Weekly global economic update

Week of August 26, 2024

• Increasing signs that the Federal Reserve will cut rates
• There are also signs that the ECB will cut rates
• China gives more consideration to boosting domestic demand
• India debates allowing more FDI from China

Increasing signs that the Federal Reserve will cut rates

• When the US government releases data on employment, it is based on a survey of establishments in which the government receives information from a relatively small sample of organizations. Over time, more information is accumulated, including from state level tax information. This enables the government to revise the data, providing a more accurate picture of what happened. Last week, such a revision was reported and the results, although not unexpected, suggest that the labor market was weaker in the past year and a half than previously believed.

The government reported that, in the 12 months leading up to March 2024, the number of jobs added was 818,000 less than previously reported. This means that average monthly job growth was 178,000 rather than the previously reported 246,000. First, it is important to note that job growth of 178,000 is quite strong, certainly much faster than the long-term ability of the economy to generate jobs. Second, the revision says nothing about what happened since March. Thus, our only knowledge of job growth from April to July remains the initial estimate from the government.

Although the headlines warned that today’s revision indicates a much weaker job market, the revision appears to have been expected and, consequently, did not alarm investors. Bond yields barely moved today while equity prices were modestly up. Given that investors already expected the Federal Reserve to cut rates in September, today’s revision was not impactful. 

• And this brings us to the minutes of the Federal Open Market Committee (FOMC) meeting at the end of July, which were released last week. The FOMC is the principal policymaking arm of the Federal Reserve. It decides on short-term interest rates and on bond purchases or sales. Keep in mind that the minutes released last week are based on discussions that took place before the recent financial market volatility.

The minutes indicate that, as of July 30–31, FOMC members were happy with the trajectory of inflation. The minutes said “participants noted that the recent progress on disinflation was broad based across the major subcomponents of core inflation. Core goods prices were about flat from March through June after having risen during the first three months of the year. Some participants noted that the recent data corroborated reports from their business contacts that firms’ pricing power was waning, as consumers appeared to be more sensitive to price increases.” In summary, “participants judged that recent data had increased their confidence that inflation was moving sustainably toward 2%.” They noted the easing of tightness in the labor market and “moderation of growth in labor costs,” boding well for further improvement in inflation.  In addition, they noted that rising labor force participation, including immigrant labor, was reducing wage pressure. 

Going forward, the members noted that some indicators are pointing to a weakening of the job market, which will “merit close monitoring.” In addition, the members noted that lower to middle income households are facing greater financial stress as evidenced by rising credit card delinquencies. This is leading households to switch “away from discretionary spending and switching to lower-cost food items and brands.” On the other hand, spending by upper income households is being boosted by rising wealth in the equity and housing markets. Thus, the household spending outlook remains moderately favorable. 

So, what does this mean for monetary policy going forward? The Fed has a dual mandate to minimize inflation and maximize employment. The members of the FOMC indicated that “while the incoming data regarding inflation were encouraging, additional information was needed to provide greater confidence that inflation was moving sustainably toward the Committee’s 2% objective before it would be appropriate to lower the target range for the federal funds rate.” On the other hand, several members were ready to cut the rate as early as July. Most importantly, “the vast majority observed that, if the data continued to come in about as expected, it would likely be appropriate to ease policy at the next meeting.”

Finally, the members noted that monetary policy is currently quite tight, thereby having a negative impact on credit markets. Moreover, monetary policy has become tighter even though the Federal Funds rate has remained unchanged. That is because, with inflation declining, the real (inflation-adjusted) interest rate has risen. Thus, one can argue that it does not make sense to allow a further tightening of monetary policy while inflation is declining and the economy weakening. That boosts the argument for a rate cut soon. It will very likely happen in September. In my opinion, the only debate now is whether it will be 25-basis points or 50.  

