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Cover image by: Sofia Sergi
Meanwhile, Germany’s government has said it does not accept the Gazprom explanation for the curtailment of gas flows and fears that more trouble is brewing. A German government spokeswoman said, “We don’t see technical reasons. Our information is that this turbine is a replacement turbine that was earmarked for use in September but, again, we are doing everything to take away possible pretexts for the Russia side.” Gazprom has said that the recent disruption of supplies is beyond its control.
There is a debate as to what Russia might do next, and why. If Russia halts or significantly reduces deliveries of gas to Germany during the winter months, the ostensible reason would be to undermine German determination to maintain sanctions, as well as to undermine German unity with other EU members. However, doing so might damage Russia’s reputation for being a reliable business partner and would likely cause an acceleration in German efforts to reduce dependence on Russia. Thus, the counterargument is that Russia has reduced deliveries as a warning but does not intend to fully upset its relationship with Germany. The well-known strategist Ian Bremmer says that, if Russia didn’t care about its future relations with Germany, it would not create implausible excuses for cutting gas deliveries. Time will tell. In any event, the European Commission says it does not expect gas flows to resume as scheduled and will plan accordingly.
As for Russia, although it stands to lose revenue by reducing deliveries of gas, the sharp rise in oil and gas prices has significantly boosted revenue. In fact, the International Energy Agency (IEA) estimates that, since the war began, Russian revenues from oil and gas have doubled from the pre-invasion level. Thus, it is likely that Russia can afford to temporarily halt gas deliveries. That, in turn, suggests that Russia has the upper hand in this conflict—at least temporarily. In the longer term, the potential loss of Russia’s share of the EU energy market could be deleterious to Russia’s economic future.
Given that Germany and other countries in Europe continue to be at risk of a substantial shortfall in gas, Germany’s government announced emergency measures to conserve gas. For example, the government will ask companies to allow employees to work at home so that heating systems in large buildings can be turned off; it will ban the use of gas to heat private swimming pools; heating of public buildings will be restricted; and there will be inspections to assure that homes are using energy efficiently. In addition, the government will lease floating LNG terminals; it is resuming the use of coal-fired power plants; and it has not ruled out delaying the closure of nuclear power plants.
In addition, Poland is quadrupling its capacity to import gas with a new pipeline from Norway that crosses the Nord Stream pipeline under the Baltic Sea. The Baltic Pipeline is set to begin operations in October. Poland will be able to make up for the loss of Russian gas since April when Gazprom cut gas deliveries to Poland. It is possible that, with the new pipeline, Poland will be able to assist Germany.
Finally, the EU signed a gas deal with Azerbaijan, but the full effects will not be felt until 2027. In addition, the European Commission called for Europeans to reduce gas consumption by 15% in order to boost storage in anticipation of the winter. European Commission President Von der Leyen said that this must be done to fight Russian “blackmail.” The EU also asked member states to give the Commission the power to implement gas rationing across Europe in order to prioritize supplies in the case of a Russian cutoff. Germany’s government already has a plan to prioritize which industries obtain gas in the event of a shortage.
Now that there is a fear that Russia will cut gas shipments to Western Europe during the winter, the question arises as to the severity of the potential economic impact. The International Monetary Fund (IMF) says that a cutoff of up to 70% of Russian gas is manageable “in the short term by accessing alternative supplies and energy sources and given reduced demand from previously high prices.” Already, gas consumption in Europe in the first quarter was down 9% from normal levels while alternative sources were increasingly tapped. Major countries are taking steps to further reduce consumption and continue to seek alternative sources.
However, the IMF says that a complete shut-off of Russian gas would lead to shortages of between 15% and 40% depending on the country. It also says that the severity of the economic impact will depend, in part, on the degree to which Europe can achieve sufficient integration so that gas is transmitted to where it is needed. If there is inadequate integration, the economic consequences will be more severe. Either way, the IMF estimates that the countries that will experience the worst economic consequences are Hungary, Slovakia, Czech Republic, Italy, and Germany in that order.
