Weekly global economic update
What’s happening this week in economics? Deloitte’s team of economists examines news and trends from around the world.
Increasing talk about recession risk in the United States
- The US Administration is reacting to market concerns that tariffs and tariff uncertainty could have negative consequences for the US economy. In a meeting with reporters, President Trump said that he will not rule out recession or higher inflation. He suggested that the current policy adjustment will have costs, but that they will produce positive results over time. Specifically, he said that “there is a period of transition, because what we’re doing is very big. We’re bringing wealth back to America. That’s a big thing, and there are always periods, it takes a little time.” He also dismissed concerns that his policies are creating uncertainty for business.
Meanwhile, although Trump acknowledged the possibility of recession, market indicators still do not necessarily point in that direction. There have been some indicators pointing to a slowdown in growth, but not an outright contraction in activity. However, it is worth recalling that, when downturns have come in the past, they were often a surprise. Forward-looking indicators are often not good at predicting turning points. In any event, Trump’s comments on the possibility of recession were quickly followed by a very sharp decline in US equity prices, with the S&P 500 hitting the lowest level since September. The tech-heavy NASDAQ was down 4%. For both indices, it was the worst day since 2022.
Separately, US Commerce Secretary Howard Lutnick acknowledged that tariffs could lead to inflationary pressure. Specifically, he said “so, will there be distortions? Of course, foreign goods may get a little more expensive, but American goods are going to get cheaper.” Regarding American goods, it is important to note that a majority of US imports are intermediate goods used by US companies to produce goods and services. As such, there is a strong likelihood that tariffs will boost domestic production costs, thereby leading to higher prices for American goods.
Also, US Treasury Secretary Scott Bessent, in acknowledging the possibility of higher prices due to tariffs, said that “access to cheap goods is not the essence of the American dream.” Rather, he defended tariff policy on other grounds. He talked about “what tariffs are designed to address: leveling the playing field such that the international trading system begins to reward ingenuity, security, rule of law, and stability. Not wage suppression, currency manipulation, intellectual property theft, non-tariff barrier, and draconian regulations.” Although these issues are important, he did not make it clear how tariffs would resolve them.
- With increasing discussion in the media and in politics about recession risk, the question arises as to whether there is indeed a serious risk of recession. It is hard to know. In the past, recessions often, but not always, were not strongly signaled by the data. Moreover, sometimes when the data screamed recession, a recession did not actually happen. Still, there are some cautionary signs about the US economy, suggesting a potential slowdown in the near term if not recession. What are those signs?
First, an index of consumer confidence published by the University of Michigan fell sharply in February. It declined from 71.1 in January to 64.7 in February, the lowest level since November 2023. The decline was led by a 19% drop in the sub-index for buying conditions for durable goods. Evidently, consumers became more averse to such purchases due to fears of tariff-fueled price increases. Moreover, they likely responded to weakening financial conditions. Indeed, the sub-index for expected financial conditions fell 10%. On the other hand, inflation expectations soared. The increase in the sub-index for inflation expectations was the biggest gain since May 2021.
Consumers were not alone in having weakened confidence. An index of small business confidence published by the National Federation of Independent Business (NFIB) fell in February for the second consecutive month. NFIB commented that “economic policies are raising concerns among firms that depend on imports or export, as tariffs are being broadly applied and retaliated against, changing the prices of imports and exports. The federal government is shedding workers and trimming expenditures. Many small firms are supported by assisting firms with government contracts. How these developments are resolved will shape the economy’s future.” It concluded that “confidence that the economy will continue to grow is fading.” Meanwhile, the survey found that NFIB members are increasingly worried about inflation.
Another warning sign came from the latest employment report for February released recently by the US government. The overall report was quite favorable, with a healthy increase in the number of employed. Yet within the report were troubling signals regarding under-employment. Specifically, the household survey found that, although the headline unemployment rate increased modestly from 4% in January to 4.1% in February, a broader measure of unemployment that encompasses discouraged and part-time workers (known as U-6) increased sharply from 7.5% in January to 8% in February. This was the highest rate since October 2021 and the biggest monthly jump since during the pandemic. This rise in U-6 suggests that the labor market is softening after a long period of tightness.
Finally, financial markets are signaling concern. Often, but not always, sharp movements in asset prices portend changes in the real economy. In recent weeks we have seen softening of equity prices, a decline in bond yields, and a drop in the value of the US dollar. Loss of wealth in financial markets can influence spending decisions. Volatility can stifle risk taking. Thus, the financial situation, if not soon reversed, could have consequences.