There are also signs that the ECB will cut rates

• In the eurozone, inflation has come down, with prices up 2.6% in July versus a year earlier, well within the central bank’s target range. Yet the main concern of the European Central Bank (ECB) has been the persistence of inflation in services, which was 4.0% in July as it was in February. The problem is that services tend to be labor intensive while wages have been rising strongly in a tight labor market. 

Thus, the ECB was likely relieved to learn that wage inflation is receding. Specifically, the ECB reported that, in the second quarter of this year, wages set through negotiations between employers and unions were up 3.55% from a year earlier.  This was down from 4.74% in the first quarter. This deceleration likely sets the stage for a decline in service inflation in the months to come. As such, it increases the likelihood that the ECB will continue to cut interest rates, having taken the first step in June. 

One possible explanation for the deceleration in wages is that the labor market might be weakening. In June, the unemployment rate increased from the previous month. In addition, a survey taken by the European Union (EU) found a “significant worsening of employment plans” at both manufacturing and service companies. In addition, the flash PMI for the eurozone (more details below) found a slight decline in private sector employment in August. If this persists, then wage inflation will likely recede further.  Thus, the stage is set for an easing of monetary policy.

• Regarding monetary policy, the ECB released the minutes of its last policy committee meeting in July. The minutes indicate that, in July, members had an “open mind” about further rate cuts. Moreover, they were evidently not concerned that core inflation had accelerated slightly from May to June. The minutes indicate that “the September meeting was widely seen as a good time to reevaluate the level of monetary policy restrictions. That meeting should be approached with an open mind.”

In addition, the members noted signs that the eurozone economy is weakening, thereby reducing inflation risk. Also, they noted that the current level of interest rates is “keeping financial conditions restrictive,” thereby increasing the risk of an economic downturn. As such, it is not surprising that the members were amenable to cutting rates in September. Moreover, the minutes were recorded before the latest data on wages and PMIs. This new data likely reinforces the view that the ECB will resume interest rate cuts in September.

China gives more consideration to boosting domestic demand

• China’s recent economic weakness has been attributed to slow growth of domestic demand.  While output of manufacturing products has risen rapidly, fueled by government efforts to boost exports of key technologies, domestic demand has faltered. This, in turn, has led to excess capacity and deflationary pressure. Many pundits have urged the government to address domestic demand rather than focus on exporting. Now, there is evidence that the government is taking this seriously. 

At a plenary meeting of the State Council, Premier Li Qiang said that “we must take more powerful measures to boost domestic demand. Boosting consumption is the key. We must adopt targeted measures to smooth economic circulation.”

One area of domestic demand that has been weak is private sector investment, pulled down by the slump in the property market.  In part, private sector investment weakness reflects concern about the government’s bias toward state sector investment. Li said that he wants to “create a better business environment” for the private sector. This would entail removing regulatory obstacles and allowing private sector companies to participate in government infrastructure projects. 

Another challenge has been the sharp decline in inbound foreign direct investment (FDI), which was down 29.1% in the first half of 2024 versus a year earlier. Li said that “we must take greater action to use foreign investment and improve services for them.”  Yet this could be challenging given the fraught relationship between China and the West, which has led global companies to reduce their exposure to China. 

Also, the State Council has approved plans to build five new nuclear power plants, which will include 11 reactors, at a cost of US$28 billion. This is meant to boost economic growth and to address climate change. The hope is that this investment will have a positive spillover effect on industries that supply the nuclear plants. China currently operates 55 nuclear plants, ranking it third in the world, with 36 more under construction. Yet only 5% of electric power in China is generated by nuclear plants. The goal is to boost this to 25% by the end of the decade.

Finally, the most important obstacle to growing domestic demand is weakness in consumer spending. Li said that the government will “give full play to tapping potential consumption.”  Yet few details were given. The problem with consumer spending is that households have experienced a loss of wealth due to the drop in property prices. In addition, the implosion of the residential property market has weakened demand for home-related products. What is likely needed is government fiscal stimulus aimed at boosting the purchasing power of households. Yet this would require the government to borrow heavily at a time when it is worried about the ability of local governments to service their debts. 