The gas crisis in Europe did not just begin recently. The head of the IEA, Fatih Birol, said that “in September 2021—five months before Russia’s invasion of Ukraine—the IEA pointed out that Russia was preventing a significant amount of gas from reaching Europe. We raised the alarm further in January, highlighting how Russia’s large and unjustified reductions in supplies to Europe were creating ‘artificial tightness in markets’ and driving up prices at exactly the same time as tensions were rising over Ukraine.” Indeed, Russian flows of gas to the EU are now running at about 25% of the level seen a year earlier. Mr. Birol says that, in order to avoid disaster in the winter should Russia cut off gas, Europe must now take steps to conserve sufficiently to bring gas storage to 90% capacity.
As for the price of natural gas in Europe, it initially tripled following the Russian invasion of Ukraine, but then fell back to close to the pre-invasion level. However, in recent weeks, the price has rebounded sharply, and is now roughly double where it was in early June.
Despite the clarity of the policy decision, the ECB faces the challenge of assuring consistency of policy across the various member states. As the ECB has embarked on a program of reducing bond purchases, bond yields have increased, but to different degrees in different countries. The gap between bond yields in Germany and Italy, for example, has risen. This raises the possibility that the tightening of monetary policy will disproportionately hurt some countries more than others. As such, Lagarde announced that the ECB will implement a “transmission protection instrument,” or TPI, meant to reduce the yield spreads between countries and avoid undue stress on such countries as Italy, Spain, Portugal, and Greece.
The plan entails having the ECB purchase the bonds, and possibly other assets, issued in key countries such as Italy, Spain, Portugal, and Greece. ECB president Lagarde indicated that the ECB “is capable of going big.” This suggests that there is no specific limit to the volume of asset purchases that can be undertaken. This statement was likely meant to indicate that the ECB will do whatever it takes to avoid a financial crisis. In a way, it is reminiscent of the statement made by then-ECB president Mario Draghi in 2012 during the Eurozone debt crisis. At that time, he said that the ECB was “ready to do whatever it takes. Believe me, it will be enough.” That statement was critically important in reviving investor confidence and, ultimately, ending the debt crisis.
On the other hand, the statement by the ECB about the terms of the TPI suggests that there are constraints on what the ECB can do. These constraints likely explain the cautious investor response to the announcement. Specifically, the ECB said that the TPI will only be used if the member state in question adheres to certain fiscal rules.
TPI will only be used if countries adhere to fiscal rules. These include not having excessive deficits, adequately responding to ECB recommendations on fiscal policy, and having “sound and sustainable macroeconomic policies.” In other words, the ECB will not attempt to reduce bond yields through asset purchases if those yields are actually warranted by circumstances. This raises the question as to what happens if a government acts irresponsibly. Would the ECB not purchase that country’s bonds? And, if so, could that endanger the sustainability of the euro, or that country’s membership in the Eurozone?
Meanwhile, the announcement of the TPI program came on the same day that Italian prime minister Mario Draghi resigned. Draghi had previously threatened to resign unless the coalition partners agreed to a reform program. Now, it turns out, several coalition partners will not agree to the program and will not provide a vote of confidence for the government. Thus, Draghi is leaving, despite strong popularity and support from other EU governments. He was in office only for a little more than a year. He came in at a moment of crisis, supported by an odd coalition of disparate and extreme parties eager to stabilize Italy. He was highly regarded by business, financial, and diplomatic leaders and his presence, which engendered confidence in Italian policy, helped to reduce Italian borrowing costs. He promised that the 200-billion-euro funding from the EU would, along with market-oriented reforms, be used to improve Italy’s competitiveness.
Following Draghi’s resignation, the yield on Italy’s 10-year bond increased sharply while German yields fell, the opposite of what the ECB wants. It is likely that there will soon be new elections. The fiscal probity of the next government is questionable. This comes at a time when Italy’s debt-to-GDP ratio is roughly 150%, meaning that a significant rise in yields could lead to higher default risk and/or the need for dramatic fiscal austerity or tax increases. Thus, Lagarde’s TPI program comes at a critical moment. Yet the Italian situation makes Lagarde’s job somewhat harder.
