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Cover image by: Sofia Sergi
First, real (inflation-adjusted) disposable personal income was unchanged from March to April. Although nominal income increased 0.4%, this was entirely offset by rising prices. However, due to a decline in the personal savings rate, real household spending increased 0.5% from March to April, the first and biggest increase since January. Notably, this involved a 1.4% increase in real spending on durable goods. In addition, real spending on nondurables increased 0.4% while real spending on services increased 0.3%.
In addition, the government reported that new orders for nondefense, nonaircraft capital goods increased 1.4% from March to April. New orders for computers were up 1.8% while new orders for transportation equipment were up 3.7%. These numbers indicate robust intentions for business investment. The data on household spending and capital goods orders suggest that the US economy remains relatively vibrant.
Meanwhile, the bad news is that inflation appears to be settling at an elevated level after having decelerated sharply. The Fed’s favorite measure of inflation, the personal consumption expenditure deflator, or PCE-deflator, increased 4.4% in April versus a year earlier. This was up from 4.2% in March. Moreover, when volatile food and energy prices are excluded, the core PCE-deflator was up 4.7% in April versus a year earlier. This was up from 4.6% in March. Since November, the core measure has moved within a narrow band between 4.6% and 4.8%. As such, it appears that underlying inflation is stuck. This is expected to be worrisome for the Federal Reserve as it contemplates either continuing to tighten monetary policy or taking a pause.
Interestingly, the lion’s share of inflation was attributable to services. Prices of services were up 5.5% from a year earlier. Prices of durable goods, however, were up only 0.8% while prices of nondurables were up 2.9%. The latter includes food which continues to see big price increases.
The minutes indicate that FOMC members believe “recent developments in the banking sector had contributed to some tightening of lending standards beyond that which had occurred during previous quarters, especially among small and mid-sized banks.” Moreover, they noted that “small businesses tend to rely on small and mid-sized banks as primary sources of credit and therefore may disproportionally bear the effects of tighter lending conditions.” They also said that “stress in the banking sector would, in coming quarters, likely induce banks to tighten lending standards by more than they would have in response to higher interest rates alone.”
On the other hand, the minutes noted that inflation remains unacceptably high, indicating “tighter credit conditions may not put much downward pressure on inflation in part because lower credit availability could restrain aggregate supply as well as aggregate demand.” As such, this leaves the Fed facing uncertainty about the appropriate path forward. The members noted “the possibility that the cumulative tightening of monetary policy could affect economic activity more than expected, and that further strains in the banking sector could prove more substantial than anticipated.” Consequently, the participants said that “in light of the lagged effects of cumulative tightening in monetary policy and the potential effects on the economy of a further tightening in credit conditions, the extent to which additional increases in the target range may be appropriate after this meeting had become less certain.” The committee agreed that it will carefully monitor economic data in the months ahead to find the right balance.
But enough about the past. Let’s consider the future. Now that China’s economy is so massive, the path that China takes in the next decade and beyond will have global implications. Can China continue to grow rapidly, thereby matching the G7 in per capita income? Or will it grow slowly, maintaining its position as a middle-income country? The answer to these questions will matter not only for China, but for the world. The path that China takes will influence global growth, global commodity markets, climate change, and geopolitics.
A debate is now underway about how fast China can grow. Michael Pettis, a well-known expert on China’s economy, says that China’s growth in the coming decade will be constrained and that the best-case scenario has China growing no more than 4% per year. His medium scenario has China growing between 1.5% and 2% per year, no more than the more mature economy of the United States. In the latter scenario, China never catches up to displace the United States as the world’s largest economy.
Why does Pettis believe that China is constrained? In part, it has to do with the nature of economic growth in the last two decades. China grew rapidly, in part, because of a massive wave of investment. This involved investment in property, infrastructure, and businesses—especially state-owned businesses. This investment was largely fueled by debt. Indeed, debt as a share of GDP, at nearly 300%, is now at a very high level relative to other emerging economies. Consumer debt has risen dramatically and is now about 30% of disposable income, an unusually large number. Pettis argues this cannot go on indefinitely, and that further increases in debt will be unsustainable.
Investment is a good thing. It boosts productivity and productive capacity, allowing future increases in output. Yet China invested too much. In the last two decades, investment averaged well more than 40% of GDP, hitting a peak of 47% in 2010. For the world economy, investment is about 25% of GDP. Many emerging economies have investment at 30%–35% of GDP while advanced economies invest around 20% of GDP. Yet China is in a class by itself. Too much investment renders excess capacity and makes it appear that the economy is growing faster than is sustainable. In China, we see this especially in the property market but also in heavy industry. In China, the return on investment in terms of incremental economic growth per renminbi invested has declined for the last few decades and is low relative to other emerging countries. This means that incremental investment has been highly inefficient, perhaps wasteful.
