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Powell said that the Fed will keep raising interest rates “until the job is done.” He said that rates will go up to a higher level and stay there until it is clear that inflation is receding. He acknowledged that such a policy will likely lead to “a sustained period of below-trend growth” and that there will very likely be “some softening of labor market conditions.” He said that “these are the unfortunate costs of reducing inflation.” However, he noted that “failure to restore price stability would mean far greater pain.” He said that “we are taking forceful and rapid steps to moderate demand so that it comes into better alignment with supply, and to keep inflation expectations anchored.” As for the latter, he noted that “the longer the current bout of inflation continues, the greater the chance that expectations of high inflation will become entrenched.”
Powell’s hawkish line comes after several weeks in which investors appeared to expect that the Fed would become cautious about monetary tightening lest it engineer a recession. That expectation led to higher equity prices. However, Powell attempted to dispel the notion that the Fed is not laser-focused on inflation. He said that “the historical record cautions strongly against prematurely loosening policy.”
Meanwhile, investors expect the Fed to boost the Federal Funds Rate by another 75 basis points in September. However, Powell did not offer any prediction, other than to say the decision will be data-driven. He also said that “at some point, as the stance of monetary policy tightens further, it will likely become appropriate to slow the pace of increases.” In summary, he said that “we are moving our policy stance purposefully to a level that will be sufficiently restrictive to return inflation to 2 percent.” There is no doubt that the Fed has sufficient tools to do that. The real question is whether the Fed can achieve this goal without causing a recession. The track record of the Federal Reserve suggests that this will be difficult. Powell himself did not use the word recession.
Powell’s comments were quite different than what he was saying almost a year ago when he described the uptick in inflation as likely to be transitory. His view at that time was that the sudden surge in inflation had been due to supply chain disruption resulting from the pandemic and that, over time, it would resolve itself. What has changed since then? A few things happened. First, the war in Ukraine exacerbated inflation by raising oil and other commodity prices. Second, inflation expectations changed with an inflationary psychology emerging. Third, underlying demand in the economy remained strong in the face of an extraordinarily tight labor market and persistent supply chain problems. The latter were fueled by the war in Ukraine and lockdowns in China.
This raises the question as to whether the Fed should have started to tighten monetary policy earlier. The answer is probably yes, but hindsight is 20/20 vision. Moreover, the US inflation experience was not unique. There has been an acceleration in inflation in the United Kingdom, Eurozone, Canada, and elsewhere. Most central banks were caught off-guard. One can reasonably argue that, in the absence of the pandemic and the war in Ukraine, we would not now be discussing inflation.
As for the PCE-deflator, the government reported that consumer prices were up 6.3% in July versus a year earlier. This was lower than the high of 6.8% reached in June and no higher than in any month since January. Thus, it appears that headline inflation has peaked. Prices were down 0.1% from the previous month. Of course, this was due to declining energy prices, which fell 4.8% from the previous month. When volatile food and energy prices are excluded, core prices were up 4.6% from a year earlier, lower than in June and no higher than in any month since January. Core prices were up 0.1% from the previous month. Thus, even after taking account of energy and food prices, inflation appears to have peaked and started to recede. The main exception was food prices, which were up 11.9% from a year earlier and up 1.3% from the previous month. Finally, from the previous month, goods prices were down sharply while services prices were up modestly. The movement of goods prices is a clear reversal from earlier this year.
Meanwhile, real personal consumption expenditures were up 0.2% from the previous month. The personal savings rate remained unchanged at 5%. Interestingly, real disposable income was down 3.7% from a year earlier while real consumer spending was up 2.2% from a year earlier. Looking at the details of spending, real spending on durable goods was up 1.5% from June to July, nondurable goods down 0.5%, and services up 0.2%.
This report offers conflicting signals. On the one hand, the inflation numbers are favorable. On the other hand, the consumer segment of the economy appears to have been relatively strong in July. This might, in part, reflect the impact of declining gasoline prices that enabled consumers to boost spending on other things. Indeed, the Conference Board’s measure of consumer sentiment improved recently for just that reason. A stronger economy suggests a more difficult path for the Federal Reserve in suppressing inflation.
In response to this report as well as to Fed chairman Powell’s hawkish remarks, equity prices fell sharply. The yield on the Treasury’s 10-year bond was up very modestly while yields on shorter maturity bonds were up much more, thereby further inverting yield curves. The bond market is, therefore, signaling a greater likelihood of recession but also an expectation that inflation will be brought under control relatively soon.
Another explanation, however, is that investors have been shorting Italian bonds on a large scale. It is reported that the volume of contracts shorting Italian bonds has grown rapidly in recent weeks. Those investors evidently anticipate a financial problem for Italy. Will those investors make a killing, or will they suffer a significant loss? The answer depends partly on what happens in the Italian election, and partly on how the ECB responds to the current situation. It could purchase far more Italian bonds. Indeed, there is no limit to what they can do other than the political limit of not wanting to appear to bail out a country with questionable fiscal policies.
In addition, the members expressed the view that the program to purchase bonds of highly indebted member countries likely allowed the ECB to be more aggressive in pursuing a rapid increase in the benchmark interest rates. They also noted that the impact of higher rates on credit availability had not varied significantly by country. Specifically, the minutes said that “in contrast to previous episodes of heightened volatility in sovereign bond markets, there had so far been no visible differentiation between banks across euro area jurisdictions.” That is good news and suggests that, despite divergent fiscal policies and politics, the impact of monetary policy has, so far, been distributed relatively evenly.
Given that climate change is getting worse and will not likely get better anytime soon regardless of actions meant to reduce carbon emissions, it appears likely that supply chain disruptions related to climate change will get worse as well. Moreover, climate change will not simply mean low water levels and shortages of water. It can also mean increased storm activity and flooding. This suggests a need for increased infrastructural investments meant to protect coastal areas from disruption. For businesses, these trends suggest a need to develop plans to respond to disruption, diversify risk, and consider climate risk when making decisions regarding location, types of energy used, and access to water.