US inflation decelerates, but risk remains
- Inflation in the United States was lower than anticipated in February. This fact applied to both headline inflation and core inflation, to both year-over-year and month-to-month inflation. Along with signs of a possible slowing of economic activity in the United States, this inflation news bolsters the likelihood that the Federal Reserve will engage in multiple interest rate reductions this year. In fact, the futures markets are pricing in a 60% probability of three or more rate cuts this year. That is up from a 7.4% probability one month ago—a dramatic change reflecting big changes in investor views on the current and expected state of the US economy. Let’s look at the inflation data.
In February, the consumer price index (CPI) was up 2.8% from a year earlier, down from 3% in January and the lowest rate of annual headline inflation since October. Energy prices were down while food prices rose more slowly than headline inflation. Thus, when food and energy are excluded, core prices were up 3.1% in February from a year earlier. This was the lowest figure since April 2021. This is notable as core inflation has been relatively steady for the past half year. Now, underlying inflation appears to be decelerating.
Among the notable price changes revealed in the government’s inflation report were a 58.8% increase in the price of eggs. This was largely due to avian flu and has become a huge source of consumer frustration as well as some very funny videos on social media. In addition, the price of smartphones fell 13.7%, tomatoes were down 9.7%, and cigarettes were up 7.8%.
More broadly, prices of durable goods were down 1.2%, non-durables excluding food and beverages were down 0.2%, and prices of services were up 4.1%. Although this remains too high, it is the lowest rate of services inflation since December 2021. This fact is likely important to the Federal Reserve. For a long time, services inflation has been driving overall inflation. Moreover, services tend to be labor intensive while a tight labor market has driven up wages. Yet lately, the Fed has indicated labor market conditions are no longer fueling inflation. Plus, data suggests that the tightness of the job market has eased. Also, gains in labor productivity have offset the inflationary impact of rising wages. Thus, there are plenty of reasons for the Fed to be more comfortable about potentially easing monetary policy.
Moreover, the Fed has a dual mandate from the US Congress. It is charged with minimizing inflation and maximizing employment. With signs that the economy could be slowing and that the job market is weakening, and with signs that underlying inflation is easing as well, it is not surprising that investors now expect the Fed to engage in multiple interest rate reductions this year. If that happens, it will likely lead to lower bond yields, lower mortgage interest rates, a boost to housing activity, and a boost to private equity deals and overall M&A activity. Lower interest rates could help minimize the risk of recession.
On the other hand, if the US administration imposes sizable tariffs on major trading partners (which is by no means certain), this could change the trajectory of inflation and Fed policy. High tariffs would be inflationary, at least temporarily, thereby reducing the likelihood of interest rate cuts. Also, tariffs would reduce consumer purchasing power and hurt the competitiveness of US producers, thereby slowing the economy. That, in turn, could lead the Fed to maintain an aggressive policy stance. Thus, a high degree of uncertainty remains. Uncertainty, of course, can have a stifling impact on business investment.
Meanwhile, the only significant tariffs that had been imposed by February were the additional 20% tariffs on imports from China. As of February, this did not yet have an impact on import prices. Yet an impact will likely come, thereby potentially affecting US inflation. Plus, tariffs on steel and aluminum went into effect today. Tariffs on imports from Canada, Mexico, the European Union, Japan, and South Korea remain on the table.
Europe’s pivot to increased defense spending could boost growth
- There is a growing consensus in Europe that defense spending ought to be increased substantially. A recent survey found that only 16% of Europeans see the United States as a reliable ally. Aside from the geopolitical impact, increased European defense spending could be the tool by which European growth is revived through fiscal stimulus, especially as it will likely be financed through increased borrowing. Faster growth would mean that European assets become more attractive to global investors, thereby boosting the value of the euro. Faster growth likely means higher borrowing costs and slower easing of monetary policy by the European Central Bank (ECB).
In the process of developing a joint defense capability outside the NATO umbrella, Europe could set the stage for boosting the global role of the euro. Joint issuance of debt by the European Union (EU) would move Europe in the direction of creating a large and liquid secondary market for European debt that might one day challenge the dominance of US Treasury securities. It is the vast US market for debt that, in part, enables the dollar to be the world’s dominant currency. Yet it is likely that European governments and investors would like to reduce dependency on dollars.
One key to Europe’s fiscal revival is Germany, Europe’s largest economy, where the incoming government is likely to engage in a degree of debt issuance that would have been considered nearly unthinkable just a short time ago. This change in thinking has been facilitated by the change in US policy toward Europe. A survey of economists by the Financial Times found that Germany could boost debt by nearly two trillion euros with impunity, especially given that the country’s current debt/GDP ratio is relatively low. German government debt is the benchmark against which all other European government bonds are measured. If there is a dramatic increase in the volume of German government debt, this could enable the euro to become a partial alternative to the US dollar as a reserve and trading currency.
