments, thereby improving their cashflow. The result is that, unlike during past episodes of monetary tightening, business investment has remained relatively healthy. Moreover, corporate profits have remained strong, thereby partly explaining the continued growth of employment. Plus, the continued strong balance sheets of the corporate sector might explain the relatively low level of risk spreads. 

Over time, however, Fed tightening could gradually stifle both household and business borrowing and worsen their debt-service costs. Thus, monetary policy might work with a longer lag than normal. This suggests the possibility that the US economy could face more downside risk in 2024. In that case, and assuming that inflation abates further, the Fed would likely choose to reduce interest rates. That, in turn, would likely lead to lower long-term borrowing costs, enabling companies to refinance.

Why have US bond yields risen?

  • Lately, US government bond yields have been relatively high, hitting a level roughly where they were 17 years ago. What do high bond yields imply? Given that breakeven rates (which measure bond investor expectations of long-term inflation) remain low, it appears that real (inflation-adjusted) rates are quite high. This implies that bond investors expect relatively strong economic growth to continue combined with sustained high short-term interest rates in the years ahead. 

In other words, investors expect that Fed tightening and the inversion of the yield curve will not lead to a recession as usually happens. Rather, they expect a soft landing in which the Fed retains high short-term rates for an extended period. This implies that bond investors expect a return to late 20th-century economic conditions, or at least early 21st-century conditions. Recall that, in the period 2000 to 2008, the yield on the US government’s 10-year bond averaged around 4%, close to where it is now. In the late 1990s, the yield was closer to 6%. That was not considered onerous. Thus, the extraordinarily low yields in the past decade could be seen as an aberration. 

If, however, the economy slows in a lagged response to monetary tightening, then bond yields will likely fall. Moreover, if the economy slows and core inflation falls sharply, the Fed will loosen policy by cutting short-term interest rates. Under this scenario, we might not face a prolonged period of higher borrowing costs. Rather, we could return to the historically low borrowing costs seen in the past decade.

Have US households depleted their excess savings?

  • In the past two years, as real incomes fell due to wages failing to keep pace with inflation, consumer spending continued to grow due, in part, to the ability of households to dip into the massive pool of excess savings accumulated during the pandemic. This pool came mostly from the government stimulus implemented during the pandemic. Now, there is a debate about how much of that excess pool remains. This is important as it can influence the growth of consumer spending. Still, even if it is mostly gone, wages are now rising faster than inflation, thereby providing a potential cushion for spending.

The debate about excess savings has been fuelled by a study done by the Federal Reserve Bank of San Francisco. In this study, the authors estimate that excess savings reached US$2.1 trillion in June 2021 but that only US$190 billion remained as of June 2023. At that rate, the excess pool will be depleted by the end of this quarter. That, in turn, suggests more constraint on the ability of consumers to increase spending. 

On the other hand, some private sector economists believe that a much larger amount remains, thereby allowing continued growth of spending. The difference in estimates reflects differences in how to define the excess amount. Moreover, other factors play a role in driving consumer decisions. For example, household balance sheets are historically strong. Net wealth as a ratio of disposable income is close to an historic high. Household debt as a share of income is at a 20-year low. Debt-service payments are also low. Plus, employment continues to grow while real wages are now rising. Therefore, there are plenty of reasons to expect continued growth in spending, regardless of the volume of excess savings.

What is happening with oil prices?

  • Since July, the global price of crude has increased sharply, recently hitting a nine-month high. There are several explanations. First, the global economy has exhibited greater strength than had been expected. While Europe is likely to enter a very mild recession, this differs from previous expectations of a deep recession. Importantly, the United States continues to grow at a brisk pace, despite monetary tightening.

Second, inflation has declined sharply in the United States, leading to expectations that the Federal Reserve will stop raising interest rates, thereby helping to avert recession. 

Third, supply is constrained. OPEC+ has agreed on production restrictions while Saudi Arabia, the largest member of OPEC, has voluntarily cut production with the goal of supporting prices. Russia likely wants higher prices to fund the war and to weaken the Biden Administration. Saudi Arabia needs a higher price to fund its various nonoil investments.

What are the implications if oil prices remain elevated or rise even more? In part, the decline in inflation in major economies was driven by declining energy prices. If energy prices stabilize or rise, this will boost headline inflation. Core inflation (which excludes the impact of food and energy prices), however, could continue declining. In any event, higher headline inflation might change the calculus for leading central banks. 

Also, higher energy prices will eat into household budgets, thereby stifling spending on other goods and services. Moreover, in the United States, measures of consumer confidence are strongly inversely correlated with gasoline prices. A rise in prices could undermine confidence and influence the economy and US politics.