In China’s Sichuan Province, home to 84 million people and a major center for producing metals, chemicals, electronics, and power-generation equipment, a severe heat wave has resulted in a shortage of electricity and, because of rationing, the shutdown of many factories. It is reported that unusually high temperatures have led to big increases in electricity demand as well as a sharp decline in water levels—which affect hydroelectric output. The result is that, in recent days, industrial production was halted in all but two of the province’s 21 major cities. In Sichuan Province, more than half of electricity is generated using water. Yet the amount of water available in reservoirs has declined by 50% from normal levels. In the Yangtze River, which feeds into local reservoirs, the water level is now the lowest since 1865.
Sichuan is not alone. Some other provinces are experiencing heat waves with resulting big increases in electricity demand. Also, other provinces rely on hydroelectric power generated in Sichuan. Already there is rationing of electricity resulting in factory slowdowns, including automotive plants in Shanghai.
If this situation lasts for more than a few weeks, it will likely have a discernible impact on overall GDP growth for China. Regardless, it demonstrates how climate change can disrupt economic structures that are more fragile than was previously realized. The irony for Sichuan is that the solution to climate change is to use clean energy, such as hydroelectric power. Yet climate change has resulted in a shortage of water for hydroelectric generators. Another irony is that Sichuan is a major supplier of lithium used in electric car batteries.
Meanwhile, low water levels are having other effects. It is reported that, in Chongqing, China’s most populous city, there are problems for farms and livestock. Some 25 reservoirs have dried up and city water levels are at only 63% of normal levels. In addition, this problem is not seen as temporary or one-off. Rather, it likely reflects a permanent shift in climate that will force businesses and utilities to think anew about future plans—not only in China but around the world.
Now, Chinese utilities are starting to rethink their energy needs. Specifically, after a long period of low investment in carbon-based fuels (meant to comply with longer-term climate targets), coal is back. Vice Premier Han Zheng said that the government will support an increase in coal-fired power generation and coal mining. If coal use increases significantly, which now seems likely, it will be more difficult for China to achieve its climate goals. Plus, usage of coal will exacerbate the climate change that has resulted in low water levels. The challenge will be to find sources of power that do not result in carbon emissions but that are reliable in the face of climate change. This could involve thermal, nuclear, and solar.
The government reports that, in July, retail sales were up 2.7% from a year earlier, less than in the previous month and, aside from during the recent severe lockdowns, one of the slowest rates of growth in recent years. There was a decline in sales of apparel, furniture, and building materials. Sales of cosmetics and personal care products barely grew. This performance was far worse than most analysts expected. This suggests underlying weakness in aggregate demand.
Meanwhile, the government also reported that industrial production was up 3.8% in July versus a year earlier, slower than in the previous month. This, too, surprised observers. Manufacturing output was up only 2.7% with declining output of processed foods, textiles, and general equipment. On the other hand, there was strong growth in output of automobiles.
Fixed asset investment continued to decelerate in July. In the first seven months of 2020, investment was up a modest 5.7% from a year earlier, slower than in the first six months. Infrastructure investment was up a strong 9.6% due to government stimulus. However, property investment fell 6.4% from a year earlier while property sales were down 28.8%. That bodes poorly for increased construction in the months ahead. One result of the latest property market data is that house prices in the country’s 70 largest cities were down 0.9% in July versus a year earlier. This is the sharpest decline since September 2015 and the third consecutive month of decline. Given that property ownership is a major form of saving for millions of households, the decline in property prices means a loss of wealth that can influence spending decisions. Interestingly, prices were up modestly in China’s largest cities, indicating an even sharper decline in second-tier cities.
In response to the evident weakness in the economy, the PBOC cut the medium-term lending rate by 10 basis points, the first such decline since January. It also cut the seven-day reverse repo rate by 10 basis points, the first such action since January. These moves, while modest by the standards of other major central banks, were significant in China. They likely reflected deep concern about the state of the economy and a desire to jumpstart demand. Moreover, they reflect a shift in focus. That is, in recent months, the PBOC, while slightly easing monetary policy, has been reluctant to take stronger action due to fear of inflation—which has, in fact, accelerated. Now, with the economy clearly weak, the PBOC is embarking on a somewhat different policy.
Interestingly, the PBOC is evidently less focused on the exchange rate than previously. After all, as the interest-rate differential with the United States widens, there is more impetus for outflows of capital from China, thereby leading to downward pressure on the currency. This can only be offset by selling foreign currency reserves. A weakening currency can be inflationary, but that is clearly not the primary focus of the PBOC at this time.
In any event, the question remains as to whether demand can be stimulated within the context of COVID-19–related economic restrictions. Indeed, the government cited COVID-19 restrictions as one of the causes of slow growth. Already, the government reported that bank lending weakened in July. Will monetary easing, which is meant to stimulate credit activity, offset the impact of COVID-19–related restrictions? Time will tell.
Here are the details: In July, consumer prices in the Eurozone were up 8.9% from a year earlier, the highest level since the Eurozone was created. However, prices were up only 0.1% from the previous month, the lowest monthly inflation in two years. This reflects the 2.2% monthly decline in prices of nonenergy industrial goods and the 0.8% decline in prices of unprocessed foods. When volatile food and energy prices are excluded, core prices were up 4% from a year earlier, the highest rate on record, and down 0.2% from the previous month. Clearly, this data does not indicate a consistent trend.