Markit reports that the manufacturing PMI fell from 52.1 in June to 49.6 in July, a 25-month low and an indication of a modest decline in activity. The subindex for manufacturing output fell to 46.1, indicating a significant drop in output. The separate services PMI fell from 53 in June to 50.6 in July, a 15-month low indicating that the services sector largely stalled.
Combining these, the composite index fell from 52 in June to 49.4 in July, indicating a decline in overall economic activity. Markit suggests that this is consistent with a decline in real GDP at an annual rate of 0.1%. Excluding the early months of the pandemic, this is the first decline in activity since 2013. Markit commented that “the eurozone economy looks set to contract in the third quarter as business activity slipped into decline in July and forward-looking indicators hint at worse to come in the months ahead.” It noted very weak new orders, poor business sentiment, and a surge in inventories for manufacturers. The latter augurs a drop in production in the coming months. Markit also noted that tightening of monetary policy by the ECB will mean higher borrowing costs “at a time when the demand environment is one that would normally see policy being loosened.” The result is expected to be greater recession risk.
Markit also released data for the Eurozone’s two largest economies, Germany and France. In Germany, both the service and manufacturing PMIs were in negative territory, resulting in a composite PMI of 48 in July. In France, the manufacturing PMI was negative while the services PMI indicated continued modest growth. The composite PMI was 50.6. In the United Kingdom, on the other hand, Markit reports that the PMIs for both manufacturing and services were in positive territory, indicating that the British economy continued to growth in July, albeit at a very slow pace. Markit commented that “pent-up demand for vehicles and consumer-oriented services such as travel and tourism helped to sustain growth in July.” However, it said that the current PMIs are consistent with growth at a rate of just 0.2% per year and that “forward-looking indicators suggest worse is to come.” Thus, Europe appears on the precipice of a downturn.
First, there is increasing divergence between the behavior of current inflation and investor expectations for future inflation. For example, in the United States, inflation has surged, with consumer prices up 9.1% in June versus a year earlier—a 40-year high. Yet the five-year breakeven rate, which measures bond investor expectations for average inflation over the next five years, has declined from 3.59% on March 25 to 2.59% recently. This means that investors believe the current high level of inflation will quickly decline, driven by tighter monetary policy, weaker consumer demand for goods, stable or declining oil prices, and improved supply chain efficiency. Meanwhile, the latest inflation numbers might reinforce the view that the Federal Reserve will act aggressively to reduce inflation, even at the cost of recession.
Second, oil and other commodity prices have been all over the place but are lately down sharply. The price of Brent crude has fallen from US$121 on June 9 to roughly US$100 in recent weeks. Likewise, the prices of copper, iron ore, wheat, lumber, and other commodities have fallen sharply in recent days. This likely reflects an increasing expectation that the global economy will slow down, especially as numerous central banks implement tighter monetary policy. It might also reflect increased pessimism about China. Specifically, the number of new daily infections in China is now at the highest rate since May. This has led to fears that China will reimpose lockdowns in major cities, thereby quelling economic activity and reducing demand for energy and other commodities. Stable or declining oil prices, if sustained, will likely help to reduce inflation in major economies.
Third, there has been a sharp decline in the value of cryptocurrencies. Previously, some promoters of crypto have said that these assets are a good inflation hedge. If so, values would be rising during the current period of accelerating inflation. Rather, crypto appears to have the characteristics of a speculative asset. That is, they are attractive when yields on fixed income assets are low. When yields rise, as they have lately, investors shift from speculative assets to fixed income assets, thereby suppressing the value of speculative assets. This is what appears to have happened with crypto. This also happened with gold, often seen as an inflation hedge. The difference is that crypto has fallen far more sharply than gold.
Fourth, bond yields in major markets have fallen sharply in recent days. In the United States, the United Kingdom, Germany, France, Italy, and Australia to name a few, yields on government-issued 10-year bonds fell sharply in the last three weeks. This likely reflects revisions of investor expectations about economic growth and recession, as well as revisions to expectations about inflation. Expectations of rapid tightening of monetary policy, combined with increasingly bleak consumer and business assessments of economic prospects, have led investors to expect slower growth and lower inflation. This in turn means less demand for government bonds. The good thing about this is that lower borrowing costs might boost demand for credit, or at least halt the downturn in credit demand.
