Weekly global economic update
What’s happening this week in economics? Deloitte’s team of economists examines news and trends from around the world.
A disconnect between reality and perception in the United States
- The headline on the cover of the latest Economist magazine calls the US economy “the envy of the world.” And yet, surveys find that few Americans think the economy is doing well. Some think the economy is in recession while many think that inflation remains high. Why is there such a disconnect between the actual economic numbers and perceptions about the state of the economy?
First, consider the numbers. The International Monetary Fund (IMF) predicts that US GDP growth in 2024 will be 2.8%, a stellar number that is far higher than the likely long-term ability of the economy to grow. Meanwhile, the unemployment rate, at 4%, is historically low. Plus, the Federal Reserve’s favorite measure of inflation is now well under 3%, meaning that inflation is essentially gone. By any measure, this is a spectacular set of circumstances, especially following the huge disruption that emanated from the pandemic and the initial stages of the Ukraine-Russia war. Moreover, the US economy is far outperforming most other industrial economies.
So why the negative sentiment? There are a couple of potential explanations. First, many Americans were evidently shaken by the sharp rise in food prices during the pandemic. The price of food increased 27% from just prior to the pandemic while the overall consumer price index was up 21%. This is not a huge difference, but previously Americans had become accustomed to relatively stable food prices. Food is purchased frequently, so the price change is something that is noticed acutely. Meanwhile, the prices of durable goods have declined sharply since peaking while food prices continue to rise modestly. This is likely a source of frustration. Second, interest rates, although declining, are much higher than pre-pandemic levels. This has an impact on the willingness to purchase automobiles and homes, as well as stifling the ability to sell homes. That, too, is a source of frustration. Third, prior to the pandemic, Americans had become accustomed to stable prices over a long period of time. The sudden sharp rise in prices was jarring. And although prices are no longer rising sharply, they are now much higher than the levels to which people were accustomed in the past. Many people have asked me when prices will drop back to previous levels. My answer is that it doesn’t work like that, and that we really don’t want deflation. Evidently, many people don’t recognize that their wages have mostly kept up with prices, rendering them with relatively unchanged purchasing power.
Finally, Americans are likely to believe the talking points of the party to which they are affiliated. Thus, politics plays a role in perceptions about the economy.
More comments on bond yields and currencies
- Since mid-September, the yield on the US Treasury’s 10-year bond has increased by roughly 60 basis points. This, in turn, has had a significant impact on currency values. For example, the value of the US dollar versus the Japanese yen has increased from 141 yen per dollar in mid-September to 153 yen per dollar today (conversely, the value of the yen has fallen sharply against the dollar).
The rise in US bond yields reflects both expectations of higher inflation and expectations of a different trajectory for Federal Reserve policy. The shift in expectations came about because the US economy turned out to be stronger than previously anticipated. The strong employment report for September, released in early October, played a role in shifting expectations. Recent data on retail sales also confirmed a strong US consumer sector.
Notably, the so-called breakeven rate, which is a measure of bond investor expectations of long-term inflation, has risen about 20 basis points since mid-September. This means that expectations of higher inflation only explain some of the 60-basis-point increase in the bond yield. Rather, changes in expectations regarding Fed policy also played a role. The Fed is now expected to be more cautious in easing monetary policy because the economy remains more resilient than expected. It means that the Fed must worry that an excessively easy monetary policy will overstimulate the economy, thereby boosting inflation. That worry will likely inhibit Fed easing.
The rise in US bond yields has shifted expectations for the yield differential between the US and other countries, thereby boosting the value of the dollar against major currencies. The most notable shift has been the value of the Japanese yen. After having bottomed at around 160 yen per US dollar, the yen started to appreciate sharply in July when investors started to expect a sharp tightening of Japanese monetary policy combined with easing of US policy. The appreciation lasted until mid-September. After that, however, investors revised expectations. First, comments by the new Japanese prime minister led to expectations that the Bank of Japan (BOJ) might slow or stop monetary tightening. Second, the rise in US bond yields added to negative sentiment about the yen, causing a depreciation. A similar trend can be seen for the euro and the British pound.
Where do we go from here? Much will depend on the trajectory of both US monetary and fiscal policy. My expectation is that the Fed will gradually reduce the benchmark interest rate, each time by 25 basis points. If the economy appears stronger than expected, or if inflation fails to continue receding, the Fed might skip cutting rates at one or more meetings. Under this scenario, bond yields will likely either stabilize or eventually decline, but gradually.
As for fiscal policy, much will depend on who wins the presidential election, and which party controls each house of Congress. Both US presidential candidates favor tax and spending policies that would be expansive to varying degrees, thereby potentially boosting inflation and causing higher interest rates. However, much will depend on the makeup of the Congress with which they must contend. A divided Congress would reduce the likelihood of a very expansive fiscal policy. A trade policy, however, that involves much higher tariffs would likely boost inflation, thereby potentially changing the calculus for the Federal Reserve.
Finally, the yen/dollar exchange rate will partly depend on the actions of the BOJ, or more precisely expectations of such actions. If investors expect the BOJ to continue its tightening policy, then the yen will appreciate. Moreover, BOJ decisions will likely be influenced by what the Federal Reserve does.