Financial markets react to the latest US trade policy decisions
- Following the US election in November, US equity prices soared on expectations that a combination of tax cuts and deregulation would boost US economic growth, thereby increasing corporate profits. Yet, since that time, most of the economic news has focused on tariffs rather than taxes. Tariff increases are expected to be inflationary and potentially lead to tighter monetary policy. In addition, tariff increases are expected to subdue aggregate demand by reducing consumer purchasing power. Finally, tariffs are expected to hurt the competitiveness of US manufacturers by boosting the cost of imported inputs. Thus, it is not surprising that US equity price indices have fallen back toward the pre-election level. Plus, it is not surprising that equity prices in other markets have fallen on fears of the potential impact of tariffs. There have been especially sharp declines in equity prices for automotive companies in anticipation of massive supply chain disruption due to trade restrictions.
What is surprising, however, is that investor expectations about monetary policy have shifted. Following the election, an expectation of lower taxes, less regulation, higher tariffs, and less immigration led to expectations of higher inflation. This, in turn, led futures markets’ implied probability that the Fed would cut rates several times in 2025 to decline sharply. It became conventional wisdom that the Fed would engage in a wait and see policy for much of 2025, possibly cutting rates only once if at all. Yet lately, expectations have changed, and the futures markets are now predicting as many as three rate cuts in 2025. What happened?
The answer is that the policy of tariffs, combined with uncertainty about tariffs, have led to increased angst on the part of many business leaders. Indeed, the composite purchasing manager’s index (PMI) for the United States fell sharply in February from the previous month, hitting a 17-month low, suggesting an expectation that the US economy will soon start to decelerate if not contract. If the US economy slows down or contracts, that would likely necessitate an easing of monetary policy. Recall that the Fed has a dual mandate from the US Congress: It must minimize inflation while maximizing employment.
Also, it is notable that once the tariffs were implemented the value of the dollar did not rise sharply as normally expected. Here is why the dollar ought to rise: The trade deficit is due to an excess of investment over savings. When a country invests more than it saves, it must experience an inflow of foreign capital to make up the difference. This requires that foreigners accumulate excess dollars. This happens when foreigners sell more to the United States than they purchase (a trade surplus for the foreigners). Thus, if tariffs are introduced, which initially cut demand for imports, there is a drop in demand for foreign currency, thereby boosting the dollar. In addition, something must happen to maintain the trade deficit so long as the gap between investment and savings endures. A rise in the value of the dollar will boost imports and reduce exports, thereby preserving the trade deficit.
The recent experience, however, is troubling. Although the dollar rose sharply against the Mexican peso when the tariffs were introduced, the dollar movement against other major currencies was more muted than expected. Why?
One reason for dollar softness is that investors now see a significant likelihood of a slowdown in the US economy. All other things being equal, a weaker economy means a weaker currency. Plus, the expectation of a weaker economy has led to an expectation of an easier monetary policy. That, too, implies a weaker currency. Thus, the future trajectory of the dollar could be different than previously anticipated.
Another factor driving down the dollar could be the decision by Germany’s two largest parties to engage in massive borrowing to fund defense and infrastructure. This has led to a rise in European bond yields, thereby boosting the value of the euro. Also, investor expectations regarding actions by both the US Federal Reserve and the European Central Bank have shifted substantially in the past few months.
One possibility is that investors are becoming worried that the dominant role of the dollar will decline amid a weakening of the global trading system. Previously, the United States was one of the world’s most open economies, playing a role as the market of last resort for the world’s producers. It also provided a safe haven for investors experiencing risk elsewhere. Yet now, some investors worry that a world in which large trade barriers are erected might become a world in which the dollar is far less attractive.
On the other hand, there is no currency that can easily substitute the role currently played by the US dollar. The United States has a massive, deep, and liquid market for easily substitutable government securities, something the euro lacks. China has capital controls, which makes it nearly impossible for the renminbi to play a major role. No other currency has sufficient scale to challenge the US dollar.
- Investors have been shifting funds toward lower-risk assets as uncertainty, especially regarding tariffs, undermines confidence. Equity prices have been falling, with the Magnificent Seven down 16% from its peak. The tech-heavy NASDAQ index is down 10%. Meanwhile, funds have been pouring into money market funds, which hit a record high volume this week.