Finally, residential property prices in the United States continue to rise even as housing market activity has dampened in response to lower affordability. Mortgage interest rates in the United States have roughly doubled in the past year due to Federal Reserve actions that have caused bond yields to rise. We learned recently that, in addition to a decline in pending home sales, there was also a sharp increase in the number of pending sales that were cancelled. The cancellation rate hit the highest level since the start of the pandemic. This raises the question as to when and whether suppressed housing market activity will cause a decline in prices? Or do investors see residential property as a hedge against inflation? It is known that a good deal of housing transaction activity involves purchases by private equity investors.
The relative ascendancy of the dollar reflects several factors. First, US monetary policy is tighter than the policies of other central banks. This is certainly the case with respect to Japan where the Bank of Japan retains an expansionary monetary policy. As for the euro, the European Central Bank (ECB) is starting to tighten monetary policy, but at a slower pace than the US Federal Reserve. Higher interest rates in the United States lead to capital outflows from other countries, putting upward pressure on the value of the dollar.
In addition, there is an expectation among many market participants that the US economy will grow more strongly than these other countries, despite a perception of recession risk. The US job market is healthier than that of Europe, for example, and the United States is perceived as being at less risk from the war in Ukraine. In addition, the United States is perceived as a safe haven at a time of global geopolitical and economic turmoil. US assets, especially US government–issued bonds, are perceived as relatively safe. This, too, puts upward pressure on the dollar.
What happens next? Only a fool would believe they can forecast currency values. And an even greater fool would be someone who believes the forecasts of others. Rather, I can offer some thoughts on the consequences of a high-valued dollar. First, a rising currency is deflationary because it leads to lower import prices. For the United States, the surge in the dollar should ultimately help to suppress inflation, although with a lag. Conversely, the declining euro will add to inflation. It will also add to the cost of higher-priced commodities such as oil that are usually priced in dollars.
Second, a higher-valued currency often means higher-priced exports, thereby either hurting the competitiveness of exports or leading exporters to take lower profit margins. For countries with declining currencies, the opposite can be true. However, in Japan, where the yen has fallen sharply, the fact that much manufacturing capacity has gone offshore reduces the potential trade benefits of a weak currency. Meanwhile, Japan’s authorities are concerned that higher import prices will eat into consumer spending power, thereby hurting domestic economic growth.
Finally, the strength of the US dollar, if sustained, will likely reduce talk about the potential demise of the dollar as a dominant currency. Recent events reinforce the view that the dollar remains the undisputed leader among currencies—at least for the foreseeable future.
Still, how people perceive things matters and can influence their behavior. One European friend says that this is a failure of leadership and signals the decline of Europe. I say no: It simply means that the euro is declining in value because of changes in relative interest rates, changing expectations of growth, and a perception that Europe is at greater risk from the war in Ukraine than the United States. A cheaper euro will probably be helpful to Eurozone exports of goods and services while boosting the cost of some imported goods. The ECB could boost the value of the euro by tightening monetary policy faster than currently anticipated, but this would not necessarily be a good idea. It would likely lead to a recession. Conversely, if the Federal Reserve were concerned about a strong dollar, it could let up on monetary tightening, but this is not advisable or likely. Meanwhile, it is worth keeping in mind that, although the euro has fallen sharply against the US dollar, it has fallen only marginally against a broader basket of currencies.
In June, Russia halted shipments of gas through the Nord Stream pipeline, ostensibly to engage in repairs that are meant to be completed later this month. When the pipeline shut down, it meant not only a reduction in gas to Germany but reduced onward flows to France and elsewhere. This was not a crisis for France as it was able to tap into alternative sources such as imports of liquid natural gas (LNG) through its four LNG terminals.
If, however, Russia fails to reactivate the pipeline later this month, and especially if it cuts off all flows of gas to Western Europe, it would create a serious crisis for multiple countries, especially for Germany, which is most dependent on Russian gas and lacks LNG terminals. Meanwhile, Germany has concluded solidarity agreements with several other EU members that commit countries to assist one another in the event that Russian gas is cut off. The idea is to prevent Russia from achieving its goal of dividing Europe. Yet a Polish official asked, “Where was Europe’s energy solidarity and energy security when the Germans built Nord Stream 1 against the will of Poland and many others?” This is part of a broader complaint that the current situation reflects Germany’s choice to invest heavily in Russian gas to the exclusion of other sources. But that’s water under the bridge. What matters now is how to deal with the existing situation.