Meanwhile, inflation varied by country in July, with Spain, Belgium, and Italy experiencing monthly deflation. Here are the numbers for key countries:
Country M/M (%) Yr/Yr (%)
Germany 0.8 8.5
France 0.3 6.8
Italy –1.1 8.4
Spain –0.6 10.7
Netherlands 2.2 11.6
Belgium –0.6 10.4
What can we infer from this? First, rising energy prices accounted for roughly half of the annual increase. Thus, underlying inflation remains relatively modest. That explains the reluctance of the European Central Bank (ECB) to implement a more aggressive monetary policy, especially given the risk of recession. The slower monetary tightening in Europe than in the United States has led to the sharp decline in the value of the euro. Second, the monthly data suggests that the worst may be over absent a sudden further surge in energy prices. This might reflect the slowing of the Eurozone economy as well as the end of war-related oil price increases. Third, the big unknown now is what Russia does with respect to natural gas in the coming months. The very high inflation partly reflects the previous increases in gas prices. If Russia cuts off gas to Europe, then gas prices will likely rise again, thereby boosting inflation—and vice versa. And, of course, if Russia cuts off gas, a recession is expected to come. This will put the ECB in a difficult position.
This inflation report is consistent with the view that inflation has become relatively broad-based and has not yet peaked. As such, it does not suggest a likelihood that the Bank of England will alter the trajectory of monetary policy. Further tightening is likely, real incomes are falling rapidly, and the likelihood of recession remains high. Still, the fact that core inflation appears to have stabilized offers hope that the worst will soon be over, especially if energy prices stabilize.
A more common measure of inflation in Japan, known as core inflation and which excludes the impact of fresh foods, increased 2.4% from a year earlier. Excluding the impact on inflation when the national sales tax was increased twice in the last two decades, this was the highest rate of inflation since the 1990s. Moreover, when volatile food and energy prices are excluded, the measure known as core-core inflation was up a more modest 1.2% in July versus a year earlier. Still, this was the biggest increase in core-core prices since 2015.
Thus, although inflation is far below the levels seen in other advanced economies, it is significantly higher than anything seen in recent decades. The fact that inflation remains so low explains why the Bank of Japan (BOJ), contrary to the experience of most major central banks, persists with an easy monetary policy. After all, the core-core measure remains below the BOJ’s target of 2% inflation. BOJ governor Kuroda has said that policy won’t be adjusted until it is clear that inflation is sustained at or near the target and that underlying demand in the economy is growing at a favorable pace. The good news is that, in the second quarter, real GDP grew at a strong 2.2% pace.
Here are the details: In July, retail sales were unchanged from June and up 10.3% from a year earlier. Sales at automotive dealerships were down 1.6% from the previous month and up only 2.1% from a year earlier. In addition, sales at gasoline stations were down 1.8% from the previous month but up 39.9% from a year earlier. Thus, when autos and gasoline are excluded, retail sales were up 0.7% from the previous month and up 9.3% from a year earlier. The latter two figures are higher than the overall rate of inflation.
Some categories of spending were very weak in July. For example, sales at grocery stores were up 0.2% from June to July, restaurants were up 0.1%, department stores were down 0.5%, clothing stores were down 0.6%, and furniture stores were up 0.2%. On the other hand, sales at nonstore retailers were up 2.7% and home improvement retail sales were up 1.5%.
Retail sales mainly encompass the goods portion of consumer spending. Evidently, it was reasonably stable. Moreover, it is reported that tourist spending has accelerated sharply, auguring well for the services portion of consumer spending. Thus, the overall performance of the consumer sector is modestly positive, good news as the third quarter begins.
Here are the details: In July, consumer prices were up 8.5% from a year earlier, down from 9.1% in June and the slowest annual increase since April. In addition, prices were unchanged from the previous month, the lowest monthly inflation since early 2020. The reason, of course, was a sharp decline in energy prices, which fell 4.6% from June to July and were up 32.9% from a year earlier. The latter figure is a significant deceleration from the previous month. The decline in energy prices largely reflects the sharp drop in the price of crude oil, a reflection of easing global demand and a modest increase in output.
When volatile food and energy prices are excluded, core prices were up 5.9% from a year earlier, the same as in June. The last time annual core inflation was lower was in December 2021. Core prices were up a modest 0.3% from the previous month, the slowest pace since March.
However, although energy prices fell, other prices continued to rise at a robust pace. Notably, food prices were up strongly, rising 10.9% from a year earlier and up 1.1% from the previous month. On the other hand, the prices of some important products and services either fell or rose modestly. For example, prices of used cars were down 0.4% from the previous month. The price of apparel fell 0.1% from the previous month. And airline fares fell a dramatic 7.8% from the previous month, although airline fares remained 27.7% above the year-earlier level.
Assuming that oil prices do not suddenly rebound, it is now likely that headline inflation will continue to decelerate in the months ahead, even if oil prices stabilize rather than decline. However, the Federal Reserve will likely pay close attention to core inflation as it signals whether or not there is an underlying problem. The fact that core inflation decelerated in July is good news and, if it continues, will likely lead the Fed to adjust the trajectory of its policy.
Here are the numbers: In July, producer prices were up 9.8% from a year earlier, down from 11.3% in the previous month. This was the lowest annual rate of producer price inflation since October of last year. Moreover, producer prices were down 0.5% from the previous month. The last time there was a monthly decline was in April 2020 at the start of the pandemic.
The weakness of producer prices was, in part, due to the sharp decline in energy prices. When volatile energy and food prices are excluded, core producer prices were up 5.8% from a year earlier, the lowest rate since October. Core prices were up 0.2% from the previous month, matching the low in February. Also, producer prices of goods were down 1.8% from the previous month. Excluding food and energy, goods prices were up a modest 0.2%. Prices of services were up a very modest 0.1%. Finally, energy prices were down 9% from the previous month.
Overall, this report suggests that, not only are declining energy prices causing a deceleration in producer prices. Instead, core prices are decelerating as well. This could be due to overall weakening of the economy, improvements in supply chain efficiency, and declines in nonenergy commodity prices. As for the latter, prices of unprocessed nonfood and nonenergy materials fell 13.3% in July versus the previous month. Prices of food commodities fell a more modest 0.8%. Also, prices of all materials used in manufacturing were down 1.1%. It is likely that the Federal Reserve will pay close attention to this report.