How to potentially boost growth in Europe
- The debate about how to revive the European economy continues. Recently, former European Central Bank (ECB) President Mario Draghi was commissioned by the European Union (EU) to report on how to end Europe’s productivity slump and revive growth. Now, the IMF is entering the debate, offering its own ideas on how to fix Europe.
First, consider the problem. In the 1990s, labor productivity in the EU was slightly higher than in the United States. This reflected considerable investment in labor-saving and labor-augmenting technologies in Europe. Still, US per capita income was higher than in Europe simply because Americans, on average, worked longer hours than Europeans. Today, however, US labor productivity is significantly higher than in Europe, the result of relatively rapid productivity growth in the United States versus slow or no growth in Europe. This reflected large US investment in technology, facilitated by a strong system of venture capital investment. This has led to a significant increase in the per capita income gap between the United States and Europe. Many policymakers in Europe are afraid that, if this pattern is not reversed, Europe will fall far behind the United States.
Moreover, European policymakers are likely worried that failure to improve living standards will create frustrations that will boost the impulse toward populist politics on both the right and the left. Plus, given that Europe’s population is growing more slowly than that of the United States, total GDP will fall even further behind the US, thereby reducing Europe’s influence on global economic and geopolitical issues.
Thus, what should be done? Mario Draghi suggested increased investment, financial market reforms aimed at facilitating more venture capital investment, and more regional integration to support large-scale investment in research, technology infrastructure, and human capital. The IMF has offered similar suggestions. It says that the fundamental problem is that productivity has stagnated, especially in technology. Specifically, it says that “a larger and more integrated single market for goods, services, and capital will incentivize investment, innovation, and generate scale benefits. Deepening European integration will also strengthen economic resilience by insulating businesses and labor markets from global fragmentation pressures.” Both Draghi and the IMF emphasize that it is not enough for individual European countries to implement reforms. Rather, integration is key to achieving scalar benefits.
The IMF’s vision is actually fairly similar to the vision of those who were responsible for creating the single market and the Eurozone. However, Europe has been challenged to fully implement that integrated vision, restrained by national government concerns about a loss of sovereignty and control. Meanwhile, the pandemic created a negative fiscal shock from which the region is still recovering, although the pandemic did lead to the first significant effort at fiscal integration. Large budget deficits and government debt inhibit expenditures on joint investments within the EU. Yet the hope is that the accelerating competition from leading-edge companies in the United States and China might cause policymakers to kickstart new efforts to boost productivity.
Inflation in the Eurozone recedes further
- Inflation in the 20-member Eurozone has receded faster than previously expected. Plus, economic activity in the Eurozone remains stagnant. Consequently, there is a growing expectation that the ECB will speed up the process of easing monetary policy. In this cycle, the ECB has already cut the benchmark rate three times, each by 25 basis points. Yet it is reported that ECB officials are considering speeding up the process. Meanwhile, in a television interview, ECB President Christine Lagarde said “the direction of travel: clear. Pace: to be determined.”
In September, headline inflation in the Eurozone was below the ECB’s target of 2% (at 1.7%). Plus, economic activity appears poor. Moreover, the IMF is predicting real GDP growth in 2025 of only 0.7%. Although the ECB has a single mandate to minimize inflation (unlike the US Federal Reserve, which has a dual mandate to minimize inflation and maximize employment), the ECB nevertheless cannot ignore the real economy. After all, economic conditions influence inflation and financial stability. Therefore, a decision by the ECB to accelerate monetary easing would be based on concern about the health of the regional economy.
Although Lagarde has said that the ECB policy committee ought to be cautious in its deliberations, the Portuguese member of the committee said that “I don’t think the governing council will not be considering a faster trajectory if data tell us to do that.” An expectation of faster monetary easing will likely lead to lower bond yields and a lower valued euro against other currencies.
BRICS countries discuss a new financial architecture
- The dominant role of the US dollar in the global economy is a source of frustration to some members of the BRICS coalition, especially Russia. That is because Russia has been sanctioned by the West in ways that make it nearly impossible to engage in dollar-denominated transactions. Consequently, Russian President Putin is vetting the idea of creating a BRICS currency and, more importantly, creating alternative channels for engaging in international transactions.
One problem for Russia is that, after the start of the war in Ukraine, the major industrial economies banned Russian banks from using SWIFT, the widely used system for messaging transactions worth trillions of dollars. At the latest meeting of BRICS leaders, Russia proposed a new system for transaction messaging, which it calls the “BRICS bridge.” President Putin said, “We are not rejecting or fighting the dollar. But if we are not given the chance to use it, what can we do? We are then forced to look for alternatives.”
Meanwhile, other BRICS members likely have concerns about the possibility of future Western sanctions. However, even if such an alternative system is introduced, if it is not accepted by the large Western powers, it might not be efficacious for facilitating much of the trade and cross-border financial movements that take place in the global economy. On the other hand, if this alternative system is introduced, it could lead to greater fragmentation of the global economy.
Also, at the latest BRICS meeting, Russia promoted an idea that had first been discussed at the last BRICS meeting. That is the creation of a BRICS currency. While Russia is especially keen on this idea, it is not clear that the other members are particularly interested. For example, the finance ministers of China, India, and South Africa did not show up for a meeting last month to discuss this proposal. Their aversion might reflect concern about US intentions. The US government has said it will sanction third countries that facilitate Russia’s war in Ukraine. That can include facilitating some types of trade that have been sanctioned by Western powers.