Russia might say that it has the upper hand because Germany is dependent on Russian gas. As such, Russia has sufficient leverage to pressure Germany into avoiding new sanctions. Moreover, Russia has seen increased revenue from the sale of oil and other commodities where prices have risen sharply. Germany, however, might say that it has the upper hand because Russia depends on German cash. As such, Germany might have sufficient leverage to pressure Russia to agree on a ceasefire in Ukraine. In any event, it is not clear who has the upper hand.
If Russia cuts off gas this coming winter, Germany will face a difficult economic situation. It will likely abandon market-oriented distribution and effectively ration gas, denying supplies to industry in order to assure that homes have sufficient heat. That could lead to job losses in key manufacturing industries. The government is already taking steps to assure supplies of electricity by reactivating coal-burning plants. It is not, however, taking steps to retain nuclear power from plants that are being closed. In any event, it is highly likely that a significant reduction of gas will result in a sharp decline in German economic activity, which would have negative spillover effects on the rest of Europe. Still, many other European countries are better prepared to partly replace Russian gas using LNG terminals.
Importantly, Germany is the most significant hub for transmitting gas to other EU countries. Germany’s economics minister said that Germany will not reduce gas transmission to other countries because “that would be illegal—and absurd.” On the other hand, he said that, if German consumers are to become more frugal about energy use, which is what the government is encouraging, “that will only work if the countries to which we transport the gas reduce their consumption as well.”
Finally, the risk of recession is one of the reasons that the ECB has been more cautious than other central banks in tightening monetary policy. The surge in Eurozone inflation is disproportionately due to rising energy prices, especially the enormous rise in gas prices. The ECB likely fears that a more aggressive monetary policy will worsen a gas-driven recession if and when it comes.
The UN reports that, in 2021, global population grew less than 1%, the slowest rate of increase since the end of World War Two. Aside from the lingering effects of the pandemic, the low population growth also reflected a continuing decline in birth rates in many parts of the world. This is not expected to reverse. Indeed, it is expected to expand to new places as countries achieve a modicum of affluence. As countries move from poverty to middle income, girls go to school longer, participate in the workforce in higher numbers, marry later, and have fewer children.
Looking forward, the UN predicts that global population will peak in the 2080s at 10.4 billion. Most of the increase in population will take place in Africa and South Asia. The countries that are expected to jointly account for more than half of global population growth are Democratic Republic of Congo, Egypt, Ethiopia, India, Nigeria, Pakistan, the Philippines, and Tanzania. As India’s population rises while that of China falters, India will become the most populous country in the world in 2023.
Also, the UN predicts that the world will continue to age. As birth rates fall, and as people live longer, the elderly will rise as a share of the total population. Specifically, the over-65 population will rise from 10% of the total today to 16% in 2050. It is already much higher than that in many affluent nations. As populations grow older in middle-income countries, this will create strains for pension and health care systems. Yet with slower growth of working-age populations, economic growth could become slower absent offsetting improvements in productivity growth. To ensure that productivity growth is strong, countries will need to invest in improving human capital and infrastructure and encouraging business investment in innovation.
Finally, we are seeing something happen in the world that has only ever happened before during wars or pandemics—population decline. The UN predicts that, in 61 countries, population will decline by more than 1% between now and 2050. This reflects low birth rates and, often, emigration. The countries that are expected to have the largest percentage declines in population between now and 2050 are Bulgaria, Latvia, Lithuania, Serbia, and Ukraine—largely driven by emigration. Meanwhile, the UN says that immigration will be the sole driver of population growth in most high-income countries in the next few decades.
For the business community, demographic trends will affect where goods and services are sold and produced as well as what types of goods and services are offered. They will influence labor costs, tax rates, government services, geopolitical relations, environment damage or renewal, and the ethnic composition of countries.