First, unit labor costs are the labor costs of producing a unit of output. It is measured as labor costs divided by labor productivity, where productivity is the amount of output per labor. Thus, if productivity rises in line with labor costs, then unit labor costs remain unchanged. That is, the additional cost of labor is fully offset by the additional output of each worker. For an employer, this means that there is no additional labor cost involved in producing more.
On the other hand, if productivity declines while labor costs rise, then there is a sharp rise in unit labor costs. That is what happened in both the first and second quarters of 2022 according to the latest data from the government. Labor costs increased at an annualized rate of 5.7% from the first to the second quarter while productivity declined at a rate of 4.6%. And productivity declined because hours worked increased 2.6% while output fell 2.1%. Yet why did output fall? The answer is that businesses, having accumulated a massive stockpile of inventories during the pandemic, chose to cut production and work down their inventories in order to satisfy demand. The drop in inventories explained the decline in output. In fact, there was no decline in underlying demand. Moreover, if inventory movements are excluded, output increased. In other words, the very sharp rise in unit labor costs was somewhat misleading.
Another possible explanation for the sharp rise in unit labor costs is labor hoarding. That is, facing persistent shortages of labor, companies are hiring as many workers as they can, even if those workers are not immediately needed. This can result in a drop in labor productivity, thereby causing a rise in unit labor costs.
Going forward, the sharp decline in inventories likely means that businesses will have to increase production to meet future demand. Thus, the extreme weakness of productivity is likely to reverse, thereby enabling an easing of unit labor costs. In any event, a sudden surge in unit labor costs would normally be a signal that inflation is getting out of control. Given the unusual circumstances of the latest data, I think that is not the case—at least not yet.
Danny Bachman, an economist with Deloitte US, offers some comments on the question of recession:
1. We have not entered a recession as of now.
Recessions are defined by a broad decline in economic activity in most sectors. By that standard, the United States is not in a recession at this point. A currently popular way (among economists) to determine in real time if a recession is occurring is the Sahm rule: a rise in the unemployment rate of half a percentage point over the low in the last 12 months. As the unemployment rate has not been rising, this indicator is clear that we are not in a recession. The two negative quarters of GDP rule has never been used in US business cycle research.
2. The current Fed policy trajectory is not likely to create a recession on its own.
It takes an average of 36 months from an initial Fed rate hike to the subsequent recession. The immediate cause of most recessions is not monetary policy itself. Recessions in the postwar period have been mostly caused by “shocks” (surprise events such as the pandemic or the oil price hike of 1973) or financial crises. The latter can be touched off by rising short-term interest rates, when rising interest rates reveal mispricing of risk in financial markets. The 2007–09 (housing finance), 2001 (dot-com stock market crash), and 1990 (S&L crisis) recessions are examples. So far, no such mispricing has been seen. The recent successful bank stress tests also suggest such mispricing is not likely (although not impossible).
3. How much does the Fed have to raise rates to cause a recession?
The most recent recessions caused by Fed policy itself were the twin downturns of 1980–82. The Fed funds rate was over 17% in March-April 1980 (during the recession in the first half of 1980) and then again up to 19% in late 1980 and early 1981. This led to the severe recession in 1981–82. The real (inflation-adjusted) Fed funds rate during this period ran above 5% for several years—and reached almost 9% in 1981. By contrast, even aggressive action by the Fed today would not raise the nominal Fed funds rate over 5% by the end of 2023. None of the Wall Street Journal forecasters even assume the Fed will raise rates this much. If inflation moderates to the 2% level, the real Fed funds rate would be around 3%. That is somewhat tight, but nothing like the levels in 1982.
4. Interest-rate hikes may have less impact on the economy now than in the past.
Higher interest rates affect the economy through both residential and nonresidential investment. They affect longer-term investments—in particular, structures—more than shorter-term investments such as equipment and intellectual property. Investment in structures (both residential and nonresidential) is now about 7% of GDP compared to about 10% of GDP in 1979. Thus, a swing in interest sensitive investment has a smaller impact on GDP than it used to. We expect investment in consumer durables to fall regardless of interest rates, as households rotate spending back to services. Higher interest rates may speed this process, but at least some of the decline is already included in our relatively optimistic baseline.
5. Current data does not indicate a broad decline in activity.
Employment growth is very strong. Shipments of nondefense capital goods—a monthly indicator of investment activity—fell in June after rising in every previous month. This was entirely due to a decline in aircraft shipments; however, capital goods shipments less aircraft continue to grow. Auto sales continue to be affected by supply problems, and auto inventories remain very low. Dealers are likely to demand more, not fewer, cars to sell in the coming months. Retail sales remain positive, although clearly slowing (when taking account of inflation).
6. There are signs of a slowing economy. And construction does seem like it is going into recession.
Housing starts have fallen from a 1.8 million pace in April to less than 1.6 million in June. Permits for new construction, which tend to lead starts, have also fallen. The total value of nonresidential construction put in place fell in May and June. However, this measure has been weak since the pandemic, reflecting expectations of a decline in the long run demand for office and commercial space. Manufacturing output has fallen for two months straight.
First, it is likely that the next recession, if it comes in the next year or two, will be relatively mild. That is because there is probably no major systemic risk to the financial system as there was 14 years ago. Both consumers and businesses have healthy balance sheets. Moreover, the labor market remains tight, thereby likely limiting labor market damage when a recession comes. However, if employment doesn’t fall precipitously during the recession, there will be limited opportunity for a dramatic rebound in employment. Thus, the recovery is likely to be mild as well.
Second, the factors that have created a labor shortage in the last two years (reduced participation, limited immigration) are not likely to go away quickly. As such, businesses facing a rebound in demand and possibly unable to hire enough workers to meet that demand will likely choose to invest in boosting productivity. This could entail investing in labor-saving or labor-augmenting technologies that have the effect of boosting productivity growth. Thus, the longer-term growth of the economy in the decade following recession could be stronger than we might expect. Plus, faster productivity growth implies lower inflationary pressure, all other things being equal.