Finally, the BRICS countries hope to create a more cohesive organization that might eventually challenge the dominance of the G7. The BRICS countries account for a bit more than one-third of global GDP and a larger share of trade in certain commodities. For example, President Putin said, “BRICS countries are among the world's largest producers of grains, legumes, and oilseeds. In this regard, we proposed opening a BRICS grain exchange.” Yet the problem is that the BRICS countries have little in common with one another in terms of income levels, political systems, economic structures, and geopolitical alliances. This is very different from the G7, which is a highly cohesive group. Thus, the potential for cooperative behavior is limited, especially as many BRICS countries remain heavily reliant on G7 countries for trade and investment.
Chinese economic indicators and government plans
- In China, inflation remains low. In September, consumer prices were up 0.4% from a year earlier, the lowest rate since June. Prices were unchanged from the previous month. In part, inflation was sustained by rising food prices, which were up 3.3% from a year earlier, including a 16.2% increase in the price of pork. The rise in food prices was mainly the result of poor weather. Energy prices also fell. When volatile food and energy prices are excluded, core prices were up only 0.1% in September versus a year earlier, the lowest rate since February 2021. Core prices were down 0.2% from the previous month. Moreover, the prices of airfares and hotels were down as demand for travel eased.
In response to the inflation report, the price of oil fell sharply on concerns about the weakness of the Chinese economy. The low inflation likely reflects weak domestic demand at a time when production of goods is strong, thereby leading to excess capacity and downward pressure on prices. Indeed, producer prices were down 2.8% in September from a year earlier, the sharpest decline since March. Moreover, the retail price of electric vehicles sold in China fell 6.9% from a year earlier. This is an indication of excess capacity, especially at a time when Chinese electric vehicles (EVs) are being hit by high tariff barriers in the United States and Europe. Meanwhile, with export growth receding (see below), investors likely worry that the government will not take sufficient action to boost domestic demand. The weak inflation numbers once again raise questions about what the government ought to do to boost growth.
China’s government recently signaled an intention to use fiscal policy to kick start a weakening economy, but so far has not provided the kind of details that investors likely crave. Recently, China’s finance minister attempted to provide more information about his intentions. Lan Fo’An said that there will be four policies: providing support for local governments to reduce their debt burden; issuing special purpose bonds to boost bank capital; using local governments to halt the downturn in the property market; and providing aid to students to support spending.
With respect to local governments, the minister said that there will be a one-time large increase in the debt ceiling for local governments. In addition, local governments will be permitted to use special bonds to purchase unused land from property developers, to purchase existing homes, and to provide subsidies for home ownership.
In addition, Lan said that there are “other policy tools that are under study” and that “there is still relatively large room for the central government to increase debt and raise the deficit.” However, when asked about the size of a potential addition stimulus, Lan did not provide details. It appears that this has not yet been decided.
- In the third quarter of 2024, China’s real GDP grew 4.6% from a year earlier, the slowest rate in six quarters and lower than the 4.7% growth recorded in the second quarter. Moreover, it is below the government’s 5% target. On the other hand, it was faster than investors had anticipated. Plus, real GDP was up 0.9% from the second to the third quarter. In addition, there were some positive signs from monthly indicators such as retail sales and industrial production. On the other hand, as previously reported, export growth was weak in September. Finally, many investors anticipate an uptick in growth in the coming quarters, provided that the government implements a large fiscal stimulus.
Regarding retail sales, they were up 3.2% in September versus a year earlier, the fastest growth since May. Some categories saw strong growth. These included grain, oil, and food (up 11.1%), appliances and AV equipment (up 20.5%), and medicine (up 5.4%). On the other hand, there was a 4.5% decline in spending on cosmetics, a 7.8% drop for jewelry, and a 6.6% drop for building materials. Retail sales are not adjusted for inflation. Although overall inflation in China is exceptionally low, food prices have risen, which partly explains the strong growth of spending on food.
China’s industrial production also performed well in September. It was up 5.4% versus a year earlier, the fastest increase since May. This included a 5.2% increase in manufacturing output and a 10.1% increase in utility output. Within manufacturing, non-auto transportation was up 13.7%, computers and communication up 10.6%, and metal smelting up 8.8%.
Chinese fixed asset investment in the first eight months of 2024 was up a modest 3.4% from a year earlier. Investment in manufacturing, however, was up 9.2% while investment in utilities was up 24.8%. On the other hand, investment in property was down 10.1%.
China’s exports grew slowly in September after four consecutive months of rapid growth. In September, exports (measured in US dollars) were up 2.4% from a year earlier, the slowest rate of growth since April. Exports were up 2.2% to the United States, 1.3% to the European Union, 5.5% to Southeast Asia, and 16.6% to Russia. Chinese customs officials cited extreme weather and related shipping disruption as reason for the slowdown in exports. Also, declining prices of domestic goods in China have had a spillover effect on export pricing, thereby suppressing reported exports.
Also, imports into China were up only 0.3% in September versus a year earlier, the slowest pace since June. Imports were up 6.7% from the United States and up 4.2% from Southeast Asia. However, imports from the European Union declined 4%. There was a big increase in imports of high technology products as well as basic metals, but a sharp decline in imports of rare earth minerals. The weakness of imports might reflect weak domestic demand. It could also reflect weak demand for exports that require imported inputs.