German industrial production falls, contributing to overall weakness

  • German industrial production continues to decline. In July, output was down 0.8% from the previous month, including a 2.9% decline in output of capital goods—boding poorly for investment. Also, there was an especially sharp 9% drop in output of automobiles. It was the third consecutive month in which industrial production fell. Moreover, output has fallen in four of the last five months. Output was down 2.1% from a year earlier.

German industry has been hit by relatively high energy costs, high interest rates, and weak Chinese imports. According to Germany’s government, output by energy-intensive industry is down almost 20% since the start of 2022. In addition, the German Chamber of Commerce and Industry found that 32% of companies surveyed prefer foreign investment to domestic investment. Indeed, there are several notable cases of German companies making large investments in China or the United States rather than in Germany. 

The bad news about industry bodes poorly for overall economic growth. In the most recent three quarters, the Germany economy has not grown. The July numbers suggest weakness or decline in the third quarter. The stagnating economy, Europe’s largest, has led German authorities to look for ways to kickstart growth. Chancellor Scholz wants to ease the process of starting businesses for entrepreneurs. He also wants to ease bureaucracy through digitalization of government services. 

The most notable proposal came from Germany’s 16 Federal states, which, together, proposed subsidized electricity for heavy industry, at least until the clean-energy transition is widely available. Within Germany’s government, this idea is supported by the economy minister who comes from the Green Party. The chancellor and the finance minister, who come from the Social Democratic Party and the Liberal Party, respectively, oppose this idea.

Direct investment into India is falling

  • In recent conversations with clients in the United States, I have heard guarded enthusiasm about India as an alternative to China for investing. India’s strong economic growth as well as the fraught relationship between China and the West have led some business leaders to consider investing in India as they reduce their exposure to China. 

Yet the latest data indicates that inbound direct investment into India is declining. In the fiscal year that ended in March 2023, inbound foreign direct investment into India fell 16.3% from the previous year. Moreover, net foreign direct investment (FDI), which accounts for repatriation of profits, fell 27%. Meanwhile, it is reported that many companies seeking to reduce their exposure to China are investing rapidly in Vietnam. 

Notably, the decline in inbound FDI into India was entirely due to a drop in investment by companies based in the United States and Europe. Meanwhile, investment by companies based in Asia and the Middle East continued to grow. This included companies based in Japan, Singapore, and the United Arab Emirates.

Among the possible explanations for Western company aversion to India are India’s continuing high tariff and nontariff barriers (as well as a lack of free trade agreements with other countries), poor infrastructure, onerous regulation of industry, and regulations meant to curtail Chinese investment, which, unwittingly, have the effect of discouraging investment from other countries. Nevertheless, India’s government has taken steps meant to encourage more inbound investment. These include reduced corporate tax rates, subsidies for certain industries, and tariffs meant to protect domestic producers from foreign competition. Yet such tariffs boost prices for domestic consumers and boost the competitive position of inefficient businesses.

PMIs suggest potential global economic weakness

  • The latest purchasing managers’ indices (PMIs) for major economies indicate that economic activity is decelerating, likely due to monetary policy tightening in Europe and North America. PMIs are forward-looking indicators meant to signal the direction of activity in manufacturing and services. PMIs are based on subindices such as output, new orders, export orders, employment, pricing, pipelines, inventories, and sentiment. A reading above 50 indicates growing activity. The higher the number, the faster the growth.

The latest global PMI for manufacturing improved from 48.6 in July to 49.0 in August, indicating a moderate rate of declining activity. The separate services PMI fell from 52.7 in July to 51.1 in August, indicating modest growth. Combined, this resulted in a composite PMI falling from 51.6 in July to 50.6 in August. This implies a very slow rate of expansion of the global economy. 

By country, the general trend in August was deceleration, with some exceptions. The US PMIs both worsened in August, with the PMI for manufacturing remaining below 50 and the services PMI dropping to a level indicating only modest growth. S&P Global, which reports the data, said that “the PMI numbers for the third quarter so far point to a faltering of economic growth after a robust second quarter, as a renewed manufacturing downturn is accompanied by a deteriorating picture in the service sector.” It said that the tailwind from the postpandemic renewal is abating. It said that rising wages and higher energy costs are sustaining relatively high inflation for services. This will likely sustain tight monetary policy by the Federal Reserve, thereby slowing the economy.