Third, fear that we have entered a new era of persistently high inflation might be misplaced. If the United States has a recession, it will go a long way toward reducing inflationary pressures. In addition, there are reasons to expect inflation to diminish even absent a recession. These include the stabilization and decline in oil prices; improvements in supply chain efficiency; and an easing of wage pressure that is already evident in the average hourly earnings data. Thus, a plausible scenario is that inflation declines to a tolerable level within the next two years. Of course, there are other plausible scenarios.
Bond yields tell the story. On March 1, just as the war in Ukraine began, bond yields were low across Europe. The yields on 10-year bonds were 1.37% in Italy and –0.107% in Germany, a gap of 1.47 percentage points. By June 14, with oil prices up, inflation soaring, and the ECB having signaled an imminent change in policy, the yields were 4.3% in Italy and 1.83% in Germany—a gap of 3.477 percentage points.
Yet in the past month, the ECB has purchased roughly 10 billion euros in Italian debt while selling roughly 15 billion euros in German debt. The result is that, late last week, the yields were 3.1% in Italy and 0.877% in Germany—a gap of 2.22 percentage points. Yields have come down since June due to declining oil prices and expectations of weakening economic performance. But notably, yields came down faster in Italy, reflecting the ECB intervention. Also, it should be noted that, during the past month, the ECB sold bonds issued by the Netherlands and France while purchasing bonds issued by Spain and Greece.
The focus on Italy is important, given that Italy has the third largest economy in the EU and has an unusually high level of sovereign debt. Moreover, Italy is in the midst of political change, creating uncertainty for investors. The fear that Italy’s bond yields would soar was instrumental in creating the ECB policy. Now it appears that bond yields are remaining suppressed, thereby averting a financial crisis for Italy.
The latest PMIs for manufacturing suggest a global economy that continues to grow but at a decelerating pace. In almost every major economy, the manufacturing PMI fell from June to July, with the PMI indicating negative growth in the Eurozone, Mexico, Taiwan, and South Korea. Growth remained positive in the United States, the United Kingdom, Japan, ASEAN, and China. One glaring exception to the deceleration trend was India where the PMI increased substantially, indicating rapid growth of manufacturing.
The global PMI from Markit fell from 52.2 in June to 51.1 in July, the lowest level in two years and indicating a very modest pace of growth. Moreover, the subindex for global output indicated no growth at all in July. Output fell in advanced economies such as the United States, the United Kingdom, Eurozone, and Japan but increased in emerging markets. Meanwhile, new orders and export orders both declined. Both input and output prices rose sharply, but at a slower pace than in the previous month. The countries with the highest PMIs (indicating the fastest growth in activity) were India, Australia, the Netherlands, and Brazil. The countries with the fastest declines in activity were Poland, Taiwan, Myanmar, Czech Republic, and Turkey. Of the 28 countries surveyed by Markit, 13 showed declining activity.
In the United States, the manufacturing PMI fell from 52.7 in June to 52.2 in July, a 24-month low, but reflecting moderate growth. Output and new orders declined. Export orders fell at the fastest pace in two years. Companies reported that difficulties in finding suitable workers, combined with shortages of raw materials, contributed to weakness in production. Also, cost inflation, while high, fell to the lowest level since mid-2021 as the prices of many components declined. Markit said that supply chain problems have eased. This implies that faltering demand might have a favorable impact on inflation. Markit reported that “companies are taking an increasingly cautious approach to purchasing and inventories amid the gloomier outlook, and likewise appear to be cutting back on investment, with new orders falling especially sharply for business equipment and machinery in July.” Markit concluded that, with the exception of the early days of the pandemic, “US manufacturers report the toughest business conditions since 2009.”
In Europe, the Eurozone is experiencing a decline in manufacturing activity. The PMI for the region fell from 52.1 in June to 49.8 in July, a 25-month low. Output fell at the fastest pace since the start of the pandemic as did new orders. On the positive side, price pressures diminished as inventory accumulation soared and supply chain pressure eased. Business sentiment was very poor owing to concerns about the war in Ukraine and the overall state of the economy. The four largest economies in the Eurozone (Germany, France, Italy, Spain) all fell into negative growth territory (Italy being the lowest) while there was positive and strong growth in the Netherlands. Meanwhile, it was reported separately that retail sales in Germany declined at the fastest rate on record. Markit pointed to the energy sector as posing the greatest risk to the region.
In the United Kingdom, the manufacturing PMI fell from 52.8 in June to 52.1 in July, a 25-month low but a level reflecting modest growth. Output fell in July, with an especially sharp decline in output of capital goods. New orders and export orders declined. As elsewhere, supply chain stress declined leading to reduced price pressures. Interestingly, employment growth accelerated. The tightening of monetary policy by the Bank of England (BoE) is seen as the biggest downside risk.
In China, the PMI, having rebounded in June as lockdowns were eased, declined again in July. It fell from 51.7 in June to 50.4 in July, a level indicating barely any growth. The weakness reflected “subdued demand conditions” and led to an easing of price pressures. Indeed, although input prices increased, output prices declined in July, thereby putting pressure on profit margins. Also, fresh COVID-19 outbreaks led to a slight increase in supplier delivery times. Given that real GDP declined from the first to the second quarter, the July PMI numbers suggest a likelihood that GDP will grow in the third quarter.
The latest service PMIs indicate a deceleration of activity, likely reflecting the global economic slowdown. The global PMI fell from 53.9 in June to 51.1 in July, indicating a very modest rate of growth. The subindex for export orders indicated a decline. Other indicators suggested further growth but at a slower pace. Notably, the subindices for pricing showed that inflationary pressure eased, most likely due to weakened demand.
The most interesting story about PMIs comes from the United States. The PMI published by Markit showed a sharp decline in activity, with the PMI falling from 52.7 in June to 47.3 in July. Yet another organization, the Institute of Supply Management (ISM), publishes its own PMI for services and found an acceleration in activity. Specifically, the PMI from the ISM increased from 55.3 in June to 56.7 in July. How is this possible?