Meanwhile, China’s central bank introduced a scheme to encourage non-bank financial institutions to purchase equities. The result was a sharp increase in Chinese equity prices, despite the weak economic growth. Yet the more important fiscal stimulus program has yet to be announced.
Bond investors uncertain about inflation and Fed policy
- In the United States, the yield on the 10-year Treasury bond is now at roughly the highest level since late July. Why have bond yields risen at a time when the Federal Reserve is cutting interest rates? After all, the Fed usually cuts rates when it believes that inflation is falling while the economy is weakening. In this case, the rise in yields reflects investor concern that inflation will be higher in the coming years than previously expected. We know this because the so-called breakeven rate has risen sharply in recent weeks.
Just a quick refresher on the breakeven rate: This is calculated by subtracting the yield on Treasury Inflation Protected Securities (TIPS) from the yield on regular bonds. TIPS are securities where the principal value moves in line with inflation. Consequently, the yield on TIPS is the inflation-adjusted, or real, yield. The difference between the headline yield and the TIPS yield, is expected inflation. This is known as the breakeven rate.
The breakeven rate for the 10-year bond rose from 2.02% on September 10th to 2.33% by the end of last week. Meanwhile, the yield on the 10-year bond rose from 3.64% on September 10 to 4.04% now. The rise in the bond yield was, therefore, largely related to increased expectations of inflation. The increase in both the breakeven rate and the 10-year yield took place right after the Fed announced a 50-basis-point cut in the benchmark interest rate.
The rise in yields suggest that investors might believe the Fed is acting too quickly, especially given the evident strength of the US economy. The employment numbers for September, which were far better than anticipated and were released after the Fed cut interest rates, revealed that the US labor market remains unusually strong. Moreover, the inflation report for September revealed that core (underlying) inflation accelerated slightly. Meanwhile, the Fed continues to signal an intention to keep cutting rates, albeit at a moderate pace.
Notably, US equity prices have soared lately. This reflects optimism about growth combined with expectations of lower interest rates. Moreover, even though expectations for inflation have risen, the 10-year breakeven rate remains at 2.33%. This means that investors expect inflation to average 2.33% in the next 10 years—not a bad performance and close to the Fed’s 2% target. From an investor perspective, this is a sweet spot. Investors evidently don’t expect the Fed to over-stimulate the economy. Rather, they appear to expect the Fed to implement a policy that is slightly more loose than optimal.
One Fed Governor, Christopher Waller, often considered a monetary policy hawk, is warning that policy should not be too easy. He said that “I view the totality of the data as saying monetary policy should proceed with more caution on the pace of rate cuts than was needed at the September meeting.” However, he did not suggest that the trajectory of policy should be changed. Rather, he said that the US economy is in a “sweet spot” and that he wants it to stay there.
- Optimism about the outlook for the US economy and for lower interest rates has led to a sharp decline in yield spreads. The gap between the yields on investment grade corporate bonds and US Treasury bonds fell to the lowest level since 2005. In addition, the gap between the yields on high yield (junk) bonds and US Treasury bonds fell to the lowest level since 2007.
Yield spreads are also called risk spreads. That is because they reflect investor perception about the risk of holding risky assets versus non-risky Treasuries. The fact that spreads have fallen indicates that investors have become less concerned about the risk of default. The impact of declining spreads will likely be increased credit market activity. We have already seen a sharp rise in transactions undertaken by private equity and venture capital funds. Further issuance of bonds is likely. On the other hand, yields remain higher than they were prior to the recent inflation surge.
ECB cuts rate again
- For the third time since June, the European Central Bank (ECB) has cut its benchmark interest rate by 25 basis points, bringing it down to 3.25%. This was not a surprise. Within the Eurozone, inflation has fallen to a low level and the economy has exhibited weakness. While the job market remains tight, wage growth has eased somewhat. Thus, from the perspective of the ECB, a loosening of monetary policy is warranted. It is likely that the ECB will continue to take such action in the months to come.
The recent inflation numbers in the Eurozone were better than the ECB had forecasted earlier this year. Christine Lagarde, president of the ECB asked, “Have we broken the neck of inflation? Not yet. Are we in the process of breaking that neck? Yes.” Her hesitation to declare victory likely reflects continued strong growth of prices of services, which reflect rising wages in a tight labor market.
Still, if Lagarde does not believe that inflation is defeated, why is she pursuing a policy of monetary policy easing? The likely answer is that she and her colleagues are concerned lest the lagged impact of a tight monetary policy push the Eurozone economy into a downturn. It is clearly very fragile while the hope is that easing policy will provide some support to credit creation.
Finally, although domestic demand in Europe is weak, exports had been seen as a potential source of offsetting growth. Yet it is reported that, in August, EU exports to China were down 11% from a year earlier, likely a reflection of weak domestic demand in China. It is hoped that a potential Chinese government stimulus might reverse this trend.
US inflation and Federal reserve sentiment
- The US consumer price index (CPI) continued to decelerate in September. The government reported that, in September, the CPI was up 2.4% from a year earlier, the lowest rate of inflation since February 2021. Prices were up 0.2% from the previous month. The deceleration was largely prompted by a sharp drop in energy prices and very slow growth of food prices. When energy and food are excluded, core prices were up 3.3% from a year earlier. This was higher than the 3.2% core inflation reported for August. It was the first time since March 2023 that core inflation had risen from the previous month. Still, the September rate of core inflation was the second lowest since April 2021. Meanwhile, core prices were up 0.3% from the previous month.