Pettis argues that China’s economy not only needs to rebalance away from investment but is bound to do so as the alternative is not feasible. That is, investment as a share of GDP will decline while consumption will increase. To avoid a sharp slowdown in growth due to declining investment, two things must happen. First, investment must become more efficient, with less property investment and more investment in technology in the private sector. Second, and more importantly, consumption must grow more rapidly. This will entail transferring a larger share of income to households. Pettis suggests that even if these things happen, growth will be modest, perhaps 4%. If they don’t happen sufficiently then growth will be under 2%. The path that China takes will be heavily influenced by the mix of policies implemented by the government.
Meanwhile, China’s economy already shows signs of weakness. Household spending has not rebounded as rapidly as expected, youth unemployment is up sharply, private sector investment is weak, and exports are being hurt by the slowing global economy. The troubled property sector has contracted while, with lower property prices, household wealth has been hurt. Given this weakness, as well as continued low inflation, many observers had expected the central bank to ease monetary policy. However, recently the People’s Bank of China (PBOC) left the benchmark interest rate unchanged for the ninth consecutive month, evidently concerned about further downward pressure on the currency stemming from tightening US monetary policy.
The US granted MFN status to China a generation ago, which played a major role in China’s integration into the global economy. Repeal would mean a significant increase in tariffs on almost all imports from China. Critics warn that this could have a devastating impact on US industry, which relies on Chinese inputs, drive up consumer prices and thereby reduce US consumer purchasing power, and ultimately lead to retaliation by China. Repeal of MFN would go far beyond the impact of President Trump’s tariffs on China. There is likely sufficient support for repeal to pass in the US Congress. However, there might not be sufficient support to override a presidential veto.
Not anymore. Price controls are back. In several European countries, governments have imposed controls on the retail price of food. In other countries, value-added taxes on food and other household goods have been cut. Food, especially, is of great concern. The European Union (EU) reports that, in April, while overall consumer prices were up 8.1% from a year earlier, food prices were up 16.6%, with prices of some key food items up much more sharply. For lower-income households, this is a big burden, especially given that wages are rising far more slowly than prices.
Price controls impose a burden on retailers, damaging their profit margins. This can result in shortages. The World Bank has urged European governments to use more targeted approaches to assist troubled households. This can involve government payments to low-income households. Yet many EU governments, having accumulated considerable debt during the pandemic, are not in a fiscal position to boost spending.
During the pandemic, the Federal Reserve Bank of New York created an index meant to measure global supply chain stress. The index incorporates measures of transportation costs (such as the Baltic dry index) as well as indicators of manufacturing stress (such as purchasing managers’ indices and their components). During the pandemic, the index increased dramatically. Its peak, in December 2021, was at a level four standard deviations above the average for the period 1997 to 2020. Since then, the index has declined. The New York Fed now reports that, in April of this year, the index fell to 1.3 standard deviations below the historic average. This was the lowest level since late 2008.
What are the implications of this? First, it is likely that the reduction in supply chain stress is mostly due to the weakening of the global economy. Tighter monetary policy in North America and Europe has caused a slowdown in consumer demand. Second, as the pandemic has ended, consumers have been shifting away from durable goods toward services. Third, the improvement in supply chain efficiency has likely contributed to the reduction in inflation, especially in the United States. Today, durable goods prices are actually falling. The remaining inflation mainly has to do with services.
Finally, the New York Fed reports that the lion’s share of the improvement in the index was due to “Euro Area delivery times, Euro Area stocks of purchases, and Korean delivery times.” The New York Fed said that this was partly offset by “a notable upward contribution from Taiwan stocks of purchases.”
Here is the data: Retail sales were up 18.4 percent in April versus a year earlier, up from 10.6 percent growth in March but still lower than analysts expected. The surge was due, in part, to a low base in April 2022. Despite the strong growth, some categories were weak. Auto sales were up only 5.4 percent. Sales of home appliances, communications equipment, office supplies, and building materials were all down from a year earlier. This likely reflected the troubles in the property sector.
Industrial production was up 5.6% in April versus a year earlier. In addition, fixed asset investment in the first four months of the year was up 4.7% from a year earlier. Investment in manufacturing increased 6.4% while investment in real estate fell 6.2%.
As for China’s labor market, the unemployment rate fell to a 16-month low of 5.2%. The rate for those aged 25 to 59 fell to 4.2%. On the other hand, the unemployment rate for those 16 to 24 years old rose to 20.4%, a record high. As recently as late 2021, the youth unemployment rate was a bit over 14%. With over 11 million university graduates set to enter the labor force this year, the high youth unemployment rate could be an impediment to absorbing those young workers.