In Europe, the PMI for Eurozone manufacturing fell sharply to 43.5, a level indicating rapid decline. The services PMI for the Eurozone went from 50.9 in July to 47.9 in August, a 30-month low signaling a significant decline in activity. S&P Global commented that, although the Eurozone avoided recession in the first half of the year, “the second half will present a greater challenge.” Until recently, strength in services offset weakness in manufacturing. That is no longer the case. Also, S&P said that Germany and France were largely responsible for the worsening while Spain and Italy experienced a milder downturn. Germany is struggling with high energy costs and weak exports to China, while France has struggled with unrest related to the government’s effort to raise the retirement age.

China’s manufacturing PMI improved, rising from 49.2 in July to 51.0 in August. Yet this was offset by a sharp decline in the services PMI from 54.1 in July to 51.8 in August, an eight-month low indicating very slow growth in activity. Domestic demand evidently weakened, likely related to the problems in the property sector.

India’s PMI for services was relatively stellar in August, falling slightly to 61.0, a level indicating very rapid growth. India remains the fastest-growing large economy in the world. Finally, Japan’s PMI for manufacturing was unchanged at 49.6 while the services PMI increased from 53.8 in July to 54.3 in August, a level indicating relatively strong growth in activity. The strength of services reflected robust domestic demand, offsetting the decline of manufacturing, which is affected by a weakening global economy.

Why the US dollar is likely to remain dominant

In recent presentations to clients, one of the most frequently asked questions I receive is about whether the US dollar will retain its dominant role in the global economy. This question arises, in part, because many governments have demonstrated a desire to reduce the role of the dollar. China, for example, has negotiated currency swap deals with many emerging countries. In part the question reflects concern that, with a large amount of sovereign debt, the United States might choose to debase its currency in order to reduce the effective size of the debt. Such debasement could lead to a run on the dollar. 

Despite these concerns, I always answer that the dollar is likely to remain the dominant currency for a long time. Here is why: First, the volume of US sovereign debt as a share of GDP is not unprecedented and, as evidenced by historically low bond yields, is not a concern to the investment community. Given the current policy of the US Federal Reserve and its role as an independent central bank, debasement seems unlikely. Second, despite China’s hopes, it is not likely that the renminbi will take the place of the dollar any time soon. China has capital controls, which means that holders of renminbi are not assured the flexibility that comes from holding dollars. 

My rule of thumb is that one should ask whether a farmer in Argentina would prefer dollars or renminbi in exchange for his/her wheat. What would the farmer do with renminbi? It cannot be as easily used as the dollar for making global purchases. Moreover, if the farmer wanted to invest renminbi, it would be difficult to do outside of China, and such investments in China would be subject to capital controls. Thus, it is likely that the farmer would choose dollars. And, if so, the dollar will likely remain dominant. 

What could undermine the role of the dollar? There are several possibilities. First, if China were to eliminate capital controls, the renminbi would have a better chance of becoming a major trading and reserve currency. Yet this seems unlikely for now. Second, around three quarters of global holdings of dollar reserves are held by US military allies. Therefore, if the US turns inward by withdrawing from alliances and/or failing to support friendly governments, investors might lose confidence in the dollar. 

Finally, excessive use of sanctions by the United States (effectively weaponizing the dollar) could lead to greater efforts to boost non-dollar trade. For example, when the United States unilaterally sanctioned companies that interact with Iran, the European Union sought to create alternative venues to support non-dollar transactions with Iran. Still, a recent Federal Reserve research publication concluded that, “without changes in the economic incentives for holding reserves in US dollar assets, an increased threat of sanctions is unlikely to drastically reduce the dollar share of reserves.”

US job market remains strong despite some cooling

Recent headlines noted that, in the United States, the unemployment rate increased significantly, rising from 3.5% in July to 3.8% in August. This might be considered to indicate that the job market is cooling. However, there are two important caveats. First, the unemployment rate increased because there was a dramatic increase in labor force participation. Employment growth, while good, was not commensurate with this increase. Hence the higher rate of unemployment. Second, the payroll report shows that job growth accelerated in August to the highest level in three months. For the past three months, job growth has been modest compared to earlier in the year. Yet employment continues to grow faster than the long-term ability of the economy to produce jobs. As such, although the job market might be cooling, it remains relatively robust.

Here are some details: The US government releases two reports on the job market; one based on a survey of households, the other based on a survey of establishments. First, the establishment survey found that, in August, 187,000 new jobs were created, the biggest increase since May. Employment is now 10.3% higher than just prior to the pandemic. 

Growth in employment in August was negatively influenced by the collapse of a major trucking company. The result was that, in the category of truck transportation, employment fell by 36,700, or about 2.3%, with about 30,000 of that due to the collapse of one company. This was a one-off event unrelated to the state of the economy. Also, there was a 15,000 job decline in employment in the information sector, largely due to the strike in the entertainment industry. Absent these events, job growth would have been significantly better. 