The details are of interest. In September, prices of durable goods were down 2.9% from a year earlier while prices of non-durable goods were down 0.7%. On the other hand, prices of services were up 4.7%. The latter included a 4.9% increase in the price of shelter. In fact, when shelter is excluded, the overall CPI was up only 1.1% from a year earlier. Thus, the housing market is one of the biggest contributors to remaining inflation. In recent months, the shelter component of the CPI has decelerated modestly.
Although the drop in inflation was smaller than most investors had anticipated, bond market reaction to the inflation news was relatively muted. The inflation report did nothing to change expectations regarding Federal Reserve policy. The inflation report will be one of the key data points the Fed considers when it meets again in November. It is now widely expected to cut rates by 25 basis points in November.
Until recently, the Fed’s principal concern was the tightness in the labor market and its impact on wage growth. Yet recently, Fed Chair Powell said that the labor market is no longer contributing to inflation. He was evidently pleased that labor market tightness had eased. On the other hand, the recent stellar jobs report unnerved some investors as it suggested the labor market remains strong. Moreover, the government reported that wages had accelerated in September. Thus, the Fed has countervailing influences with which it must contend.
- Meanwhile, the Federal Reserve released the minutes of its last policy meeting, which took place on September 17–18. Keep in mind this was before the release of the stellar report on job growth in September. Thus, the policymakers were not yet aware of the unusual strength in the job market. The minutes reveal, however, that committee members were aware of the relative strength of the economy.
Yet, despite that strength, they felt that inflation was moving in the right direction. Specifically, the minutes indicate that “participants observed that inflation remained somewhat elevated, but almost all participants judged that recent monthly readings had been consistent with inflation returning sustainably to 2%. Some participants commented that, though food and energy prices had played an important part in the decline in the overall inflation rate, slower rates of price increases had become more evident across a broad range of goods and services.”
Committee members felt that the sustained decline in inflation was due to “a further modest slowing in real GDP growth, in part due to the Committee’s restrictive monetary policy stance, well-anchored inflation expectations, waning pricing power, increases in productivity, and a softening in world commodity prices.” In addition, members cited an easing of wage pressure. They attributed this to a slowdown in job growth. Again, they were not yet aware of the strong job growth that took place in September. Interestingly, the members said that a further cooling of the job market was not required to get inflation down to 2%.
The members believed that the risks of higher inflation and weaker employment are now roughly equal. The members also were confident that the 2% target would be met reasonably soon. As such, they decided that an easing of policy was warranted. The vast majority favored the 50-basis-point cut that was agreed upon. They “observed that such a recalibration of the stance of monetary policy would begin to bring it into better alignment with recent indicators of inflation and the labor market. They also emphasized that such a move would help sustain the strength in the economy and the labor market while continuing to promote progress on inflation and would reflect the balance of risks.”
Finally, the members indicated that, even after the 50-basis-point cut, the monetary policy stance would remain restrictive. Moreover, they indicated a move toward a more neutral monetary policy is now warranted. Thus, further rate cuts would be the favored path.
- A senior Federal Reserve official says that the US is in a good position to pull off a soft landing. John Williams, president of the Federal Reserve Bank of New York, and generally seen as the second most important official at the Fed, said that “the current stance of monetary policy is really well positioned to both hopefully keep maintaining the strength that we have in the economy and the labor market, but also continuing to see that inflation comes back to 2%.”
Williams’ comments followed the unusually strong employment report for September. That report led investors to boost their expectations for 25-basis-point rate cuts rather than 50 points. Williams said that “it made sense, as the chair said, to recalibrate policy to a place that is still restrictive and is still putting downward pressure on inflation, but significantly less so.” He added that “I don’t want to see the economy weaken. I want to maintain the strength we see in the economy and in the labor market.” Williams also suggested that two more 25-basis-point rate cuts this year is a “very good base case.” On the other hand, he acknowledged the risk of higher oil prices, something that might cause an adjustment in Fed plans.
Meanwhile, the President of the Boston Fed, Susan Collins, said that steady interest rate reductions are warranted. She said that “preserving the current favorable economic conditions will require adjusting the stance of monetary policy so as not to place unnecessary restraint on demand.” She added that “the recent data, including September’s unexpectedly robust jobs report, bolster my assessment that the labor market remains in a good place overall—neither too hot nor too cold.” Her comments suggest confidence in the soft-landing scenario.
ECB concerned about weak growth
- The Eurozone and the United States have had similar experiences over the past two years. Both saw inflation rise to the highest level in 40 years. Both saw their central banks tighten monetary policy significantly. And both have seen their central banks now start to ease policy. Yet the similarities end there. While the US economy continued to experience relatively strong growth, despite tight monetary policy, the Eurozone economy barely grew. Indeed, the largest member of the Eurozone, Germany, experienced recession. The differences reflect the more onerous impact of Russia’s energy shock on Europe than on the US. They also reflect different responses of consumers to the pandemic and to monetary tightening. US consumers were far more likely than Europeans to dip into the excess savings they accumulated during the pandemic.