Overall, the latest batch of data is consistent with other recent data indicating weakness in China’s economy. Xu Sitao expects an easing of monetary policy in response but does not expect the government to engage in a more expansive fiscal policy. Rather, he expects that the government will ease restrictive policies regarding home purchases.
Notably, this shift in the geographic destination of China’s exports coincides with a shift in the composition of exports. There has been a sizable increase in shipments of intermediate rather than final goods. Many of the products exported to Southeast Asia are intermediate goods used to assemble final goods, either for export or for the domestic market. In part, this is likely due to global companies diversifying their supply chains and relying less on final assembly in China. In addition, as China has moved up the value chain, it has shed much low value-added final assembly in favor of more sophisticated production of high-tech inputs. Given that China’s wages have surged in the last two decades, basic assembly no longer makes as much sense as in the past.
The geographic shift in China’s exports has led to a sharp increase in shipping lanes running from China to Southeast Asia, Middle East, and Africa. The cost of shipping containers to these locations has increased commensurately. Meanwhile, shipping capacity between China and North America has fallen sharply.
Let’s look at the details. In April, retail sales (not adjusted for inflation) were up 0.4% from the previous month. Spending at automotive dealerships was also up 0.4%. However, some categories saw a decline in April. These included furniture (down 0.7%), electronics stores (down 0.5%), grocery stores (down 0.4%), department stores (down 1.1%), apparel stores (down 0.3%), and gasoline stations (down 0.8%). The latter was surprising given that gasoline prices increased. This suggests a decline in driving in April.
Meanwhile, spending at nonstore retailers (mainly online shopping) was up 1.2% for the month and up 8% from a year earlier. The longer-term shift away from store-based shopping continues apace. In addition, spending at restaurants and bars was up 0.6%.
In addition, the manufacturing component of industrial production was up 1% from March to April. This included a 9.3% increase in motor vehicle production and a 2.1% increase in output of computers and electronic products. Thus, it appears that the automotive and information technology sectors played a key role in the strength of the US industrial sector. As for autos, although sales were modest in April, the industry had a low level of inventories, thus requiring a strong increase in output to prepare for future consumer demand.
Most investors reacted positively to the news, driving up equity prices to close to their highest level in more than 30 years. Domestic demand has been helped by the end of COVID-19–related restrictions. In addition, wages are rising at a relatively rapid pace, thereby boost consumer purchasing power. The strength of business investment likely reflects confidence that the recovery will continue, thereby necessitating an increase in capacity. Japan’s principal headwind is a weakened global economy as well as fraught relations with China. These factors contribute to poor export performance.
Although inflation is now at a relatively high level, it is widely expected to diminish this year, thereby reducing the need for the Bank of Japan (BOJ) to severely tighten monetary policy. Indeed, the new leadership of the BOJ has maintained the unusually easy monetary policy that has characterized the last decade.
The rise in underlying inflation was mainly due to an acceleration in inflation in services. This had much to do with supply and demand conditions. Since the government removed pandemic-related restrictions, there has been an increase in consumer demand, including demand by tourists. In fact, hotel prices were up 8.1% in April versus a year earlier.
Meanwhile, the price of food (excluding fresh foods) was up 9% in April, the highest in 47 years. The price of meals eaten away from home were up 6.6%, the highest in several decades. This surge in food prices could eat into the ability of consumers to purchase other goods and services.
The evident persistence of underlying inflation raises questions about the future path of the BOJ. It has retained the relatively easy monetary policy of the past decade. In its last meeting, it did not change the yield curve control policy. The new Governor of the BOJ has said that any change will come only if there is evidence that inflation is becoming embedded and is driven by excess demand rather than supply chain problems.
Specifically, the International Energy Agency (IEA) and others report that Russia’s oil revenue was down 43% in March from a year earlier. This was despite the fact that the volume of oil sold had increased, hitting a record level in April. One result is that Russia’s government has changed the way it taxes oil production in order to claw back some of the lost revenue. Yet this might have the effect of limiting investment in new capacity. Moreover, the net loss of revenue to the Russian government likely damages its ability to wage war.
Aside from the price cap, the West has imposed sanctions that limit Russian access to global shipping and insurance services. Consequently, it is reported that Russia is spending money to build its own network of ships and insurance companies. It has significantly boosted the sale of oil to China and India, which together now account for 80% of Russian oil sales. The Deputy US Treasury Secretary recently said that “the Russian price cap is working and working extremely well. The money that they’re spending on building up this ecosystem to support their energy trade is money they can’t spend on building missiles or buying tanks. And what we’re going to continue to do is force Russia to have these types of hard choices.”
The Fed’s report on financial stability found that despite “decisive actions” by authorities, the bank crisis could undermine the “economic outlook, credit quality, and funding liquidity” and could cause “banks and other financial institutions to further contract the supply of credit to the economy.” It also said that “a sharp contraction in the availability of credit would drive up the cost of funding for businesses and households, potentially resulting in a slowdown in economic activity.”
