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

Generative AI, climate change, carbon emissions, and Chinese electric vehicles

  • The recent surge in equity prices in the United States was largely, but not entirely, related to enthusiasm about investment in generative AI. There is an expectation that such investment will grow rapidly in the coming few years, potentially having a positive impact on productivity. Yet there is another aspect of generative AI that has drawn less attention. It is the fact that AI uses lots of power, potentially causing a sizable increase in carbon emissions. 

First, it should be noted that generative AI has the potential to assist in minimizing carbon emissions among other benefits. It can detect pipeline leaks and contribute to the development of new materials and processes that are more energy efficient. Still, the use of billions of devices connected to the internet, and especially the use of data centers, leads to considerable consumption of electricity. This is not to mention the air-conditioning necessary to cool data centers. 

It is reported that connected devices will account for 3.5% of global carbon emissions in 2025, and possibly 14% of global emissions in 2040. The future increase would likely be due to generative AI as well as increased usage of devices in emerging countries. In addition, a study by scientists at Cornell University found that training large language models (LLMs), which must be done continuously, consumes a large amount of electricity, thereby pumping more carbon into the atmosphere. 

What can be done? First, the world will need to shift toward producing electricity using clean energy. This would include solar, wind, hydroelectric, nuclear, and hydrogen power. Second, producers of AI-related services will have to engage in efficient usage of energy. A recent study offered suggestions on how to accomplish this. Yet unless governments compel companies to follow these suggestions, it will not be clear whether efficiency is being undertaken. 

As a resident of California, I recall that, about a decade ago, we faced a temporary yet serious shortage of electricity. In part, it was due to a rapid increase in demand, almost entirely due to the rapid rollout of new servers and data centers in our state’s large technology industry. This was, I think, a warning about what could happen globally in the years to come. 

  • Meanwhile, despite all the efforts underway to reduce carbon emissions, the International Energy Agency (IEA) says global emissions hit a record level in 2023, up 1.1% from the previous year—down from 1.3% growth in the prior year. Moreover, the increase was entirely due to emerging countries. Emissions in advanced economies fell 4.5% from 2022 to 2023, hitting a 50-year low.  Emissions fell 9.0% in Europe and fell 4.1% in the United States. In advanced economies, renewables and nuclear accounted for 50% of electricity generation. 

On the other hand, emissions were up 5.2% in China and up 7.0% in India. China was, by far, the biggest emitter of carbon. The IEA says that 40% of the increase in global emissions last year was due to burning fossil fuels as a replacement for hydro power. Climate-induced droughts led to a decline in the ability to produce hydro power. Going forward, this could be a serious issue. 

The good news is that, in the last 10 years, global emissions only grew at an annual rate of 0.5%, the slowest since the 1930s. However, that was due, in part, to the disruptive impact of the pandemic which suppressed travel. Going forward, the IEA anticipates a big increase in the use of clean energy to produce electricity and a big increase in the use of electric vehicles (EVs). 

  • Regarding EVs, major governments around the world are awaiting a flood of EVs from China to arrive. Chinese EV producers have been dramatically ramping up capacity. Moreover, very inexpensive EVs are now available from Chinese producers. This has alarmed Western governments, many of which are considering restrictions on imports of Chinese EVs. 

In the United States, President Biden initiated an investigation into potential security threats from Chinese EVs. The issue is whether the data capture capacity of such vehicles can be used in a way that threatens US national security and/or privacy for US households and businesses. Biden said that “China is determined to dominate the future of the auto market, including by using unfair practices. China’s policies could flood our markets with its vehicles, posing risks to our national security. I’m not going to let that happen on my watch.”  Although national security is the stated reason for concern, his action comes following pressure from US-based automotive producers and the union representing their workers.      

However, there is concern that there could also be restrictions on Chinese parts and software that are used by US producers. Moreover, any restrictions will mean that US consumers will face higher prices for EVs than otherwise. Some Chinese EV producers are investing in production outside of China. It is not clear if US restrictions would apply to vehicles made, for example, in Mexico. Meanwhile, the European Union and the United Kingdom are both investigating Chinese EVs with an eye toward potential import restrictions.