India debates allowing more FDI from China

• At a time when Chinese products increasingly face tariff and other obstacles to entering markets in Europe and the United States, many Chinese companies are investing in other countries to produce goods for export. These overseas facilities import inputs from China and produce final products to be sent to the United States and Europe. Such investments have taken place in Southeast Asia and Mexico. This trend is part of a larger trend called China plus one. It involves diversification of supply chains away from China while retaining Chinese involvement. 

Yet India has not fully enjoyed the benefits of this trend. India placed restrictions on inbound FDI from China in 2020 following a military skirmish on the Himalayan border.  Now, however, V. Anantha Nageswaran, the chief economic advisor to the Indian government says it is time to reconsider. He said that “choosing FDI as a strategy to benefit from a China plus one approach appears more advantageous. As the United States and Europe shift their immediate sourcing away from China, it is more effective to have Chinese companies invest in India and then export the products to these markets rather than importing from China, adding minimal value, and then re-exporting them.”

Although India’s finance minister appears to support this shift in policy, the minister of Commerce and Industry said that “there is no rethinking at present to support Chinese investments in the country.” Thus, there is evidently debate within the government about how to approach this issue. 

The restrictions imposed in 2020 did not bar Chinese FDI. Rather, they required that investors obtain prior government approval before moving forward. Since 2020, there have been 435 applications for investment by Chinese companies. Only about one third have been approved. Meanwhile, India imported US$101.7 billion in goods from China in the most recent fiscal year while it only exported US$16.7 billion. 

Allowing more inbound investment would go a long way toward reducing the trade imbalance and would provide India with significant manufacturing capacity and know how, especially in those industries where China currently excels. India is now seen as potentially capable of replicating China’s economic takeoff that took place a generation ago. Yet it is important to recall that China’s takeoff involved substantial inbound FDI, enabling China to move up the value chain in many industries and become the world’s leading exporter.  India’s aversion to Chinese investment is consistent with its post-war focus on avoiding foreign exploitation and becoming self-sufficient. Yet even those countries that currently have deeply troubled relations with China continue to welcome some foreign investment.  

Week of August 19, 2024

• The aftermath of the financial market volatility
• US economic data suggests a soft landing
• German business sentiment worsens, investment in China increases
• Chinese economic data offers mixed picture

The aftermath of the financial market volatility

• Much has been written about the massive Japanese yen carry trade, the unwinding of which contributed to global financial market volatility recently. The Bank for International Settlements (BIS), which is the central bankers’ central bank, estimates that the carry trade recently exceeded US$2.2 trillion, with US$742 billion added since 2021.

A quick refresher: The carry trade was predicated on a stable value of the yen and very low Japanese interest rates. Global investors would borrow yen cheaply, purchase assets in other countries (including emerging markets such as Brazil), reap a high return, and then pay off the yen loan. It was very profitable, provided the yen was stable and Japanese interest rates remained low. Once the Bank of Japan (BOJ) indicated a likelihood that interest rates would rise, this led to an increase in the value of the yen. Many global investors then started to unwind carry trade positions, thereby putting downward pressure on the value of global equities while also exacerbating the increase in the value of the yen.

The question now is to what extent the unwinding is over. Some estimates suggest that about half of the carry trade was unwound in the past few weeks. It is uncertain whether further unwinding will take place. It has been estimated that a significant amount of carry trade involved investors borrowing yen to invest in US tech stocks. The recent volatility of US tech stocks would be consistent with an unwinding of these positions. Moreover, it has been said that the Japanese government itself has effectively engaged in a carry trade. That is, the Government Pension and Investment Fund (GPIF), which manages public pensions, has about half its assets invested in foreign equities and bonds. It is not clear if the GPIF is unwinding its positions, especially given that it is a long-term rather than speculative investor. 