In the United States, the National Bureau Economic Research (NBER), a private organization, has long catalogued the timing of recessions, using monthly data to determine when a recession began and when it ended. The US government relies on the NBER data. The NBER defines a recession as “a significant decline in economic activity that is spread across the economy and that lasts more than a few months.” It looks at “real personal income less transfers (PILT), nonfarm payroll employment, real personal consumption expenditures, wholesale-retail sales adjusted for price changes, employment as measured by the household survey, and industrial production.” While most recessions as defined by the NBER have involved two quarters of declining GDP, this was not always the case. Likewise, there have been instances where there were two quarters of declining GDP while a recession did not take place. As the NBER notes, “real GDP could decline by relatively small amounts in two consecutive quarters without warranting the determination that a peak had occurred.”
Which brings us to the current situation. In the United States, real GDP declined in the first quarter. Meanwhile, there are several forecasters who think that GDP might decline in the second quarter. If it does, will that mean the United States is in a recession? Not necessarily. The first-quarter decline was mostly due to a drop in inventory accumulation and a decline in exports. Final sales to domestic purchasers were up in the first quarter. In addition, gross domestic income (GDI) was up, signaling strength of demand. Thus, the first-quarter data could be seen as an anomaly. Also, the employment and production measures that the NBER examines remain favorable. Thus, it seems unlikely that a recession has begun. Still, the US economy is surely facing significant headwinds, potentially setting the stage for a recession later this year or next year.
With inflation historically high and the economy not yet showing signs of recession, the Fed now appears likely to continue on the path of rapid tightening of monetary policy. It noted that, not only is the economy growing, but the labor market remains unusually tight, thereby potentially creating a new source of inflationary pressure. It said that the major sources of inflation are the sharp rise in energy prices and continued supply chain disruption. It worried that current labor shortages might generate further inflation. As such, “participants judged that an increase of 50 or 75 basis points would likely be appropriate at the next meeting. Participants concurred that the economic outlook warranted moving to a restrictive stance of policy, and they recognized the possibility that an even more restrictive stance could be appropriate if elevated inflation pressures were to persist.”
Finally, the minutes indicate that “elevated inflation could become entrenched if the public began to question the resolve of the Committee to adjust the stance of policy as warranted. On this matter, participants stressed that appropriate firming of monetary policy, together with clear and effective communications, would be essential in restoring price stability.” This is consistent with the view that an important role for the Fed, or any central bank, is to anchor market expectations of inflation.
In June, job growth continued at a brisk pace, the unemployment rate remained low, and wage growth was modest. These are favorable pieces of news. However, strong job growth signals more inflation risk, thereby suggesting that the Federal Reserve may need to continue to tighten monetary policy rapidly. On the other hand, modest wage gains suggest that the tight labor market is likely not contributing to inflation.
Here are some highlights of the government’s latest employment report. The report encompasses two surveys: The establishment report is based on a survey of businesses and government; the household report is based on a survey of households. First, the establishment survey found that 372,000 jobs were created in June, better than expected and only slightly below the level in May. In June there were 524,000 fewer jobs than just prior to the start of the pandemic. Private sector employment was about one million jobs higher than the prepandemic level, but this was offset by a decline in government employment. Employment is still lower than would have been the case if there had been no pandemic. Meanwhile, employment is up 10.4% from a year earlier, a huge increase. Yet the continued existence of a labor shortage reflects a decline in labor force participation since the start of the pandemic.
Among the sectors that experienced strong job growth were manufacturing (up 29,000 from May), transportation and warehousing (up 35,500), professional and business services (up 74,000), health care and social services (up 77,800), and leisure and hospitality including restaurants and hotels (up 67,000). There was only modest or no growth in retail and wholesale trade, financial services, information services, and government.
The establishment survey also found that average hourly earnings were up 5.1% from a year earlier, the slowest rate of increase since December 2021. Earnings were up only 0.3% from the previous month. This is a bit baffling considering that inflation has accelerated and that the labor market is unusually tight. A surge in wages would be expected. Moreover, there are press reports of increased strike and labor-organizing activity. Conversations with clients reveal some instances of big wage increases. Yet the data demonstrates that, for the economy as a whole, labor income is relatively tame. From the perspective of workers, this is bad news in that real (inflation-adjusted) earnings are declining. From the perspective of the Federal Reserve, this is good news in that we are not seeing the kind of wage-price spiral that could ignite prolonged inflation. This bodes well for getting inflation under control.