By industry, there were moderate gains in employment in construction and manufacturing, slow growth for wholesale and retail trade as well as financial services, and a decline in employment in the information sector. Job growth was moderate for professional services and moderately strong for leisure and hospitality. The biggest driver of employment gains was healthcare, with 70,900 new jobs created. In fact, healthcare/social assistance and leisure and hospitality combined accounted for 73% of job growth in August.

The establishment survey also reported that average hourly earnings of all workers were up 4.3% in August from a year earlier, roughly the same as for the past six months.  In other words, wage inflation has stabilized after having decelerated last year. Now, wages are rising faster than prices, meaning that households are seeing a real (inflation-adjusted) increase in purchasing power. That is good news for consumer spending. 

But it is challenging news for the Federal Reserve. The Fed worries that, if wage inflation fails to decline further, the goal of bringing inflation down to 2.0% will be chimerical. The Fed has indicated that it wants to weaken the job market, thereby weakening wage pressure. Whether that entails further interest rate hikes is not known.  On the other hand, recent press commentary on the employment report suggested that, after three months of slower job growth than previously, the job market is weakening sufficiently for the Fed to avoid rate hikes. Equity prices rose and bond yields fell on this expectation. 

Finally, the separate survey of households found that, although the working age population rose by 211,000 in August, the number of people participating in the labor force increased by 736,000. Thus, the participation rate increased from 62.6% in July to 62.8% in August, the highest level since just prior to the pandemic when it was 63.3%. The household survey also found that employment (including self-employment) was up 222,000. Thus, the unemployment rate rose considerably, hitting 3.8%.   

US consumer spending grows strongly despite weak income growth

In July, real (inflation-adjusted) consumer spending in the United States grew strongly, but not due to an increase in income. In fact, real disposable personal income declined slightly from the previous month. Rather, American households cut the share of income that they save, thereby enabling the big increase in expenditures. There were some one-off factors that explained the drop in real income. Thus, households evidently cut savings in order to stabilize spending. Moreover, it appears that underlying consumer demand remains strong.

Here are some details: In July, real disposable personal income (income after taxes and inflation) fell 0.2% from the previous month. Underlying wage income continued to rise, but there were some one-off factors that cut income. Real personal consumption expenditures increased 0.6% from the previous month, the biggest monthly increase since January 2023. Real spending was up 3.0% from a year earlier, the biggest increase since February 2022. This was facilitated by a decline in the savings rate from 4.3% of disposable income in June to 3.5% in July. 

The real monthly increase in spending involved a 1.4% increase in spending on durable goods, a 0.7% increase for non-durables, and a 0.4% increase for services. Recall that, after the surge in spending on durables at the start of the pandemic, spending on durables declined then stagnated for a while. Since December, however, spending on durables has been on an upward path. The result is that, in July, real spending on durables hit the highest level since April 2021. Real durables spending in July was 12.8% higher than in the month prior to the start of the pandemic. Also, recall that the initial surge in durables demand disrupted supply chains and contributed to the early rise in inflation. Now, however, supply chains have adjusted and there is no inflation for goods.

Speaking of inflation, the government also released data on the Federal Reserve’s favorite measure of inflation, the personal consumption expenditure deflator (PCE-deflator). In July, it was up 3.3% from a year earlier, rising from the 3.0% recorded in June.  Prices were up 0.2% from the previous month. When volatile food and energy prices are excluded, core prices were up 4.2%, up from the 4.1% recorded in June. Core prices were up 0.2% from the previous month. The slight rebound in this measure of inflation generated plenty of discussion and angst in the business press.  However, one month does not make a trend. In recent months, the general trajectory of inflation has been down. It is too soon to determine whether the rise in inflation in July was meaningful.

Meanwhile, the inflation was entirely due to services. Prices of durable goods were down 0.8% from a year earlier while prices of non-durable goods were down 0.2%. Prices of services, however, were up a strong 5.2%.

Eurozone core inflation recedes, raising questions about ECB policy

Eurozone inflation stopped decelerating in August while core inflation declined. The latter led investors to re-evaluate their expectations for European Central Bank (ECB) policy. That is, they became less certain that the ECB will raise interest rates again. The result was that the euro fell in value against the US dollar today after German and French bond yields fell sharply. Is the eurozone out of the woods? Certainly not. Inflation still remains high.  The question now is whether the tightening of monetary policy that has already taken place will be sufficient to bring inflation down further, especially given that policy acts with a lag.