Regarding technology shares, it is worth noting that the value of US equities accounts for roughly 60% of global equity valuation. Plus, technology stocks account for about one-third of US equity valuations. Thus, US technology shares account for about 20% of global equity valuations. That is huge. It means that volatility for tech stocks can have a big impact on global wealth. This is why the unwinding of carry trade positions that were taken to finance investment in US tech stocks has such a big impact on global wealth. 

In any event, after much hand wringing about the recent events, the reality is that things are mostly back to normal. Global equity markets have roughly reverted to where they were before the volatility begin. However, bond yields are significantly lower than before given that expectations for Federal Reserve policy have changed markedly. On the other hand, the view that market volatility signaled an imminent US recession appears to have dissipated.  

US economic data suggests a soft landing

• It is well known that the Federal Reserve’s target for inflation is 2%. What is less well known is that the target is meant to be an average rather than a ceiling. That is, the Fed wants inflation to be 2% plus or minus 1%. In other words, a range of 1% to 3% would satisfy the Fed. By that definition, the Fed has achieved its target. For the first time since March 2021, the year-over-year percentage change in the consumer price index (CPI) fell below 3%. Not surprisingly, many investors interpreted this as confirming the likelihood that the Fed will cut interest rates in September. Indeed, there is probably no one who thinks otherwise. Let’s look at the details.

In July, the CPI was up 2.9% from a year earlier and up only 0.2% from the previous month. In fact, since April, the CPI is up only 0.1%. Thus, inflation is clearly abating. When volatile food and energy prices are excluded, core prices were up 3.2% from a year earlier, the lowest level since April 2021. Core prices were up 0.2% from the previous month. 

Energy prices were up only 1.1% from a year earlier while prices of food eaten at home were also up 1.1%. Yet prices of food eaten away from home were up 4.1%. This reflects the fact that inflation in services remains high, with prices up 4.9%, driven by rising labor costs. Meanwhile, prices of durable goods were down 4.1% while prices of non-durable goods were up 1.3%. The biggest component of services is shelter, with prices up 5.1%. When shelter is excluded from the CPI, prices were up only 1.7%. Moreover, the shelter component of the CPI reflects the impact of home prices with a long lag. There is good reason to expect shelter inflation to diminish further. 

The good news for services inflation is that labor market tightness is easing. This should lead to an easing of wage pressure. Moreover, recent data indicated strong growth of labor productivity, meaning that the inflationary effect of wage gains is reduced. Thus, the Federal Reserve may likely feel comfortable in cutting interest rates in September. On the other hand, the fact that headline and core inflation have been receding slowly suggests that the Fed’s mission is not yet accomplished. Consequently, the futures market’s implied probability that the Fed will do a 50-basis-point cut in September fell from 50% before release of the CPI to 45% afterwards. 

• The recent pessimism about US economic growth might have to take a back seat given today’s report on retail sales. Spending was up sharply in August, surprising investors and reducing the expectation for a dramatic cut in interest rates by the Fed. On the other hand, most of the increase in retail sales was due to strong demand for automobiles. The report doesn’t necessarily imply a strong consumer sector. Let’s examine the details.

In July, total retail sales (not adjusted for inflation) were up 1% from the previous month, the fastest growth in more than a year. Spending at automotive dealerships was up 3.6%. When this is excluded, retail sales were up a more modest 0.4%. There were other segments of retailing that performed well. For example, spending at electronics and appliance stores increased 1.6%, building materials was up 0.9%, and grocery stores was up 1%. On the other hand, spending at clothing stores fell 0.1% while spending at department stores fell 0.2%. 

Meanwhile, the Federal Reserve reported that industrial production fell 0.6% from June to July, partly due to the impact of a hurricane. Thus, it is not clear if the industrial economy is weakening. On the other hand, the National Federation of Independent Business (NFIB) reported that its survey of small business managers found optimism at the highest level since February 2022. This measure is said to be a good leading indicator of economic performance. Moreover, the NFIB said its survey found that concern about the prices that small businesses pay has receded to a level barely above where it was before the pandemic. Thus, inflationary worries have clearly abated. 