The separate survey of households indicates that labor force participation fell modestly from May to June but was up moderately from a year earlier. The unemployment rate remained unchanged at 3.6%, one of the lowest levels in the past half century. The principal labor market problem now is that participation remains significantly lower than the prepandemic level. The other big problem is that the number of foreign-born workers is significantly lower than the prepandemic path. A combination of weak immigration and aversion to labor force participation has rendered a labor shortage that is a huge concern to many of our clients. It is not clear how or when this will be resolved. One potential solution is greater investment in labor-saving or labor-augmenting technologies, meant to boost the productivity of existing workers.
Financial-market reaction to the employment news was relatively muted. Equity prices were stable and bond yields increased modestly. This suggests that investors were not surprised and, consequently, have not revised their expectations for growth, inflation, or Fed policy based on the news.
Although the ECB noted that market measures of inflation expectations remain “anchored at the ECB target,” the risk remains that persistent inflation could lead to the kind of wage-price spiral that might generate prolonged inflation. Meanwhile, the members agreed that one of the precepts of policy ought to be “gradualism,” although there was disagreement as to what this means. The minutes state: “The view was put forward that the notion of gradualism could be misleading if it was interpreted as implying too slow or too rigid a pace of adjustment in the monetary policy stance. In particular, it was necessary to avoid gradualism being seen as precluding interest rate steps in excess of 25 basis points.” In other words, bigger increases are now on the table. Indeed, “it was argued that the principle of gradualism suggested responding early and in a forward-looking manner, which would then reduce the need for larger and more disruptive adjustments later.”
This exercise in semantics was evidently needed to justify what appears to be a shift in intentions. The ECB has already said it intends to raise the benchmark rate by 25 basis points later this month. This might still happen, but the chances of a bigger boost have increased. Even if nothing changes this month, it is increasingly clear that more rapid adjustment is likely in the months to come. This could further weaken the Eurozone economy and it could put upward pressure on the value of the euro. On the other hand, the ECB reiterated that it intends to be data-driven and flexible in the implementation of monetary policy. Thus, if inflation peaks and the economy weakens, it could adjust policy accordingly. With all of the major central banks of Europe and North America now pursuing rapid monetary tightening, the risk of a global downturn is greater.
In recent months, there has been increasing talk about the renminbi becoming a more dominant global currency, eclipsing the US dollar. I don’t see that happening anytime soon. If the renminbi were a popular reserve and trading currency, then the PBOC wouldn’t need to hold massive reserves. Consider that the United States holds a paucity of reserves because the dollar is dominant in global markets, and because the United States allows the dollar to float. That means the United States doesn’t need reserves to stabilize the value of the dollar. If China wants the renminbi to become more dominant (thereby enabling Chinese traders to trade in their own currency and avoid currency risk), then it will have to end capital controls and allow the renminbi to float. This would dramatically reduce the need to hold more than US$3 trillion in reserves.
To measure the degree of disruption, the Federal Reserve Bank of New York developed a Global Supply Chain Pressure Index. The index increased sharply at the start of the pandemic, then dropped sharply as global demand waned. Then, as demand recovered, the index soared to new heights, peaking in December 2021 before beginning to decline gradually. That decline likely reflected an easing of consumer demand for goods combined with improvements in supply chain efficiency as businesses increased capacity and as delays and shortages abated. However, the index rebounded when the war in Ukraine started and as China imposed lockdowns. However, since April, the index has been declining, with an especially sharp decrease in June, which the New York Fed attributes to the end of lockdowns in China. In fact, the June level of the index was the lowest since March 2021. Still, it remains significantly above the prepandemic level.
What can we infer from this information? First, there is a long way to go before global supply chains return to normal. Second, the improvement in recent months is significant and should help to unclog bottlenecks thereby allowing more production and less inflation. Going forward, the index might also decline as companies diversify their supply chains as an insurance policy against future disruption.
Cover image by: Sofia Sergi