While the basic methodology of the two organizations is similar, there are some important differences. Both organizations poll the purchasing managers of companies. The ISM focuses on big companies while Markit polls both big as well as medium and small businesses. The ISM includes the public sector while Markit polls only the private sector. The ISM index is based on a straight average of subindices. The Markit index is a weighted average where forward-looking subindices are given greater weight. Markit claims that its index is more closely correlated with actual economic data than the ISM index. For our purposes, the Markit index is preferred as it can be compared to the indices in other countries. Still, today’s ISM report, which signaled strong growth in services, generated considerable press coverage and cannot be completely dismissed. The sharp divergence between the two PMIs reminds us that survey data can sometimes be fickle and should be taken with a grain of salt.
In any event, the Markit index for the United States was the lowest since May 2020. Markit commented that “tightening financial conditions mean the financial services sector is leading the downturn, with a further steep rise in interest rates from the FOMC.” With respect to consumer services, Markit said that “the surge in household spending on goods and activities such as travel, tourism, hospitality and recreation seen in the spring has now moved into reverse as household spending is diverted to essentials.” On the other hand, Markit said that the weakening of the economy has led to an easing of inflationary pressure.
The services PMI for the 19-member Eurozone fell from 53 in June to 51.2 in July, a six-month low that signals a significant deceleration in activity. The decline was led by Germany and Italy, with PMIs of 48.1 and 47.7, respectively, indicating declining activity. For Germany, this was a 25-month low. For Italy it was an 18-month low. The PMIs for France and Spain remained in positive territory. Market commented that, for the Eurozone, “a much hoped-for surge in consumer spending after the easing of pandemic restrictions is being thwarted as households grow increasingly concerned about the rising cost of living, meaning discretionary spending is being diverted to essentials such as food, utility bills and loan repayments.” In fact, the European Union reports that, in June, Eurozone retail sales volume (adjusted for inflation) fell 1.2% from the previous month and was down 3.7% from a year earlier. Excluding food and petrol, retail sales volume was down 2.6% from the previous month and down 4.8% from a year earlier.
As in the United States, Markit said that inflationary pressure in Europe is likely easing. However, it said that “easing of inflation could fail to materialize if energy prices spike higher as we head towards the winter.” Regarding Germany, Markit said that the earlier revival of the services sector has now hit significant headwinds “from soaring energy and food prices and a sharp drop in confidence across the economy.”
The services PMI for the United Kingdom showed deceleration in July. The PMI fell from 54.3 in June to 52.6 in July, still a moderate level of growth. Markit noted that “reduced levels of discretionary consumer spending and efforts by businesses to contain expenses due to escalating inflation have combined to squeeze demand across the service economy.” On the other hand, Markit said that input price inflation eased in July, “likely reflecting lower commodity prices and a gradual easing of global supply shortages.”
In China, services activity continued to grow at a brisk pace in July, similar to June, following a dramatic decline in activity in May related to lockdowns. The PMI increased from 54.5 in June to 55.5 in July. There was a combination of accelerated demand and reduced pressure on capacity as evidenced by a decline in backlogs. Unlike in Europe and North America, there was an increase in inflationary pressure. Markit said that “concerns over the possibility of future Covid outbreaks remained.” The revival of China’s services sector bodes well for a return to normal economic growth in the third quarter.
The rate hike did not shock investors, but the comments by the BoE were surely shocking. The BoE predicted that inflation will peak at 13% in the fourth quarter, driven largely by the impact of rising natural gas prices. Moreover, the BoE says that the rise in gas prices, fueled largely by the deteriorating relationship between Russia and Western Europe, is already leading to a sharp decline in real incomes. It expects that the average price paid by British households for fuel will rise by 75% later this year. It also expects that, over the next year, real (inflation-adjusted) income will decline by 5% even after accounting for fiscal support from the government. This would be the biggest decline since the 1960s.
Going forward, the BoE expects that the United Kingdom will fall into recession in the fourth quarter and that real GDP will decline for five quarters. This will be driven by a sharp decline in real incomes leading to declining consumer spending, despite households dipping into their savings. Interestingly, it does not expect a dramatic rise in unemployment. Rather, it expects the unemployment rate to rise to 6.25%. However, it does expect that a prolonged downturn will be successful in suppressing inflation. It anticipates that the inflation rate will drop to 2% by the third quarter of 2024.
Given the hugely pessimistic view held by the BoE about growth prospects, it is not entirely surprising that the bank appears reticent about engaging in a dramatic tightening of monetary policy. Their view seems to be that the expected surge in inflation reflects factors they cannot control and that will probably be temporary. It also expects that those factors will play the principal role in suppressing growth. Still, investors were evidently surprised by the BoE. That surprise was reflected in a decline in bond yields and the value of the pound.
The US government issues two reports on employment. One report is based on a survey of establishments, the other based on a survey of households. Let’s first look at the establishment report. In July, 528,000 new jobs were created, about twice as much as the consensus view on Wall Street. It was the biggest gain in jobs since February. In the past three months, 1.3 million new jobs were created. Employment is now at the prepandemic level but still about 5 million jobs below the prepandemic trend. In addition, job growth was strong across a wide range of industries. Strong increases in employment were reported for construction, manufacturing, retailing, transportation and distribution (including airlines), professional and business services, health care, restaurants and hotels, and local government.
The establishment survey also reports on wages. It found that average hourly earnings across all industries were up 5.2% from a year earlier, matching the lowest reported since December. With inflation running above 9%, this implies a significant loss of purchasing power for workers. Average hourly earnings were up 0.5% from the previous month, the highest monthly gain since March. This data signals that the tight labor market is not yet generating the kind of wage gains that could lead to an inflationary wage-price spiral. Recent data shows that initial claims for unemployment insurance are rising and that job vacancies are declining. This indicates that the tightness of the labor market might be easing. The separate survey of households found that the unemployment rate fell to 3.5%, the lowest since February 2020 and the second lowest since the 1960s.