The panoply of economic news led to a sharp increase in equity prices and a modest increase in bond yields recently. Many investors evidently saw the news as reducing the likelihood of a significant slowdown. At the same time, investors remained confident that the Federal Reserve will soon cut rates.  

German business sentiment worsens, investment in China increases

• The ZEW Indicator of Economic Sentiment for Germany fell sharply in August, falling by the largest amount since 2022. The authors of the survey said that “the economic outlook for Germany is breaking down. In the current survey, we observe the strongest decline of the economic expectations over the past two years. Economic expectations for the eurozone, the US and China also deteriorate markedly. As a result, especially the expectations for export-intensive German sectors decline.”

The report cited “ambiguous” Eurozone monetary policy, a possible weakening of the US economy, uncertainty regarding stability in the Middle East, and volatility in asset markets as contributing to the weakness of sentiment. Meanwhile, an index of sentiment on the part of financial market participants fell at the fastest pace since 2020.

The ZEW report provides a strong argument for another interest-rate cut in September by the European Central Bank (ECB). The ECB cut rates earlier this year, but there has been uncertainty as to when it will act again. This reflects concern about persistent high inflation for services. Still, investors interpreted the latest survey results as boosting the likelihood of a rate cut. Indeed, German bond yields fell on this expectation. Moreover, investors are likely nervous by the decline in German real GDP in the second quarter. Weakness in economic activity is another reason that the ECB will likely consider another rate cut. 

• At a time when the Chinese economy is relatively weak, and at a time when economic relations between China and Europe are tense, it is surprising to learn that German company direct investment in China is rising sharply. This is despite efforts by the German government to discourage such investment. 

The Bundesbank reports that German foreign direct investment in China roughly doubled from the first to the second quarter of this year. Much of the investment has been driven by automotive companies, eager to retain access to the growing Chinese market. Both the German government and the European Union are concerned lest EU-based companies become too dependent on their economic relationship with China. German Chancellor Scholz warned against putting “all their eggs in one basket.” The previous dependence on Russian energy comes to mind. This became a massive problem when the Ukraine-Russia war began, leading Russia to cut off supplies of energy. If relations between Europe and China deteriorate in the future, German companies in China could face a serious risk. 

The acceleration of German investment in China comes at a time when investment coming from other countries is declining, especially investment from the United States. Moreover, it also comes at a time when Chinese companies are providing German companies with serious competition. Plus, some Chinese companies are investing in Europe to retain access to the EU market.  

Chinese economic data offers mixed picture

• Troubles in China’s property market as well as weak consumer demand continued to bedevil China’s economy in July. The latest data from the government indicate modest retail spending growth, modest investment spending, and modest gains in industrial production. While there was strong growth of investment in manufacturing and mining, this was offset by a continued sharp decline in investment in property. Let’s look at the details.

In July, Chinese retail sales were up 2.7% from a year earlier, slightly faster than in June but still relatively slow. In part this was influenced by the continuing decline in home prices, which reduces household wealth. The government reported that, in 70 major cities, prices of new homes were down 8% in July from a year earlier. Prices were down 0.6% from the previous month, the 14th consecutive month in which this happened. Prices fell in 67 of 70 cities. Meanwhile, the inventory of unsold new homes hit the highest level since 2016. It is reported that the decline in prices is leading many homeowners to try to sell, thereby exacerbating the problem of declining prices. Despite this effort, sales of new homes fell 25.9% in July from a year earlier. As for retail spending, there was a 4.9% decline in sales of vehicles and a 2.4% decline in sales of appliances. 

In addition, Chinese industrial production was up 5.1% in July from a year earlier, the slowest increase since March. However, non-automotive transportation was up 12.7% while production of information technology and telecoms were up 14.3%. 