Meanwhile, the Federal Reserve’s survey of bank loan officers found that the share of banks that are tightening lending standards increased moderately from January to March. However, the latest survey was taken only shortly after the collapse of Silicon Valley Bank. It is likely that the next survey, which will be released in July, will indicate the degree to which the crisis has affected bank-lending intentions.
The irony of all this is that the crisis in the banking system is mostly in the minds of investors and depositors. There is no systemic problem in the banking system, at least not one that should lead to a seizing up of credit activity. It is very different from 2008 when excessive leverage led to a near collapse of the banking system. This time, a handful of medium-sized banks, with roughly half a trillion dollars in assets (in a system with US$23 trillion in assets), failed, in part when depositors got scared and moved their money elsewhere. This, in turn, led to a larger exodus of deposits from smaller banks. The shrinkage of smaller banks means less ability to deliver credit to small and medium-sized businesses, thereby hurting the economy. Sheila Bair, a former US bank regulator, said that the turmoil is “overblown” and that “there is no crisis, unless media hype and short selling pressure undermine confidence so that depositors flee otherwise health banks.”
Although the banking system remains relatively safe, there is a problem involving the balance sheets of some medium-sized banks. Many face troubles due to excessive exposure to commercial property, especially the market for office buildings as well as nongrocery shopping centers. This is exacerbated by higher interest rates. Following the pandemic, many office workers continue to work remotely, leaving many office buildings only partially occupied. Many companies are gradually reducing their office footprint. Consumer online shopping accelerated rapidly during the pandemic, a trend that has not reversed. This has rendered many retail properties troubled. The result will likely be a decline in office building and shopping center revenue and greater difficulty in servicing bank loans for office and retail construction. There will also likely be a tightening of lending conditions for office space and shopping center space on the part of banks.
Two possibilities emerge. First, some banks may face problems, potentially requiring rescue by authorities. This could have a further negative impact on credit conditions. Second, troubles in the property market can have a negative impact on construction activity and the range of industries that supply the construction industry. Still, there might also be opportunities to acquire property inexpensively and repurpose it.
Let’s look at the numbers. The government reported that consumer prices were up 4.9% in April versus a year earlier, the lowest rate since April 2021. Inflation had peaked in June at 9.1% and has been declining ever since. Consumer prices were up 0.4% from the previous month. Core prices were up 5.5% from a year earlier, down from 5.6% in March and the same as in February. This was the lowest rate of core inflation since late 2021. Still, core inflation has been in the range of 5.5%–6% since November, receding much more slowly than headline inflation. Meanwhile, energy prices were down 5.1% while food prices were up 7.7%.
Inflation appears to be sustained by the sharp rise in the price of shelter, up 8.1% from a year earlier. This reflects the lagged impact of last year’s sharp rise in home prices. However, April’s shelter inflation was slightly lower than in March. Thus, shelter inflation appears to have peaked. Now that home prices have declined, it is expected that the shelter component of the consumer price index will continue to recede throughout this year, thereby helping to further reduce inflation. In any event, if shelter is excluded, consumer prices were up a modest 3.4% in April versus a year earlier.
Consumers purchase three types of categories: durables, nondurables, and services. Prices of durables were down 0.2% in April versus a year earlier. This reflects weak demand for durable goods combined with improvements in supply chains that deliver such goods. Prices of nondurables less food were down 1.3% in April. Prices of services less shelter, however, were up 5.2% in April. Thus, the persistence of inflation is largely related to trends in the service sector.
Finally, some categories saw sharp price declines in April. These included the following: car rentals (down 11.2%), used cars (down 6.6%), health insurance (down 15.8%), and airline tickets (down 0.9%).
The bottom line is that goods inflation has largely disappeared. To the extent that inflation remains persistent, it mostly has to do with shelter and other services. This likely reflects consumer demand shifting sharply away from goods and toward services now that the pandemic is over. Going forward, given that the economy is weakening due to Fed tightening, it seems likely that inflation will continue to decelerate. From the perspectives of the Federal Reserve, the inflation report is favorable news and increases the likelihood that interest rates will be kept steady. This expectation explains the rise in equity prices following release of the inflation report. However, the Fed has indicated that its decisions will be data-driven. Thus, future decisions will depend, in part, on future inflation data.
The EU is proposing sanctions on specific Chinese companies that are said to support Russia’s war effort. This would be the first such measure by the EU to sanction China. In response, China is threatening to retaliate. A Chinese official said that China is not supplying any weapons to Russia and that economic relations between China and Russia are normal. Moreover, he said that “we are against states introducing extraterritorial or one-sided sanctions on China or any other country according to their own domestic laws. And, if that were to happen, we would react strictly and firmly. We will defend the legitimate interests of our country and our companies.”