US job market offers mixed picture as Fed deliberates on policy

  • In the United States, employment continued to grow rapidly in February. Although data for job growth in December and January was revised down, the new data still indicates that, in the past three months, job growth in the United States was unusually strong—especially at this stage in the business cycle. Moreover, employment continues to grow faster than the long-term ability of the labor market to generate new jobs. This means that the job market remains tight. Indeed, wages continue to rise from a year earlier at a brisk pace.  On the other hand, the monthly increase in wages was the lowest in two years. Plus, the unemployment rate ticked up slightly, hitting the highest level in two years. Thus, the jobs report offers a somewhat mixed picture—which is exactly what the Federal Reserve likely wants to see. Consequently, bond yields fell slightly today. Let’s look at the details:

The US government releases a monthly employment report based on two surveys: a survey of establishments; and a survey of households. First, let’s look at the establishment survey. It found that, in February, 275,000 new jobs were created, more than investors had anticipated. On the other hand, the job increases in the previous two months were downwardly revised by a combined total of 167,000 jobs. Still, at 290,000 for December and 229,000 for January, job growth was relatively strong. 

There was especially strong growth in healthcare and social assistance, leisure and hospitality, local government, and construction. There was moderate growth for retail trade as well as transportation and warehousing. In our own industry of professional services, job growth was very modest. Manufacturing employment fell. 

In addition, the establishment survey provides data on average hourly earnings. In February, average earnings were up 4.3% from a year earlier, down from 4.5% in January but the same rate of increase as in December and November. More importantly, average hourly earnings were up only 0.1% from January to February, the slowest monthly gain in two years. This suggests the possibility that wage pressure is abating. The separate survey of households showed that the unemployment rate increased from 3.7% in January to 3.9% in February, the highest in two years. 

What accounts for the moderation in wages and the rise in unemployment. First, participation in the labor force by prime working age people (25 to 54) continues to rise, even though overall participation was flat in February. Second, immigration likely contributed to the rise in the labor force, thereby dampening wage pressure. 

The wage and unemployment numbers were taken as evidence that the labor market is starting to weaken, despite strong job growth. This is important for the Federal Reserve.  In Congressional testimony this week, Fed Chair Powell said “we’re waiting to become more confident that inflation is moving sustainably to 2%. And when we do get that confidence, and we’re not far from it, it will be appropriate to dial back the level of restriction so that we don’t drive the economy into recession.” The key words were “not far from it.” He uttered these words even before today’s jobs report. Thus, there is a widespread expectation that the Fed will cut rates by June. The futures markets have an implied probability of a rate cut in June of more than 50%.

China’s leaders expect strong growth despite headwinds

  • Some China watchers now believe that China’s economy will likely grow in the neighborhood of 3% to 4% per year in the coming years, a dramatic shift from the recent past.  Yet at the annual National People’s Congress (NPC) in Beijing last week, Premier Li Qiang said that he expects growth of 5% this year. This did not reflect a planned change in fiscal policy. Rather, Li said that he expects the budget deficit in the coming year to be the same as last year. Thus, no change in fiscal policy is foreseen. Moreover, his optimistic forecast did not reflect a view that China’s challenges have receded. Instead, Li acknowledged that “the foundation for the continuous recovery and improvement of our country’s economy is still not solid, with insufficient demand, overcapacity in some industries, weak societal expectations and many lingering risks.”

Thus, what is the basis for expecting relatively strong growth? The answer is that the government appears to believe that the economy has bottomed and that things are expected to improve soon. Li’s forecast assumes that inflation will be 3% in 2024, significantly up from the deflation now taking place. Li’s presentation at the NPC included plans to stabilize the troubled property market, boost the birth rate through better maternity policies, and issue about one trillion renminbi (US$141 billion) worth of special government bonds meant to “build up security capacity in key areas.”

The issuance of special bonds, the same amount as last year, is separate from the central government’s budget. Although the special bonds were seen by some observers as a signal of intent to address economic problems, the lack of change in the volume of such bonds means no change in the government’s fiscal stance and, therefore, no stimulative effect.  Thus, there was no dramatic shift in policy that could be the basis for a shift in expectations about the economy’s performance. 

The government also announced a slight increase from last year in the issuance of special purpose bonds by local governments. This is meant to help local governments gradually resolve the problem of large debts that were meant to be financed by the sale of land. Yet property market problems have significantly reduced the ability of local governments to generate revenue through the sale of land. This is not likely to change soon. In addition, the government said that central government transfers to local governments will rise a modest 4.1% this year from a year earlier. 

While the 5.0% target might not seem very high given that the economy is reported to have grown 5.2% in 2023, it is worth noting that last year’s growth was boosted by the impact of a low base in 2022 (a year of very slow growth due to covid lockdowns).  Thus, matching last year’s growth in 2024 would require a significant change in economic performance.

Finally, despite the government’s evident optimism, there remain significant headwinds that will likely make strong growth difficult to achieve. First, although consumer spending apparently accelerated modestly during the recent Lunar New Year holiday, household savings remains high. Plus, the loss of wealth due to declining property values is likely to sustain high savings, if only so that households can recoup lost wealth. Thus, it is hard to see what will cause a significant boost to household spending. 