Also, fixed asset investment was up 3.6% in the first seven months of 2024 versus a year earlier. Investment in manufacturing was up 9.3% while investment in utilities was up 23.8%. On the other hand, investment in property was down 10.2%. The government’s principal tool for economic recovery has been to stimulate investment in technology and clean energy, partly to offset weakness in property. This is clearly reflected in the latest data. The main obstacle to a full recovery is expected to be weakness in domestic demand.

Week of August 12, 2024

• Financial market turmoil comes and goes
• Chinese trade weakens

Financial market turmoil comes and goes

• In Shakespeare’s play Macbeth, there is a famous line in which the character Macbeth says, “It is a tale told by an idiot, full of sound and fury, signifying nothing.” That comes to mind when thinking about the recent financial market turmoil. There was plenty of sound and fury, and enhanced expectations of a recession. But did it signify anything? Hard to say. Let’s look at what happened.

Trouble began on Friday, August 2, when the US government released a worse-than-expected, but not terribly bad, employment report. That led some investors to believe that the Federal Reserve had waited too long to start cutting interest rates and that the risk of recession was now significant. That led to declining equity prices, lower bond yields, and a lower-valued US dollar. But that was not the only thing happening in financial markets. Other factors contributed to much more significant turmoil the following Monday, August 5.

Sadly, I am old enough to remember the day in October 1987 when global equity markets crashed. On that day, October 19, also known as Black Friday, the Dow Jones average fell 22.6%. By the end of that day, there was a widespread belief that the crash would precipitate a recession. Fear was in the air as investors worried that this was a repeat of 1929, when a crash did precipitate the Great Depression. It never happened. Instead, the market recovered while the economy continued to grow.

That experience is what comes to mind this time around. US and global equities fell sharply, oil prices fell, the dollar fell 2.7% against the yen, and the US 10-year Treasury bond yield fell to a one-year low. Should we be worried? Not necessarily.

First, the jobs numbers showed a slowdown in job growth, not a catastrophe. Some analysts pointed to the fact that the so-called Sahm Rule had been triggered, due to a sharp rise in the unemployment rate. The Sahm Rule is very simply based on how fast the unemployment rate is rising. Economist Claudia Sahm found that, in the past when the three-month average of the unemployment rate exceeded the lowest rate of the last 12 months by more than 0.5 percentage points, it meant that a recession had begun. Yet the rule is not a law of physics. Rather, it is a consistent pattern. Yet Dr. Sahm herself said that, given the unusual economic trends of the post-pandemic period, a triggering of her rule might simply be a false positive.

Second, on a day when investors were evidently panicking about the state of the US economy, the Institute of Supply Management (ISM) reported that its purchasing manager’s index (PMI) for US services increased from 48.8 in June to 51.4 in July, indicating growing activity. PMIs are meant to be forward-looking indicators. Thus, the rise in the PMI is a sign of a likely rebound in services activity.

Third, it was reported that, on August 5, investors were having difficulty gaining access to online trading platforms operated by brokerage firms. This suggests that fearful investors were struggling to unwind their positions. Selloffs beget selloffs. This has happened before. Generally, those who sat on their assets ultimately profited. This also reminds us that asset markets tend to overshoot before reverting to trend.

Fourth, there were reports that the market selloff was exacerbated by the continuing unwinding of the Japanese carry trade. This trade involves borrowing in yen to purchase higher-yielding assets outside of Japan, and then selling those assets and paying off the yen debt. Once the Bank of Japan (BOJ) signaled the start of a significant tightening of monetary policy, the yen started to rise in value, thereby reducing the incentive to engage in the carry trade. Moreover, some nervous investors have been unwinding their carry trade positions, thereby putting upward pressure on the yen and downward pressure on the value of non-Japanese assets. Plus, the sharp rise in the yen has spooked holders of Japanese equities. In fact, Japanese equities fell 12% on August 5, the biggest decline since 1987.

Fifth, the selloff involved a very sharp decline in the prices of several key technology company stocks, especially those heavily investing in gen AI. One could argue that the tech bubble has burst following an unusually strong rise in the values of these stock. Yet the bursting of a bubble does not necessarily imply an imminent recession.