Now, as the European Central Bank (ECB) evaluates its next move, its chief economist, Philip Lane, is indicating concern that monetary policy might not being sufficiently loosened given the weakness of the regional economy. The ECB minutes of the last policy meeting indicate Lane told the policymakers that the trajectory of Eurozone inflation is favorable. The minutes state that Lane “concluded that confidence in a timely return of inflation to target was supported by both declining uncertainty around the projections, including their stability across projection rounds, and also by inflation expectations across a range of indicators that remained aligned with a timely convergence to target. The incoming data on wages and profits had been in line with expectations.”
As such, Lane said that an easing of monetary policy is warranted, noting that policy remains restrictive even after the initial decline in interest rates. This provides the ECB with flexibility should inflation rear its ugly head again. Indeed, Lane said that, should inflation remain persistent, or should the economy accelerate more than expected, policy could remain tight. However, Lane noted the slower-than-expected economic growth seen in the second quarter and worried that incoming data point to further weakness ahead. Moreover, cautiousness on the part of consumers likely bodes poorly for a rebound in consumer spending. Consequently, it might become necessary to speed up the process of interest rate reduction, especially given that the restrictive stance of monetary policy is still hurting credit creation.
Finally, the ECB committee members noted the slowness of productivity growth in the Eurozone, a factor that contributed to persistent inflation and low economic growth. They lauded the recommendations of Mario Draghi concerning structural change in the regional economy. The committee members also expressed concern about geopolitical uncertainty, especially the risk that events in the Middle East might influence oil prices in a way that boosts inflation. Thus, policy flexibility remains important.
India worried about EU climate policy
- The European Union (EU) will implement its Carbon Border Adjustment Mechanism (CBAM) in 2026. This entails taxing imports based on the carbon emissions involved in producing the goods. The tax is also applied to domestically produced products. As such, the EU claims that this is not a protectionist measure as it applies equally to domestic- and foreign-produced goods. The goal is to discourage carbon emissions. Goods produced without carbon-emitting energy will not be taxed.
Despite the EU claim that the measure is not protectionist, it has generated considerable criticism and angst overseas. The finance minister of India, Nirmala Sitharaman, said that the CBAM will hurt the development of emerging nations, thereby reducing their ability to pay for the energy transition. Specifically, she said that the CBAM is a “trade barrier” and that it will stifle the green transition.
Currently, India generates more than half its electricity by burning coal. Thus, the CBAM applied to Indian exports to the EU will be substantial and likely hurt export volume. This, in turn, will hurt economic growth, thereby reducing the ability to make the energy transition. Yet absent the CBAM, European companies would be at a competitive disadvantage. The implementation of the CBAM has already been postponed once. It is not clear if this will happen again.
South Korea adjusts pension system to address demographics
- South Korea is a rich country, but it faces a daunting problem. Because of an aging population and the world’s lowest fertility rate, the ratio of workers to retirees is dropping fast, likely leading the country’s pension fund to run out of money by 2055, when today’s 35-year-olds retire. South Korea’s challenge is important to note because other developed nations are facing similar trends.
According to the Korean government, the Korean pension fund reserve will peak in 2041 and then start to decline, eventually becoming insolvent by 2055. That is, of course, unless changes are made. The current government has proposed a series of reforms, including increasing the contribution to the fund from 9% of income to 13%. This follows previous increases in the contribution rate as well as the retirement age. In addition, the government proposes that benefits periodically adjust based on changing fiscal conditions of the government.
Meanwhile, South Korea’s pension system did not reach universal coverage until 1999. Therefore, many of today’s retirees do not receive full benefits. In fact, 40% of South Korea’s elderly have incomes below the poverty level. At the same time, many households have high expectations for the pension system given that South Korea has a relatively low personal savings rate. Thus, fixing the system is seen as critically important. For other countries with similar demographic challenges, South Korea’s success or failure will be of particular interest.
Vietnam economy grows strongly
- Benefiting from its attractiveness as a supply chain center, Vietnam achieved strong real GDP growth of 7.4% in the third quarter of 2024. Leaving aside the sharp rebound after real GDP collapsed during the pandemic, this was the strongest economic growth since 2017. When I am asked which countries I expect to see grow strongly in the coming years, other than China and India, my answer is Southeast Asia, with particular emphasis on Vietnam.
Vietnam’s growth was led by exports, up 15.8% in the third quarter versus a year earlier. Exports to the United States were strong. Vietnam is home to the assembly of many consumer products headed to the United States. These products utilize inputs imported from China. As the US economy slows in the coming year, it could have a weakening effect on Vietnamese exports.
The biggest contributor to Vietnam’s export growth is electronics. In fact, electronics exports were up 20.6% in the third quarter. This included products such as smartphones, computers, and other consumer electronics. Meanwhile, global companies are investing in Vietnam to producer higher-valued added electronic products, helping Vietnam to move up the value chain.
Week of October 7, 2024
The US job market is much stronger than expected
- The general sentiment among observers of the US economy has been that the labor market is slowing down, thereby leading to slower growth for the US economy. Yet the latest jobs report from the government will likely cause investors to rethink their expectations. The report indicated a stunning level of job growth and a decline in the unemployment rate. In response, bond yields increased, equity prices rose modestly, and the value of the US dollar rose against major currencies. The jobs report suggests that the US economy is indeed headed toward a soft landing—just not as soft as previously expected. Let’s look at the details.