Second, the sharp decline in inbound foreign direct investment (FDI) will not likely be reversed this year, especially given current relations with the US and other Western countries. That means less impetus for private sector investment. Plus, shifting supply chain investment could gradually erode China’s export prowess. Yet the government’s statements have promoted FDI. For example, Premier Li said that “we will strengthen services for foreign investors and make China a favored destination for foreign investment.  We will make it easier for foreign nationals to work, study and travel in China.” Even if these words are followed by action, it is not clear if it will cause a shift in global company intentions. After all, there is already a considerable shift on the part of global companies toward assuring supply chain resilience through diversification away from China.

Third, a weak global economy combined with potential increases in trade restrictions bode poorly for an acceleration in export growth. The government is promoting key industries (electric vehicles, information technology) as export champions. Yet it seems likely that the United States and European Union will impose new restrictions on imports of these products from China. 

Finally, China remains plagued by excess capacity in industry, especially in the state-run sector. Without significant effort to boost demand, and unless the state sector is reorganized to address excess capacity, there is likely to remain disinflationary pressure.  That, in turn will likely have a dampening effect on investment and household spending.

Still, the government emphasized investments in new technologies as key to sustaining growth. It indicated an intention to boost investment in electric vehicles, pharma, hydrogen power, biomanufacturing, commercial spaceflight, and quantum technology. In part, this is meant to promote self-reliance at a time of difficult economic relations with other countries.  China can certainly rely on a vast domestic market to ramp up scale. However, significant restrictions on exporting these products, as well as restrictions on access to foreign technology, could weaken these industries and reduce their impact on growth.

ECB keeps rate high but signals expectation of lower inflation

The European Central Bank (ECB) left its benchmark interest rate unchanged at an historically high level of 4.0%. However, the ECB also downwardly revised its forecast for inflation this year, thereby signaling a likelihood that rates will be lowered sometime in the coming months. Christine Lagarde, President of the ECB, said “we are making good progress towards our inflation target and we are more confident as a result. But we are not sufficiently confident. We clearly need more evidence and more data. We will know a little more in April, but we will know a lot more in June.”

In Europe, as in the United States, the biggest obstacle to reducing inflation to the 2.0% target is the labor market. In both Europe and the United States, service price inflation remains elevated. Moreover, services tend to be labor intensive. Thus, the ECB and other central banks are carefully watching labor market conditions. Lagarde said that she would “zero in on and be laser-focused on, to see if there is confirmation of what we are beginning to see, which is moderation on the wage front and an absorption of those higher wage costs by the profit margins.” If wage inflation eases, the ECB would likely be amenable to cutting interest rates sooner rather than later.

Lagarde indicated that the ECB is not yet ready to act but is getting closer. She said “I wish everything was closer to our target, but we are not there yet. I am not saying that we will wait until we see everything at 2.0%.” On the other hand, the Bank for International Settlements (BIS), which is the central banks’ banker, said that the persistence of service price inflation could lead major central banks to keep rates higher for longer. 

In response to the ECB announcement, bond yields fell modestly. Investors were evidently not surprised by the action and words. For the ECB, the current situation involves a delicate balancing act. The Eurozone economy is weak, with Germany having been in recession and with growth in other major countries very modest. The longer monetary policy remains tight, the more likely that it will further weaken the economy. Meanwhile, inflation has been declining but is not yet where the ECB wants it to be.

Eurozone core inflation decelerates but problems remain

  • In the major advanced economies, there have lately been some common trends when it comes to inflation. Headline inflation fell sharply for a while, mostly due to the easing of supply constraints, but seemed to get stuck in the last few months. Core inflation (excluding food and energy prices) has continued to decelerate but remains above the central banks’ 2% target. Goods inflation has all but disappeared while inflation for services remains too high. The problem is that services are labor-intensive and labor markets remain unusually tight, with wages rising faster than prices. These trends are seen in the United States, Eurozone, and the United Kingdom. In each, there is much discussion about when central banks will start to cut interest rates. The persistence of services inflation has led many investors to believe that central banks will wait a bit longer than previously expected to start interest-rate normalization.

Last week, the European Union (EU) released the latest inflation data for the 20-member Eurozone, and the trends remain consistent with the story told above. Specifically, in February, consumer prices in the Eurozone were up 2.6% from a year earlier and up 0.6% from the previous month. In the last five months, annual headline inflation has ranged from 2.4% to 2.9%, seemingly stuck after a period of steady decline.