Sixth, the selloff may reflect fear that the US Federal Reserve waited too long to start cutting interest rates, thereby boosting the likelihood of a recession. Yet the futures markets now tell us that investors are expecting aggressive action by the Fed. In fact, they are pricing in a 25% probability that the Fed will take emergency action before the September meeting. And they are pricing in 125 basis points of interest-rate cuts before the end of the year. Such an aggressive action would likely lead to a sharp rebound in asset prices. It would also set the stage for a sharp increase in transactions. In fact, it’s reported that leading private equity (PE) firms have significantly increased the amount of funds deployed. Plus, they are sitting on a vast pool of “dry powder” that they intend to deploy as interest rates start to come down. Thus, there’s reason to expect a surge in M&A activity following the recent hiatus. As the head of one large PE firm said, “The deal market is back.”

None of this is to say that a recession is impossible. Rather, the point is that the rout in asset prices in the week of August 5 was not necessarily a predictor of a downturn. It could simply be a correction involving an intensification of volatility.

Indeed, US and Japanese equity prices rebounded sharply last Tuesday and markets were more stable for the remainder of the week. US traders were likely relieved that initial claims for unemployment insurance declined sharply in the week ending August 3. This suggests the possibility that the US job market is not so bad after all. Japanese traders were likely relieved that the BOJ signaled concern about the unwinding of the carry trade and appeared willing to take that into account in its deliberations about interest rates. Meanwhile, bond yields recovered, oil prices were up, and the US dollar recovered against the British pound and the Japanese yen.

Does this mean that the worst is behind us? Although market corrections happen periodically, they always seem to unnerve everyone, leading to concerns that something awful is about to happen. In this case, expectations for a US recession increased suddenly, even though underlying factors suggest otherwise.

Even now, nearly a week after the volatility began, I am still asked by clients if a further downturn in equities should be expected. The answer is: No one knows. But there’s no fundamental economic reason to expect that. In fact, if investors expect a sharp reduction in interest rates by the Fed (which they do), then this should be good for the equity market. Indeed, the rebound in equities is likely related to such expectations.

In any event, measures of volatility have eased substantially, asset prices have mostly recovered, as least partly, and the economic fundamentals have not changed. Thus, it seems safe to say that the crisis is over, or at least the perception of a crisis. After all, there was not really a crisis.

Regarding Japan, equities recovered while the currency depreciated after the Deputy Governor of the BOJ said that interest rates will not be increased while markets are unstable. He said, “As we're seeing sharp volatility in domestic and overseas financial markets, it’s necessary to maintain current levels of monetary easing for the time being. Personally, I see more factors popping up that require us being cautious about raising interest rates.” This evidently satisfied nervous traders and created an impression of calm. Does this mean that the BOJ will refrain from further rate hikes? It’s not clear. Still, uncertainty about this could mean further unwinding of the carry trade, thereby putting upward pressure on the yen. That, in turn, could hurt Japanese equity prices.

Chinese trade weakens

• It’s reported that Chinese exports in July were weaker than anticipated. If US companies are frontloading orders, however, Chinese exports might surge in the coming few months, potentially creating a false impression of strength. In any event, July exports (measured in US dollars) were up 7% from a year earlier, slower than the 8.6% increase in June and slower than investors anticipated. Exports were up 12% to Southeast Asia and up 8% to both the United States and the European Union.

The relative weakness of export value was attributed to a decline in export prices. The volume was said to be up strongly. The weakness of prices might reflect difficulty in unloading excess production. Exports of machinery, electronics, and automobiles were up strongly while exports of more discretionary products such as apparel, furniture, and luxury goods exhibited weakness.

Also, imports were up a strong 7.2% in July versus a year earlier, much better than the 2.3% decline in June. This was attributed to a sharp rise in imports of inputs used to produce exportable goods, to frontloading in anticipation of trade restrictions, and to the impact of fiscal stimulus on demand for construction related products.