Two Chinese companies that the EU might target are already sanctioned by the United States. German Foreign Minister Baerbock said that it is important that sanctions on Russia not be undermined by actions of third parties. She said that China is not being targeted, but only those companies that sell sanctioned goods to Russia.
Meanwhile, Chinese investment in Europe has fallen sharply. In 2022, Chinese investment in Europe was 22% below the year earlier level, hitting the lowest level in nearly a decade. In part, the decline reflects more stringent governmental rules in Europe about Chinese inbound investment. For example, a study by the Rhodium Group found that, in 10 of 16 infrastructure and technology projects sought by Chinese firms, governments stopped the projects from taking place. The governments were the United Kingdom, Germany, Italy, and Denmark. In many instances, governments rejected deals in which Chinese companies would acquire companies that make products with potential military applications.
In addition, it is reported that US and European companies are pointing to weaker-than-expected sales in China as an explanation for weaker-than-expected profits. Many had anticipated that, after China dropped COVID-19–related restrictions, and after the initial wave of infections dissipated, Chinese demand for goods and services would soar. Some analysts even worried that an overheated Chinese economy would lead to a surge in oil prices, thereby fueling a rebound in global inflation. Instead, China’s economy has recovered only modestly.
Why is China’s growth subpar? One explanation is that Chinese consumers are holding back. They are being cautious, in part, because they have been pummeled by volatility in the property market, which is an important source of their wealth. In addition, global demand for China’s exports is weakening due to the weakened global economy. Also, trade tensions between China and the United States and other Western countries have a negative impact not only on trade of goods but also on cross-border investment.
China’s weakness is important to the global economy. A weaker Chinese economy has negative implications for export growth for other major economies. It likely implies somewhat slower global economic growth this year than previously anticipated. However, weaker growth in China could help to suppress energy prices, thereby further enabling inflation in the West to decelerate.
In addition, after a surge in March, China’s trade with the rest of the world is easing. In April, imports fell at a record pace while exports grew at a more modest pace. Imports were down 7.9% in April from a year earlier. Exports were up 8.5%, far slower than the March numbers. Moreover, April’s numbers were distorted by very weak performance in April 2022.
The weakness of imports likely reflects both weak domestic demand as well as weak external demand. The latter implies fewer imports of inputs used in producing exportable goods. The weakness of external demand reflects the weakening of the economies of the United States, Europe, and many emerging markets. Notably, South Korean exports to China were down 26.5% in April versus a year earlier. South Korea supplies China with inputs used to produce exportable goods. In addition, China’s imports of coal, copper, and natural gas were all down in April, likely due to weak domestic demand.
Xu Sitao, chief economist of Deloitte China, offers his thoughts on the latest inflation report for China:
Even before the US Federal Reserve was approaching the end of its tightening cycle, it made sense for Chinese monetary policy to take precedence over fiscal stimulus because the latter tends to skew to large infrastructure projects. In light of decelerating headline inflation in the United States, a compelling case can be made for the PBOC (China’s central bank) to lower interest rates. Today, all Chinese banks were asked to lower the ceiling on the rates of “agreement” and “call” deposits starting on May 15. This can be seen as a prelude to the reduction of interest rates. Meanwhile, given that interest differentials between the RMB and the USD are likely to widen with expected easing in China, some minor weakening of the RMB is necessary for the PBOC’s monetary easing to gain traction.
The Institute of International Finance (IIF) says that there has been a surge in exports from key countries to Russia’s neighbors. Specifically, it found that exports from China, Germany, Japan, and the United States to Belarus, Kazakhstan, Turkey, and Georgia have increased sharply in the past year. Particularly noteworthy was the tripling of Chinese exports to Belarus in the past year. The IIF says that it does not know what products were shipped, but it suggests the possibility that such exports are undertaken to avert sanctions on Russia.
Meanwhile, Nikkei found that US-made semiconductors are flooding Hong Kong and then being sent to Russia. The G7 group of industrial nations is discussing ways to limit this flow. The G7 is also concerned that, although G7 trade with Russia has fallen sharply, Russian trade has increased sharply with China, India, and Turkey. Specifically, G7 exports to Russia were down 50% in 2022 versus a year earlier and imports were down 10%. That represented a US$52 billion decline in trade. Yet that was more than offset by a US$103 billion increase in Russian trade with China, India, and Turkey. Although the West shut off Russia from US dollar denominated transactions, Russia has substantially increased transactions in Chinese renminbi.