The decline in equities reflects not only concern about the potential economic cost of tariffs, but the chilling effect of tariff uncertainty. Consider that, in recent weeks, large tariffs were imposed on Mexico and Canada and then mostly removed, but only for 30 days. There have been several policy reversals on tariffs. Plus, there have been several tariff proposals that have not been implemented. And there have been multiple reasons offered for imposing tariffs. As such, businesses don’t know what to expect and might fear making the wrong long-term decision about allocating capital. This is especially true for companies that must make large, long-term bets such as those in the automotive industry.
Europe shifts gears
- Faced with a dramatic shift in the policy of the United States toward Europe and Ukraine, European governments and the European Union (EU) are engaged in a dramatic shift as well, one that could have significant economic implications. Recent statements by senior US officials about the US role in Europe and its policy toward Ukraine have been a shock to senior European officials. The consequence of this has been a radical shift in European official views about spending on defense.
First, Germany’s two major political parties, the center-right CDU/CSU and the center-left Social Democrats, which will likely form a government together, endorsed a major increase in spending on defense and infrastructure. The former is meant to deal with the Russian threat, the latter to address a shortage of investment that has held back economic growth. The plan calls for creation of two funds worth roughly 900 billion euros. This is a massive shift in policy.
There remain political hurdles to passing the necessary legislation. Specifically, the constitution must be changed to allow a much higher level of government borrowing. This will likely be done by the current Parliament before the newly elected one is seated.
Still, investors evidently expect that the German reforms will take place, given the sharp reaction in financial markets to the plan. Since the announcement recently, the yield on Germany’s 10-year government bond increased by 38 basis points, the biggest short-term rise in nearly 30 years. In addition, the euro surged against the dollar, reflecting a shift in the interest differential between Germany and the United States. Also, it is notable that, since early January, German equity prices have significantly outperformed US equities, evidence that investors had already anticipated some form of German fiscal stimulus. Plus, investors were likely disappointed that the focus of US policy has been tariffs rather than tax cuts and deregulation.
If the German plan is implemented, it is expected to do four important things. First, it will likely be a fiscal stimulus to the German economy that has suffered from sub-par growth. Second, it could kickstart public investment, helping Germany to catch up after a period of inadequate investment. Third, the stimulus to Germany’s economy will likely have a positive spillover impact on the rest of Europe, helping to boost growth while, at the same time, rendering higher borrowing costs (this is already happening). Finally, the surge in spending on defense will potentially play a role in supplying Ukraine at a time when US support is in question.
Second, European Commission President Ursula von der Leyen has urged a large increase in region-wide spending on defense, funded by releasing the cap on borrowing. Specifically, she wants to allow EU members to violate the current rule governing the share of GDP that can be borrowed each year, so long as the increased borrowing is meant for increased defensive capabilities.
In addition, von der Leyen foresees increasing overall European defense spending by 800 billion euros, part of which would be used to buttress Ukrainian defenses. If this happens, it could provide a region-wide fiscal stimulus while, at the same time, boosting the level and cost of government debt.
Notably, European defense company equity prices have lately soared on expectations of increased government spending. Meanwhile, some European leaders have talked about using increased funds to purchase US-made weapons for Ukraine. In doing this, Europe would assure Ukrainian defenses while, at the same time, boosting imports from the United States. The latter would be meant to discourage the United States from imposing tariffs on imports from Europe.
US job growth decelerates
- In the United States, employment continued to grow at a healthy pace in February, although slower than investors had anticipated. Meanwhile, the unemployment rate inched up slightly. The US government releases an employment report that is based on two surveys: One is a survey of establishments; the other is a survey of households. First, we look at the establishment survey results:
In February, the US economy generated 151,000 new non-farm jobs, of which 140,000 were in the private sector. There was strong growth in construction and modest growth in manufacturing. In the realm of services, employment declined for retailing, professional services, leisure and hospitality, and the Federal government. On the other hand, there was strong growth for transportation and warehousing, health care, and local government. In other categories, there was modest growth. Equity prices continued their decline following release of the jobs report. Evidently, investors interpreted the report as signaling slower economic growth than previously believed.
The establishment survey also included data on wages. The report said that average hourly earnings of all non-farm workers were up 4% in February from a year earlier and were up 0.3% from the previous month. These numbers indicate moderate tightness of the labor market, with wages rising modestly faster than inflation. Yet with labor productivity likely rising, the rise in wages is probably not contributing to inflation. Indeed, this is the view of the Federal Reserve.
The separate survey of households found a sharp decline in the number of people participating in the labor force. In part, this could reflect the fact that the number of immigrants entering the United States has dropped sharply since the end of 2024. Indeed, the government reported a 93% decline in the number of daily border encounters since the start of the new administration. The result was a decline in employment (including self-employment) and a modest increase in the unemployment rate from 4% in January to 4.1% in February.