How shall we interpret the surprising report released on August 5? First, one month does not make a trend. Data can be volatile and can be revised. Thus, sweeping inferences should be avoided. Still, the report is consistent with the strong job growth that took place during the first half of 2022. Moreover, we know that demand for labor has been strong as evidenced by high vacancy rates and anecdotal reports from clients. The problem in the job market has not been inadequate demand for labor. It has been inadequate supply. The August 5 report suggests that the latter problem might be abating somewhat, although employment remains well below where it would have been absent the pandemic. The problem has been lower labor force participation and much lower immigration.
The jobs report likely means that a recession has not yet begun, although jobs data tends to be a lagging rather than a leading indicator. In the past, employment had already started to decelerate sharply when recessions started. Still, the strength of the August 5 report might increase the probability of recession by compelling the Federal Reserve to tighten monetary policy faster.
The Federal Funds rate directly affects what banks charge one another for short-term funding, but importantly, it provides a benchmark for such credit products as adjustable-rate mortgages, consumer loans, and interest rates on credit cards. As such, the Fed action will likely have a rapid negative impact on credit market conditions, thereby quelling activity in the credit markets. This is meant to reduce the growth of aggregate demand in the economy so as to reduce inflationary pressure. The policy can no doubt succeed in reducing inflation. The question remains as to whether it can do so without setting off a recession.
In its announcement, the Fed noted that, although spending and production have softened, employment growth has been robust in recent months. This fact exacerbates inflation, which is already high due to the pandemic and the war in Ukraine. Thus, monetary policy is meant to suppress demand in the economy but cannot affect the pandemic or war situations.
In his press conference, Fed Chair Powell said that another 75-basis-point increase could happen in September, but that it will be data-dependent. More notably, he said that “as the stance of monetary policy tightens further, it likely will become appropriate to slow the pace of increases.” Powell also said that, although he is not trying to engineer a recession, and although he thinks one can be avoided, “we think it’s necessary to have growth slow down. We actually think we need a period of growth below potential in order to create some slack, so that the supply side can catch up.” In choosing policy, Powell said the Fed would closely watch economic growth, labor market conditions, and inflation itself.
In response to the Fed action, equity prices increased sharply while bond yields fell moderately. Investors evidently saw the Fed’s action as increasing the likelihood that inflation will be suppressed. Moreover, they were likely pleased that Powell spoke about eventually easing the pace of tightening.
o Employment, the most important measure of the economy’s economic performance, has been growing at a very strong pace.
o Nondefense capital goods shipments grew in June and have been growing steadily for some time.
o A decline in inventories subtracted two percentage points from growth. This means that final demand was still positive (about 1.1% growth). Inventory swings of this magnitude do happen and may impel businesses to try to rebuild inventory levels, something that could add to growth in the third quarter.
Although the United States is not likely in a recession, the GDP report was troubling in that it shows a significant deceleration in economic activity. Although the decline in inventories explains the decline in GDP, it also points to weakness in demand, which could bode poorly for growth in production. Among the components of GDP that declined were private nonresidential fixed investment, residential investment, Federal nondefense spending, state and local spending, and inventories. The categories that saw growth included consumer spending, exports, imports, and Federal defense spending.
Within business investment, there was strong growth of investment in intellectual property (software, research and development) but declines in spending on equipment and structures. Within consumer spending, there were declines in spending on both durable and nondurable goods, but a strong increase in spending on services.
The weakness of the GDP report likely reflects the negative impact of the Federal Reserve’s policy. It’s sale of government bonds led to a sharp rise in bond yields. This in turn caused the sharp rise in mortgage interest rates, which explains the decline in residential investment. The decline in business investment likely reflects a worsening of sentiment combined with fears of higher borrowing costs. On the other hand, the exceptionally strong growth of exports of both goods and services suggests that global demand for US products remains strong—despite the rise in the value of the dollar.
Finally, consumer demand remained moderately strong despite declining real incomes. This suggests that consumers have been dipping into the massive savings they accumulated during the pandemic. The sharp rebound in spending on services suggests a return to normalcy, with a drop in demand for home-related goods more than offset by a sharp increase in spending at restaurants and other service providers.
Moreover, in June, the US government also released more recent data on consumer income and spending. Despite a real (inflation-adjusted) decline in consumer disposable income, real spending grew modestly as consumers continued to save less.
Here are some details: In June, real disposable personal income was down 0.3% from the previous month and down 3.2% from a year earlier. The decline was due to two factors. First, government transfers were down from a year earlier as stimulus funding receded. Second, and more importantly, wage income did not keep pace with inflation. Thus, consumers fell behind in real terms. However, they offset this by reducing their saving. The personal savings rate fell from 5.6% in May to 5.2% in June. The result was that real consumer spending increased 0.1% from the previous month and was up 1.6% from a year earlier. Still, the spending numbers have decelerated in recent months, evidence of a weakening of the consumer sector. But the ability of consumers to dip into their savings has stabilized spending and helped to prevent a recession—at least for now.
Over the past year, consumers have been shifting away from spending on goods and toward spending on services. This reflects the view that the pandemic is no longer a problem and that it is safe to go out and interact with other people. As such, real spending on durable goods in June was down 3.1% from a year earlier, spending on nondurables was down 2.9%, and spending on services was up a strong 4.1%. However, this trend appeared to temporarily reverse in June when real spending on durables increased a robust 0.9% from May to June, nondurables fell 0.4% from May to June, and spending on services increased a paltry 0.1%. It is not clear why this happened.
The government also reported on the Federal Reserve’s favorite measure of inflation, the personal consumption expenditure deflator, or PCE-deflator. The report found that consumer prices were up 6.8% from a year earlier in June and up 1% from the previous month—a big increase. When volatile food and energy prices are excluded, the core PCE-deflator was up 4.8% from a year earlier and 0.6% from the previous month. The latter figure is relatively high and suggests that underlying inflation got worse in June. Given that this is the inflation data that the Federal Reserve most closely follows, it is expected to influence their decision-making in the coming month.