In response, Russia has increased taxes on oil producers. However, this will have an onerous impact on the ability of energy producers to invest in new capacity. Thus, Russia is attempting to boost short-term revenue to wage war, even at the expense of a longer-term loss of energy capacity. Moreover, as European governments take steps to obtain alternative sources of oil and gas, and as they accelerate investment in clean energy, Russia’s long-term prospects diminish.
In any event, the mix of sanctions and the oil price cap have already wreaked havoc with the Russian economy. This is despite Russia’s efforts to boost sales of energy to India, China, and elsewhere. In three of the four quarter of 2022, real GDP fell from a year earlier. It was down 2.7% in the fourth quarter. Retail sales were down 5.1% in March versus a year earlier and have been declining ever since the start of the war.
This transaction has evidently been welcomed by investors who feared that a more disruptive failure of the bank would have serious repercussions, potentially causing yet a new banking crisis. Equity prices are stable as are yields on government bonds. Risk spreads are also stable, having surged when Silicon Valley Bank failed and then reverting to a lower level when authorities quickly intervened. Although there are other mid-sized banks known to be problematic, the good news is that, so far, fears about the stability of those banks are not having a negative impact on the stability of financial markets.
Still, there is reason to be concerned. Many mid-sized banks are heavily exposed to loans for office buildings and shopping centers, many of which could become troubled as people increasingly work and shop remotely. The result could be a substantial write-down of those loans, thereby putting pressure on banks that have already seen a big exodus of deposits. Moreover, as mid-sized banks shrink, the availability of credit to small and medium-sized businesses could be disrupted.
The exposure of troubled banks began after the Federal Reserve raised interest rates. This has often been the case historically and should not be a surprise. Yet the contagion that followed the failure of Silicon Valley Bank, and which resulted in a decline in bank lending, had the same effect on credit markets that a further Fed tightening would have. From the Fed’s perspective, further tightening might not be necessary if markets are already doing their job. Thus, it is reasonable to expect that the Fed may soon halt the process of raising interest rates. Once this happens, troubled banks will be in a better position to become stable, possibly through being acquired or obtaining injections of capital. Either way, the Fed’s likely trajectory implies less likelihood of a further crisis in the banking system.
The continuing tightening of monetary policy is meant to stifle inflationary pressure. Powell said that inflation expectations remain well anchored. This is important because anchoring expectations is one of the main goals of monetary policy. Meanwhile, inflation has decelerated due to improved supply chains, lower commodity prices, and the impact of Fed tightening. Whether and to what degree the Fed tightens more will be data driven, as Powell indicated. However, most observers now expect the Fed to pause for a while. After all, the banking crisis is weakening credit market conditions. Moreover, Fed policy acts with a lag. The Fed needs to determine if it has already done enough.
Although Powell has suggested that rates will need to remain elevated for a while, many investors evidently think otherwise. The path of the Federal Funds rate implied by futures markets suggests that the Fed will start to cut the rate in July, pushing the rate down to 3.5% by January. Why do investors think this? Perhaps they expect the banking crisis to worsen, thereby pushing the economy into recession and forcing the Fed to ease monetary policy to stabilize the banking system. Perhaps they expect inflation to fall quickly, thereby enabling the Fed to ease policy.
What is unusual is that, after raising the Fed Funds rate by 500 bps, unemployment remains historically low. What is also unusual is that, although the number of job openings has fallen, unemployment remains very low. Powell noted that the labor market remains surprisingly tight even after monetary policy has weakened credit markets. He suggested the possibility that the Fed will succeed in significantly reducing inflation without engineering a sharp rise in unemployment. However, he left open the possibility of a big increase in unemployment and signaled that his primary focus is on suppressing inflation. Either way, he said, there is a good likelihood that a recession can be avoided.
Let’s look at the details. The government releases two employment reports: one based on a survey of establishments; the other based on a survey of households. The establishment survey indicated that, in April, 253,000 new jobs were created. This was the strongest growth since January. The strength of job growth, to which Chair Powell alluded in his press conference this week, is unusual in the context of a significant tightening of monetary policy. On the one hand, it could signal a need to further tighten in order to suppress inflationary pressure. On the other hand, it could indicate a new normal in which the economy is weakened while the job market remains relatively tight. Time will tell.
The details of the establishment survey are interesting. There was a loss of employment in the banking sector, possibly related to the troubles at some mid-sized banks. Yet job growth was positive in other financial services areas including insurance and real estate. In addition, there was strong growth in the construction sector, especially in specialty contractors. Manufacturing saw moderate growth of employment, with roughly half that growth coming from the automotive sector. The strongest growth came in professional and business services (even after a sharp decline in employment at temporary services). In addition, there was strong growth in health care and moderate growth at restaurants.