First, the US government releases two reports on the job market. One is based on a survey of establishments, and the other is based on a survey of households. The establishment survey found that, in September 2024, 254,000 new jobs were created. This was the greatest monthly number since March and far exceeded investor expectations. The increase included 25,000 new jobs in construction, 15,600 in retailing, 17,000 in professional services, 71,700 in health care and social assistance, 78,000 in leisure and hospitality, and 29,000 in state and local government. Other categories experienced only modest gains, or, as in the case of manufacturing, a decline in employment. Meanwhile, average hourly earnings were up 4% from a year earlier—the biggest increase since May. Evidently the tightness in the job market is causing a modest acceleration in wage gains, despite declining inflation. That, in turn, might be of concern to the Federal Reserve, unless productivity grows commensurately.
The survey of households, which includes examination of self-employment, found that employment grew nearly three times faster than the size of the labor force. The result was that the unemployment rate fell from 4.2% in August to 4.1% in September. This was the second consecutive month in which the unemployment rate declined.
What does this mean for Fed policy? On the day before the jobs report was released, futures markets were pricing in a 68% probability that, at the Fed’s next policy meeting in November, there will be a 25-basis-point cut. On the day of the release, however, that probability rose to 94%. In other words, many investors interpreted the strong job growth as significantly reducing the likelihood of a 50-basis-point cut. Many investors now expect the Fed to act more cautiously, especially as the jobs report indicates some acceleration in wage growth. Moreover, this view is consistent with recent comments by Fed Chair Powell, in which he signaled a likely gradual approach to interest-rate reduction.
Meanwhile, the 10-year breakeven rate, which is an indicator of bond investor expectations for average inflation in the next 10 years, has increased modestly in the past several weeks. The breakeven rate was 2.02% on Sept. 10, 2024. As of Oct. 3, 2024, it was 2.21%. It is at the highest level since late July. Investors evidently have upwardly revised their expectations for inflation based on the strength of the US economy. Still, they continue to expect relatively low inflation.
US household income and consumer spending grow modestly
- In August, real (inflation-adjusted) disposable income and consumer spending in the United States both increased modestly and at the same pace. It appears that the consumer side of the US economy is normalizing, with modest growth following a period of disruption. In August, real disposable income (income after taxes and inflation) was up 0.1% from the previous month. In addition, real consumer spending was up 0.1% from the previous month. The personal savings rate fell modestly, from 4.9% in July to 4.8% in August. It seems that households have halted the previous sharp reduction in savings, which helped to fuel strong spending growth.
The increase in spending was entirely due to a rise in purchases of services. There was no change in spending on either durable or nondurable goods.
Also, the government reported on the Fed’s favored measure of inflation—the personal consumption expenditure deflator, or PCE-deflator. This measure was up 2.2% in August versus a year earlier. This is well within the Fed’s target range. In addition, when volatile food and energy prices are excluded, core prices were up 2.7% from a year earlier—also within the Fed’s target range. Prices of durable goods were down 2.2%, nondurables were up 0.2%, and services were up 3.7%.
Fed Chair Powell recently said that, while interest rates are likely to come down, the committee does not feel “like it is in a hurry to cut rates quickly.” As such, he suggested that the committee will revert to 25-basis-point cuts in the months to come, rather than the sharp 50-point cut that took place in September. The latest report on both consumer spending and the PCE-deflator will likely confirm this point of view.
Finally, Chair Powell said that the September rate cut “reflects our growing confidence that, with an appropriate recalibration of our policy stance, strength in the labor market can be maintained in an environment of moderate economic growth and inflation moving sustainably down to our objective.”
Eurozone inflation continues to ease
- Inflation in the eurozone has fallen below the European Central Bank’s (ECB’s) 2% target. In September 2024, consumer prices were up only 1.8% from a year earlier—the lowest in three years. The ECB has already begun to cut interest rates, but only slowly for fear that inflation is not defeated. The latest report suggests otherwise.
Meanwhile, when volatile food and energy are excluded, core prices were up 2.7% in August 2024 versus a year earlier. This was the lowest since February 2022. In addition, energy prices were down 6%, food prices were up 2.7%, and non-energy industrial goods prices were up a mere 0.4%. On the other hand, services prices continued to rise significantly, up 4%. This hasn’t changed much for several months. Indeed, service inflation was 4% in November 2023. The price for services has been a factor in restraining the ECB from effecting rapid interest-rate cuts. Yet, the weakness of the eurozone economy is a good reason to continue cutting rates.
It is widely expected that the ECB will, again, cut its benchmark rates by 25 basis points, when it meets again later this month. Moreover, this expectation has increased. Following the inflation report, bond yields in major eurozone economies fell sharply, reflecting expectations of lower, short-term interest rates. Plus, the value of the euro fell sharply. However, equity prices fell, likely reflecting pessimism about the state of the eurozone economy.
BIS offers a sobering view of future central bank policy
- Greater volatility in the global economy could lead to more frequent periodic price spikes. Yet, a more protectionist trade environment means that trade will provide less of a shock absorber for price movements. The result is that central banks might have to raise interest rates more frequently than in the past. This is the view of the deputy general manager of the Bank for International Settlements (BIS), which is the central bankers’ central bank.