Going forward, the US economy is at risk of recession, especially if the Fed (as is likely) continues to tighten monetary policy. Moreover, the rapid weakening of the European and Chinese economies bodes poorly for continued strong US export growth. If, however, commodity prices come down further, this will ease pressure on consumers and might lead to an acceleration in consumer spending. Thus, a recession might be averted. Or, at the least, a recession in the next year could be relatively mild.
In the second quarter, real GDP in the Eurozone was up 4% from a year earlier and up 0.7% from the previous quarter. The latter number means growth was at an annual rate of 2.8%. Compare that to the negative GDP growth in the United States in the second quarter. Evidently, the Eurozone economy was in excellent shape. This was likely due, in part, to strong consumer demand for tourist services. With the pandemic receding, people were eager to return to their previous love of travel. This was reflected in strong growth in France, Italy, and Spain—significant tourist destinations. On a quarterly basis, real GDP was up 0.5%, 1%, and 1.1% in these countries, respectively—very strong rates of growth. Moreover, in these three countries, real GDP was up from a year earlier by 4.2%, 4.6%, and 6.3%, respectively. On the other hand, GDP stalled in Germany, not rising at all from the previous quarter and up only 1.5% from a year earlier.
Looking forward, there are several factors that bode poorly for continued strong growth. These include a continued tightening of monetary policy by the European Central Bank (ECB); declining real incomes as inflation exceeds wage gains; and the risk of a Russian cutoff of gas during the winter months.
Here are the details: Consumer prices in the Eurozone were up 8.9% in July versus a year earlier, a record increase since the birth of the euro. Yet prices were up only 0.1% from the previous month, the lowest monthly rate since July 2021. Moreover, when volatile food and energy prices are excluded, core prices were up 4% from a year earlier, also a record high. Yet core prices actually declined 0.2% from June to July. Of course, the main difference between headline and core inflation was the behavior of energy prices, which were up 39.7% from a year earlier but were up a relatively modest 0.4% from the previous month. Oil prices have declined but natural gas prices have increased.
By country, consumer prices declined 1.1% in Italy from June to July, declined 0.5% in Spain, and increased a modest 0.3% in France. On the other hand, prices were up a more robust 0.8% in Germany. Prices also declined in Belgium and Greece. Prices increased the most in the Netherlands, up 2.1% from the previous month.
The cutback, if sustained, will reduce the likelihood that EU members will be able to accumulate sufficient stocks by the winter to avert shortages. The current goal is to hit 80% of storage capacity, but this is increasingly unlikely. Meanwhile, EU governments have jointly pledged to reduce consumption of gas by 15%, with exemptions for those member states that are less dependent on Russian gas. At the same time, the evident shortage of Russian gas deliveries to Europe has led consumers of liquid natural gas (LNG) to furiously seek new supplies, setting off competition between European states and such countries as Japan and South Korea. The latter are reported to be fearful that shortages in Europe will lead to increased European demand for LNG.
What happens next? If the cutback in supplies from Russia is sustained, and assuming European governments are unable to fully offset the cutback with alternative supplies, it is likely that, in some countries, there will be rationing of gas. This will likely mean limits on industrial use, thereby leading to a sharp decline in manufacturing output. Moreover, the sharp increase in the cost of heating homes will eat into consumer purchasing power. The result will likely be a recession.
For the ECB, this will create a conundrum. Its policy of tightening monetary policy is meant to address inflation. Yet the lion’s share of inflationary pressure is coming from the rise in energy prices over which the ECB has no control. All it can do is engineer a slowdown or recession by suppressing aggregate demand. Yet if a recession is already coming, the ECB might be reluctant to tighten severely and make it worse. Indeed, the ECB has been far more cautious about tightening than the central banks of the United States, the United Kingdom, and Canada.
The good news is that, with the help of Turkey and the United Nations, an agreement was recently reached between Russia and Ukraine to ease constraints on the export of grain that were due to a Russian blockade of Black Sea ports. This blockade contributed to a sharp rise in prices and shortages in key markets. The Ukrainian Navy reports that export operations have resumed at three Black Sea ports that had been closed since the start of the Russian invasion. This is important because Ukraine and Russia are among the biggest grain and fertilizer producers in the world. They supply some of the most populous countries in the world. The biggest purchasers of Russian and Ukrainian wheat, for example, are Egypt, Turkey, Indonesia, Bangladesh, and Nigeria.
Also, even before this deal was reached, global food prices had begun to decline. This might have reflected a strong harvest in Russia combined with expectations that restrictions would eventually be eased. Also, the weakening global economy probably contributed to the downward movement of prices. On the other hand, the decline in prices does not mean that the crisis in global food distribution is over. The war, plus climate problems, are hurting food production. A US official said, “I’m more worried about 2023 than 2022.” One problem is that, in the last few months, production of grain in Ukraine fell sharply due to the war. This, combined with restrictions on distribution, meant that farmers had limited income. That, in turn, limits their ability to invest in next year’s production. The fear is that output in 2023 will be substantially limited.
Meanwhile, climate change is rearing its ugly head in the global food market. This year has seen unusually high temperatures in numerous locations, declines in water levels, and drought. This means more crop failures and shortages of water used for food production. Here in southern California, much of our water comes from the runoff when snow melts at nearby mountains. Yet, with higher temperatures, there is less snow and more rain. Hence, there is less accumulated snow available for runoff. In Italy, drought has led to a shortage of water that could reduce grain production this year by 50%. Similar stories abound in many parts of the world.
Unless climate change reverses, which seems unlikely in the near term even if governments take major steps to reduce carbon emissions, then the world likely faces problems in food production and distribution in the coming years. Not only will this mean more hunger and malnutrition, it could also mean more political and social unrest. Moreover, this trend could undermine the progress and benefits of globalization. That is, if producing countries seek to limit exports of food to guarantee domestic supplies, there could be a reduction in trade that would reduce the efficiency of food production and distribution.
Cover image by: Sylvia Chang