The establishment survey also looked at compensation. Average hourly wages were up 4.4% from a year earlier, not much changed in the past four months. Prior to January, wage inflation had been steadily decelerating from a peak of 5.9% last March. The question, then, is whether the labor market is getting stuck. If productivity accelerates, then it would not be inflationary for wage gains to exceed inflation. Yet that is not the case. Rather, the Fed likely fears that, so long as the labor market is tight, wage inflation will not decelerate further, thereby making it more difficult to bring inflation down from the current 5%. If that is the Fed’s thinking, it might consider further monetary tightening, even if this means boosting the unemployment rate.
The separate survey of households indicated that participation in the labor market was steady in April. However, participation among prime-aged workers (25 to 54) continued to rise, with participation among prime-aged women reaching a record high. Thus, the shock to participation from the pandemic appears to be easing. Rising participation will help to loosen the tightness in the labor market and to cause a further deceleration in wages.
Let’s look at the numbers. In April, consumer prices in the Eurozone were up 7% from a year earlier, higher than the 6.9% in March. However, inflation had steadily declined previously each month from a peak of 10.1% in November. One month of reversal does not make a trend. Prices were up 0.7% from the previous month, down from an increase of 0.9% in March.
The important thing is to look at underlying inflation. When volatile food and energy prices are excluded, core prices were up 5.6% in April versus a year earlier, down from 5.7% in March and the same as the 5.6% seen in February. Thus, core annual inflation does appear to be stuck. Core prices were up 1% from the previous month, an alarmingly high number. Thus, there is reason to be concerned.
By country, inflation varied considerably in April. In Germany, the Eurozone’s largest economy, consumer prices were up 7.6% in April versus a year earlier, down from a peak of 11.3% in November, and down from 7.8% in March. In Spain, however, inflation accelerated from 3.1% in March to 3.8% in April. In Italy, inflation accelerated from 8.1% to 8.8%. In France, inflation accelerated more modestly from 6.7% to 6.9%.
For the ECB, the challenge now is to get inflation under control while, at the same time, avoiding a financial crisis stemming from the troubled banks in the United States. The ECB recently reported that credit conditions for both households and businesses worsened in the first quarter. This fact will likely influence their deliberations. The goal of monetary-policy tightening is to worsen credit conditions in order to weaken inflationary pressure. So far, the ECB has been successful at worsening credit conditions, but questions remain about the persistence of inflation. The ECB must decide if April’s numbers are the start of a trend or merely an aberration. It must also decide to what degree weak credit conditions are sufficient to further suppress inflation. After all, monetary policy acts with a lag. It is difficult to know if what the ECB has already done is sufficient. In a sense, implementing monetary policy is like navigating a car on a highway while facing backwards.
ECB President Lagarde said that “we have more ground to cover and we are not pausing, that is extremely clear.” She said that the cost of borrowing is now in “restrictive territory.” She also added that the slower pace of interest-rate normalization this month reflects concerns about the banking crisis that began in the United States and its potential impact of European capital markets.
If the ECB continues monthly increases of 25 bps, it will reach a rate of 3.75% in July. This would match the highest level in ECB history, which happened in 2001. Meanwhile, the ECB said that it will slow the pace of purchasing bonds to replace those that mature. The idea is to shrink the ECB’s balance sheet at a faster pace. It is a form of quantitative tightening meant to boost longer-term borrowing costs.
Still, there is also a view that a large-scale shift of production from China to other countries is not possible, at least in the short to medium term. The ecosystem that developed in the last 40 years around Chinese manufacturing is too deep and vast to be quickly disrupted. China is so much bigger than such countries as Vietnam and other Southeast Asian nations that it is not possible to move the lion’s share of Chinese capacity to these countries. Thus, even as global companies effectively purchase insurance against political risk in China by moving assets to other countries, they are likely to be left with considerable exposure to China in the coming years.
On the other hand, there is some evidence of rapid change. For example, the Chinese share of US container import volume dropped from 42% last year to roughly 32% now. The share attributable to other Asian countries increased commensurately. Moreover, although Vietnam cannot absorb a massive shift of capacity from China, a combination of Southeast Asia and India might be large enough to facilitate a considerable adjustment over time. Within Southeast Asia, Indonesia is a massive economy with tremendous potential. Thus, debate will continue about the speed at which globalization moves away from dependence on China. Yet there is no debate that a change is taking place.
Yet the main reason that real GDP grew slowly was a sharp decline in business inventories. The change in inventories is a component of GDP. If that component is excluded, real GDP grew at a rate of 3.4%—a very healthy rate of expansion. The decline in inventories meant that businesses sold off existing inventories rather than produce enough to satisfy rising demand. This bodes well for GDP growth in the current quarter if one assumes that businesses will have to replenish their inventories to meet demand. It assumes that demand will be sustained. Thus, the outlook for the current (second quarter) is not necessarily bad, especially given the favorable purchasing managers’ indices (PMIs) reported earlier this week. They signal strong underlying demand.