Andrea Maechler pointed to geopolitical conflict, climate change, and trade disputes as boosting the frequency of sudden price movements. She said that such shocks are becoming “larger and more frequent.” She added that “this may require adjustments to the conduct of monetary policy. At times, forceful monetary tightening will be needed to ensure that inflation expectations remain anchored.”
The problem, she said, is that onerous demographics have caused persistent labor shortages. This, combined with trade restrictions, implies that unexpected shocks could have a greater impact than otherwise. Maechler said that “all this means that inflation could become more volatile, raising the risk that economies transition more easily from self-stabilizing low-inflation regimes to self-reinforcing high-inflation regimes.” Thus, monetary tightening might have to take place more frequently than previously. The implication of this analysis is that, if central banks fail to respond to periodic shocks, we could face a new era of permanently higher inflation.
Bank of Japan urged to slow down monetary easing
- In Japan, the recent spurt of inflation has eased considerably while the economy remains relatively weak. The Bank of Japan (BOJ) has begun to tighten monetary policy after a prolonged period of easing but has been cautious lest it stifle economic recovery. Moreover, although it has welcomed a rise in the value of the yen, it likely wants to avoid a sharp increase that might hurt export competitiveness.
Into this environment comes BOJ Governor Asahi Noguchi. He said that, while a rise in interest rates is warranted, the movement ought to be slow to avoid hurting the economy. He said that “if economic and price developments move in line with our forecasts, we will adjust the degree of monetary support albeit at a slow pace.”
Meanwhile, Japan’s new Prime Minister, Shigeru Ishiba, said that the economy is not ready for further interest-rate increases. Specifically, he said that “I do not believe that we are in an environment that would require us to raise interest rates further.” He said this after meeting with the governor of the BOJ. His comments caused a drop in the value of the yen to a one-month low and an increase in Japanese equity prices. Moreover, his comments were somewhat surprising, given his reputation for being a monetary policy hawk. Still, given that he will soon face voters in a snap election, higher interest rates would hardly be helpful to election success.
Global manufacturing industry continues to weaken
- The condition of the global manufacturing industry seems to be worsening: That is according to the latest purchasing managers’ indices (PMIs) for manufacturing published by S&P Global. PMIs are forward-looking indicators meant to signal the direction of the industry. They are based on subindices such as output, new orders, export orders, pricing, employment, inventories, and sentiment. A reading above 50 indicates growing activity—the higher the number, the faster the growth.
The global PMI—a composite of the PMIs of the 32 countries analyzed—fell from 49.6 in August to 48.8 in September, indicating accelerated decline in activity. All subindices worsened from August to September, and most of them were below 50. Of the 32 countries analyzed, only 10 had PMIs above 50, with the remaining 22 standing below 50. The countries with the highest PMIs were India, Philippines, Brazil, and Spain. The countries with the lowest PMIs were Germany, Austria, Turkey, and France.
The major countries/regions with growing manufacturing activity were the United Kingdom, India, ASEAN (Southeast Asia), and Taiwan. The major countries/regions with declining activity were the United States, eurozone, Japan, China, and South Korea. Within the eurozone, only Spain and Greece had growing activity.
The US manufacturing PMI fell slightly to 47.3 in September, indicating moderate decline. Output fell at the fastest pace in 15 months. New orders fell further, leading to a decline in employment in the industry. S&P noted that “spending, investment, and inventory-building have been paused in many cases amid the uncertainty caused by the presidential election.” On the other hand, the prospect of lower interest rates has boosted confidence.
In Europe, the manufacturing PMI for the 20-member eurozone fell to 45.0—a nine-month low. This was led by Germany where the PMI fell to 40.6—a 12-month low. Although Spain’s manufacturing sector exhibited momentum, it was not nearly sufficient to offset the worsening state of German manufacturing. Meanwhile, S&P reported that new orders are “plummeting fast,” boding poorly for future output. Plus, employment is falling rapidly. Also, despite the decline in demand, S&P reports that companies are struggling with supply chain problems, leading to delays and shortages. The state of eurozone manufacturing might compel the ECB to accelerate monetary easing.
Meanwhile, British manufacturing is in much better shape. The PMI fell but remained at 51.5 in September, indicating modest growth of activity. This was driven by relatively healthy domestic demand. On the other hand, confidence is declining as companies worry that a restrictive fiscal policy will dampen demand.
Turning to Asia, the manufacturing PMI for China worsened, falling from 50.4 in August to 49.3 in September, indicating a modest decline in activity. Although output increased modestly, there was a downturn in new orders and export orders. Indeed, new orders fell at the fastest pace in two years. The result was a further problem of excess supply. Employment fell and confidence deteriorated. The issue of insufficient demand is what has driven calls for more fiscal stimulus.
The manufacturing PMI for Japan fell slightly to 49.7 in September, indicating modest decline in activity. Output and new orders both declined. Employment grew very slowly while confidence remained positive, although it fell to the lowest level in two years. In addition, neighboring South Korea also saw a decline in manufacturing activity after having grown in the previous month.
The best performing manufacturing industry in the world was in India, where the PMI declined slightly to 56.5, indicating rapid expansion. All subindices were strong but decelerated from the previous month. In addition, Taiwan’s manufacturing PMI declined to 50.8, indicating modest growth. Finally, the PMI for ASEAN fell to 50.5, with the strongest growth in Singapore and the sharpest decline in Myanmar.