Meanwhile, core inflation (excluding food and energy) continues to decline. In February, core prices were up 2.8% from a year earlier, the lowest rate since March 2022. This means that underlying inflation is moving in the right direction. However, core prices were up 0.7% in February from a month earlier, suggesting trouble. The trouble, of course, is in services. First, prices of non-energy industrial goods were up only 1.6% from a year earlier and up 0.3% from the previous month. On the other hand, prices of services were up 3.9% from a year earlier and up 0.8% from the previous month. 

Thus, the main obstacle to bringing inflation down to the 2% target is labor-intensive services. Indeed, the unemployment rate in the Eurozone is now at a record low of 6.4% while real (inflation-adjusted) wages were rising at a rapid pace as recently as the third quarter of 2023. Given this, it is likely that the European Central Bank (ECB) will wait longer before cutting interest rates. 

By country, annual headline inflation in February was 2.7% in Germany, 3.1% in France, 0.9% in Italy, 2.9% in Spain, 2.7% in the Netherlands, and 3.6% in Belgium. 

US consumer spending slides while inflation in services is too high

  • American consumers cut back on spending in January, at least according to the government’s latest report on consumer spending. Recall that, a few weeks ago, data on retail sales also indicated a drop in spending in January. It is worth noting that the monthly data are adjusted for seasonal variation. Moreover, there is currently debate within the government as to whether the seasonal adjustments made by the government remain appropriate following the pandemic. That is, the pandemic led to changes in consumer behavior that might not be fully reflected in the government’s adjustment for seasonal factors. If so, the January data could be downwardly skewed. Or the data could reflect a decline in spending. After all, real (inflation-adjusted) disposable income did not grow in January.

In any event, here is the data: In January, real (inflation-adjusted) disposable income (income after taxes) was unchanged from the previous month. Real consumer spending fell 0.1% from December to January. The personal savings rate increased from 3.7% in December to 3.8% in January. The real decline in spending included a 2.1% drop in spending on durable goods, a 0.5% drop in spending on non-durable goods, and a 0.4% increase in spending on services. 

Perhaps the most important part of the government’s latest data release was the data on inflation. That is, the Federal Reserve’s favorite measure of inflation is the personal consumption expenditure deflator, or PCE-deflator. The news on this was mixed. On the one hand, the year-over-year increase in prices continues to decelerate. On the other hand, monthly price gains accelerated, especially for services–which are labor-intensive. In other words, the tightness of the labor market, and the consequent rise in labor costs, is contributing to sustained high inflation for services. This, in turn, is preventing inflation from decelerating toward the 2% target. For the Federal Reserve, this implies a need to sustain a tight monetary policy to weaken the labor market and thereby ease wage pressure.

Let’s look at the numbers: In January, the PCE-deflator was up 2.4% from a year earlier, down from 2.6% in December and the lowest annual inflation rate since February 2021. However, the index was up 0.3% from the previous month, the biggest monthly gain since September. When volatile food and energy prices are excluded, core prices were up 2.8% in January versus a year earlier, the lowest rate since March 2021. Yet core prices were up 0.4% from the previous month, the biggest increase since February 2023. 

As for the details, prices of durable goods were down 2.4% from a year earlier and up 0.2% from the previous month. Prices of non-durables were up 0.5% from a year earlier while down 0.4% from the previous month. Now, here comes the problem: Prices of services were up 3.9% from a year earlier and up 0.6% from the previous month. The latter was the biggest monthly gain since March 2022. The strength of service inflation partly reflected continued rises in home prices. In addition, it also reflected increased demand for some services including hotels, personal care, and financial services. 

Going forward there remains a widespread view that the Federal Reserve will start to cut interest rates early in the second half of this calendar year. Yet that is already a shift from earlier expectations that the Fed would begin to normalize interest rates in March or April. The persistence of service inflation is likely one of the Fed’s biggest headaches.

Japan: Inflation decelerates, industrial output falls, and demographics worsen

  • Inflation in Japan continues to decelerate, likely reducing pressure on the Bank of Japan (BOJ) to tighten monetary policy. In January, consumer prices were up 2.2% from a year earlier, down from 2.6% in December and the lowest inflation rate since March 2022. Prices were unchanged from the previous month. Moreover, in the last three months, prices only rose 0.1%. Recall that annual inflation had peaked above 4% in early 2023.

Meanwhile, when volatile food and energy prices are excluded, so-called core-core prices were up 3.5% in January from a year earlier, down from 3.7% in December and the lowest rate in 11 months. Core-core inflation had peaked in August at 4.3%. There was considerable volatility by category, with the price of hotel bookings up 26.9% in January versus a year earlier (due to strong tourist demand). On the other hand, energy prices were down 12.1% with electricity prices down 21%. 