Let’s look at some details of GDP growth in the first quarter of 2023. First, real personal consumption expenditures grew at a rate of 3.7%. This included growth of 16.9% for durable goods, 0.9% for nondurable goods, and 2.3% for services. The lion’s share of durable goods growth was due to strong demand in the automotive sector. The strength of consumer spending was related to the rapid growth of consumer income. Real disposable personal income increased at an annualized rate of 8.0 in the first quarter. This reflected strong job growth as well as the impact of a sizable cost of living increase for recipients of Social Security. Given that the increase was a one-off event, it is likely that consumer spending growth will recede somewhat in the current quarter.
Meanwhile, nonresidential fixed investment only grew at a rate of 0.7%. This included an 11.2% gain for investment in structures, a 7.3% decline in investment in equipment (computers, telephony, transport), and a 3.8% increase in investment in intellectual property (software, R&D, branding). Investment in residential property fell at a rate of 4.2% after having fallen far faster in the three most recent quarters. Thus, one could argue that the housing sector is starting to stabilize.
Exports of goods and services were up at a rate of 4.8% while imports were up 2.9%. Finally, real government purchases increased at a rate of 4.7%. This included a 10.3% increase in nondefense purchases by the Federal government, 5.9% for defense purchases, and 2.9% for state and local government.
Overall, the GDP report was not as bad as was reported in the press. That is not to say that there are no headwinds. The Federal Reserve is expected to further tighten monetary policy, likely in the coming week. It will do this at a time when the US banking system is modestly reeling from the impact of recent bank failures. Thus, a combination of tighter monetary policy and weakened credit markets could curtail growth in the coming months, thereby boosting the possibility of a recession.
The stability of real consumer spending was entirely due to an increase in spending on services. Spending on both durable and nondurable goods declined in March from the previous month. Durables were down 0.8% while nondurables were down 0.1%. This was offset by a 0.1% increase in spending on services.
This pattern is consistent with the reversion to normal consumer behavior following the pandemic-period surge in spending on durable goods. Moreover, you will recall that the inflation of the last two years was initially generated because of that surge in durables spending. Now, with spending on durables falling, inflation is abating, especially inflation for goods.
Indeed, the government’s report on income and spending included data on the Federal Reserve’s favorite measure of inflation: the personal consumption expenditure deflator, or PCE-deflator. This measure was up 4.2% in March from a year earlier, the lowest since May 2021. Notably, prices of durable goods were up only 0.8% from a year earlier while prices of nondurables were up 2.1% and prices of services were up 5.5%. This is a complete reversal of what transpired early in the pandemic. Meanwhile, when volatile food and energy prices are excluded, core prices were up 4.6% in March from a year earlier, the lowest since December 2022.
The latest report suggests that household income continues to grow modestly while spending is stagnant but not declining. It also indicates that inflation is decelerating but that core inflation is a bit more stubborn that overall inflation. This situation does not provide the Federal Reserve with an unambiguous road map, which is why debate remains about what the Fed will do and what it should do.
By country, there was divergence. Italy and Spain both grew at a moderately healthy pace with real GDP rising 0.5% from the previous quarter. Spain’s real GDP was up 3.8% from a year earlier while that of Italy was up 1.8%. France’s economy grew more modestly, up 0.2% from the previous quarter and up 0.8% from a year earlier.
The worst performer in the region was Germany, with real GDP unchanged from the previous quarter and down 0.1% from a year earlier. Still, this was better than the decline in real GDP in the fourth quarter. Germany has been especially vulnerable to the energy shock given its significant dependence on Russian energy.
Not only is the population falling. The working-age population is falling even faster as the population ages. Thus, the ratio of workers to retirees will fall rapidly. This implies onerous costs for pension and health care. This can be funded through higher taxes (which has already begun with periodic increases in the national sales tax), lower pension benefits, a higher retirement age, and/or more immigration. As for the latter, immigration has, indeed, accelerated. Still, it remains at a level much lower than is found in most advanced economies.
Ultimately, the best solution to this dilemma would be a surge in productivity growth, which, in turn, would lead to faster economic growth. That would mean that the pie would increase in size, thereby enabling retirees to have an adequate share of the pie without forcing workers to take a much smaller amount of income. Boosting productivity will require innovation, driven by strong investment in human capital, a vital market for financial capital, free flow of information and ideas, and openness to foreign investment. Also, the experience of other countries suggests that immigration can contribute to innovation.
Meanwhile, the government has taken steps to encourage people to have more children. It has also taken steps to encourage more female participation in the labor force. In addition, it has encouraged more older people to remain in the labor force. The goal is to prevent a sharp decline in the number of workers.
Cover image by: Sofia Sergi