In any event, here are the details on the European Union’s latest inflation report: In August, consumer prices in the eurozone were up 5.3% from a year earlier, the same as in July and the lowest level since early 2022. Recall that inflation peaked in October at 10.6%. Prices were up 0.6% from the previous month. When volatile food and energy prices are excluded, core prices were also up 5.3%, down from 5.5% in July but the same as in May. Core inflation peaked at 5.7% in March 2023, so it hasn’t decelerated very much. 

By country, annual inflation in August was 6.4% in Germany (down from 6.5% in July), 5.7% in France (up sharply from 5.1% in July), 5.5% in Italy (down sharply from 6.4% in July), and 2.4% in Spain (up from a low of 2.1% in July). In Spain, the acceleration in inflation, as well as 0.5% monthly inflation, was disappointing and generated concern that inflation remains a problem in Spain.

Going forward, the ECB will meet in mid-September to decide whether to raise rates again, after having boosted the benchmark rate to 3.75% (still far below the US level). On the one hand, the drop in core inflation, as well as evidence of economic weakening, points to a pause in monetary tightening. On the other hand, the fact that inflation remains far above the target level, combined with evident tightness in the labor market and sharply rising wages in Germany, suggest further tightening.

German wage behavior could be an obstacle to reducing inflation

Germany has an odd combination of likely already being in a recession and having a tight labor market. The tightness of the labor market has been manifested by a surge in wages.  In the second quarter of this year, wages rose at an annual rate of 6.6%, a record.  This followed wage gains of 5.6% in the previous quarter. 

The strength of wages could become an impediment to reducing inflation in the eurozone.  Strong wage gains likely increase the probability that the European Central Bank (ECB) will tighten monetary policy further, if only to weaken the labor market and reduce wage pressure. The ECB, like the US Federal Reserve, is concerned that, if wages continue to rise at a brisk pace, companies will likely be compelled to pass on this cost increase to consumers in the form of higher prices. 

On the other hand, wages in Germany are now rising slightly faster than inflation. This follows a prolonged period in which wages lagged inflation. That meant a decline in real (inflation-adjusted) wages and reduced impetus for consumer spending. Thus, with real wages rising, there is hope that the weakness in consumer spending might soon end. Still, real wages remain significantly below the pre-pandemic level. If consumer spending rebounds, that will help Germany’s economic recovery. If the ECB tightens monetary policy further, however, it could spell trouble for Germany’s recovery. 

Finally, the ECB has suggested that some companies in the eurozone might choose to absorb some of the increase in wages by reducing profits rather than raising prices. This would be the case if weak demand compels companies to avoid price increases.  If this is correct, then strong wage gains might not be as inflationary as some people expect.

ECB policy leads to declining money supply. Does this matter?

The broad money supply of the Eurozone has begun to decline. In July, the broadest measure of money in the eurozone, M3, was down 0.4% from a year earlier for the first time since May 2010. The actual level of M3 has been declining from month to month since October. This follows a significant tightening of monetary policy by the European Central Bank (ECB). The importance of the money supply is that it can influence inflation. All other things being equal, faster growth of the money supply implies higher inflation—and vice versa. As the Nobel Laureate Milton Friedman once wrote, “inflation is always and everywhere a monetary phenomenon.”  The situation in Europe is now similar to that of the United States, where the broad money supply (M2) has been declining since April 2022. 

The decline in the money supply includes a decline in bank deposits by households and a decline in deposits held by non-financial corporations. It coincides with a deceleration in bank lending. In fact, bank lending to households was up only 1.3% in July versus a year earlier, the slowest growth since November 2015. Lending to non-financial companies increased 2.2%, the slowest since September 2021. The weakening of credit is meant to weaken the economy and, therefore, reduce inflationary pressure. The question now is whether the decline in M3 will cause the ECB to halt interest rate increases given that the tight policy is already having the desired impact. 

The ECB has increased its benchmark rate every month since July 2022 and will decide on policy again in mid-September. It is reported that there is debate within the ECB. Some policymakers argue that, given that monetary policy acts with a lag, the ECB has done enough and should now wait to see the fruits of its labor. After all, it has increased its benchmark rate by 425-basis points while it has started to reduce its balance sheet.  Others, however, argue that, with inflation still at 5.3%, more effort is required.  The decision in September is likely to be influenced by the next inflation report. 

Is the eurozone headed toward a recession? We cannot know for sure, but some indicators are pointing in that direction. In addition to weakening of credit markets, the latest purchasing managers’ indices (PMIs) also suggest the possibility that economic activity will shrink in the third quarter. Real GDP grew 0.3% from the first to the second quarter. 

Ira Kalish

United States


Cover image by: Sofia Sergi