Going forward, there are favorable signs for a reduction in inflation. First, domestic demand remains weak, which contributed to real GDP falling in the most recent two quarters. Plus, real wages are falling as nominal wages fail to keep pace with inflation. Indeed, real wages fell 2.1% in January versus a year earlier, the 21st consecutive decline. This is different than in other advanced economies where real-wage increases are a headache for central bankers. Indeed, in North America and Europe, central banks are retaining tight monetary policies due to fears that tight labor markets will fuel continued inflation. 

This is not the case in Japan. Instead, the BOJ has maintained a very easy monetary policy throughout the recent spate of inflation, confident that the inflation was a temporary side effect of supply disruption and would ultimately recede. The BOJ is not concerned that labor markets will sustain high inflation as is the case elsewhere. Still, the BOJ has come under pressure to end the easy monetary policy. Although it has hinted at a change in policy, it has not yet taken action. 

  • In Japan, there was a sharp decline in industrial production in January, disproportionately due to a dramatic downturn in motor vehicle production. Specifically, industrial production fell 7.5% from December to January, led by a 17.8% drop in motor vehicle output. There was also a 12.6% decline in output of business machinery. In fact, production fell in 14 of 15 major industries. Moreover, the sharp drop in manufacturing output suggests that real GDP might decline in the first quarter of 2024. This would be the third consecutive quarter of falling real GDP.

The drop in automotive production was partly due to temporary suspension of production at some automotive factories due to non-economic factors. In addition, there was a 21.4% decline in lithium-ion battery output, largely due to global EV production adjustments. Still, the decline in multiple industries suggests a problem, likely due to a combination of weak domestic demand and weakening export demand. 

  • In the years to come, one of the key issues that will affect economic outcomes in many countries is demographics. In these pages I have written about demographic trends in China, the United States, and Europe. The common trend is a low birth rate combined with an aging population. All other things being equal, this implies slower economic growth and greater difficulty in servicing the pension and health care needs of the elderly. 

Nowhere is this a greater issue than in Japan. In 2023, there were a record low number of births at 758,631, down 5.1% from the previous year. In addition, the number of marriages fell 5.9% to 489,281, the first time in 90 years that this number fell below 500,000. Part of the problem is that the number of young people has been declining for some time, thereby reducing the number of births even if the birth rate doesn’t change. 

A senior Japanese government official said that “the declining birthrate is in a critical situation. The next six years or so until 2030, when the number of young people will rapidly decline, will be the last chance to reverse the trend.” He said that the government intends to take “unprecedented steps” to address this issue. This will include enhanced childcare. Prime Minister Kishida has said that this is the “gravest crisis” the country faces. Finally, the government has estimated that, barring a significant change, the population will decline 30% by 2070 with 40% of the population being over 65.

Russia’s economy is surprisingly resilient despite sanctions

  • Despite sanctions imposed by Western companies when the conflict in Ukraine began, the Russian economy has performed surprisingly well. In 2022, the year the conflict began, sanctions took a toll, leading to a 1.2% decline in real GDP. Yet in the past year, Russia has succeeded in boosting trade with non-Western countries, especially China and India. Plus, capital controls helped to stabilize the currency, leading to a sharp decline inflation. The result was that real GDP grew 3.6% in 2023. 

As 2024 begins, the economy is doing well. Industrial production was up 4.6% in January versus a year earlier, led by manufacturing. Strong defense spending, roughly 10% of GDP, contributed to this. Real (inflation-adjusted) wages were up 8.5% in January while retail sales were up 9.1%.

Part of Russia’s ability to boost production stems from access to parts from China, India, and even Western countries. Sanctions have not been airtight, so there are reports that Russia has been able to obtain inputs that were meant to be restricted.

Why is this important to us? After all, neither Deloitte nor many of our clients are active in Russia. The answer is that the sanctions were meant to cripple the Russian economy and reduce its ability to fight the conflict in Ukraine. Evidently, this has not been the case. That is not to say that Russia hasn’t suffered. Russian consumers no longer have access to many Western products and services. Plus, the conflict itself has destroyed a large part of Russia’s military arsenal. Yet it is clear that Russia’s economy is sufficiently strong that the country can continue fighting. Moreover, if the United States fails to support Ukraine, Russia will likely win the conflict. And, if that happens, it will have a big impact on the global economy.

By

Ira Kalish

United States

Acknowledgments

Cover image by: Sofia Sergi