Imports were up 24% from the United States (likely reflecting the frontloading mentioned above), up 11% from Southeast Asia, and up 7% from the European Union.

Week of August 5, 2024

• Investors revise expectations for Fed policy
• Productivity growth offers hope for lower inflation
• Eurozone growth recovers
• Eurozone inflation might be stuck
• Bank of Japan action leads to a sharp rise in the value of the yen
• China’s currency is becoming more international, but not by much

Investors revise expectations for Fed policy

• Did the Federal Reserve wait too long to start cutting interest rates? That could be what many investors were thinking following an especially weak jobs report last week. There was significant volatility in financial markets. On one day, the yield on the 10-year bond fell 18 basis points to the lowest level seen since December 2023. The S&P 500 index of equities was down 2.3%, with an especially sharp decline in the values of some tech stocks and sharp declines in overseas equity markets. The value of the dollar fell 1.6% against the Japanese yen and fell strongly against other currencies. Finally, the price of Brent crude fell by 3.4%.

Futures markets tell us that, up until recently, many investors believed the Fed will cut the benchmark interest rate by 100 basis points before the end of the year, including a 72.5% chance of a 50-basis-point cut in September. All this was in response to a jobs report that showed the second smallest increase in employment since 2020 and the highest unemployment rate since October 2021. Still, job growth was not poor. Moreover, the rise in the unemployment rate was largely due to a rise in labor force participation, not mass layoffs.

Could investors be overreacting? Possibly, but the reality is that, with inflation having receded, real (inflation-adjusted) interest rates have risen and could be having a negative impact on economic activity. In his comments earlier last week, Fed Chair Powell said, “I would not like to see material further cooling in the labor market. If we see something that looks like a more significant downturn, that would be something that we would have the intention of responding to.” Investors in recent days indicated that they expect Powell to respond.

Let’s examine the details of the jobs report. The US government releases an employment report that has two components: One is based on a survey of establishments; the other on a survey of households. The establishment survey found that 114,000 new jobs were created in July, the second smallest number since early in the pandemic. There was a decline in employment in information, financial services, and professional and business services. The only industries that saw strong job growth were construction, health care, and leisure and hospitality. 

Meanwhile, the establishment survey reported on wage behavior. Specifically, it found that average hourly earnings of workers were up 3.6% in July versus a year earlier, the smallest increase since May 2021, and were up only 0.2% from the previous month. Although wages are still rising faster than inflation, the deceleration of wages is good news from an inflation perspective. It is consistent with a weakening of the job market. 

Finally, the separate survey of households found that the number of people participating in the labor force increased much more than the rise in the working-age population. Thus, with a modest increase in employment, the unemployment rate rose from 4.1% in June to 4.3% in July, a nearly three-year high. However, the sharp rise in participation suggests confidence in the availability of jobs.

In the business press, the word “recession” appeared last week with greater frequency. Could we face a US recession in the coming months? There are some negative indicators: The slowdown in the job market and the rise in the unemployment rate, a decline in new orders for manufacturing according to a survey by ISM, weak new orders for durable goods, and a rise in credit card delinquencies. On the other hand, consumer spending and business investment have both remained strong while job growth is still at a speed that is consistent with moderate economic growth. Thus, there remains uncertainty. My view is that, if the Fed acts strongly in September, investors will likely rejoice, boosting asset prices and engendering confidence. A recession could be avoided. However, predicting the timing of recessions and recoveries is not one of the strongest skills of economists. 

• Meanwhile, before the release of the jobs report, the US Federal Reserve’s policy committee left the benchmark interest rate unchanged. Yet the wording of the Fed’s statement, as well as comments from Fed Chair Powell, reinforced the view that the Fed will indeed cut the rate in September.

The Federal Open Market Committee (FOMC) said that there is “somewhat elevated” inflation, a more moderate description than in the previous meeting when it simply said “elevated” inflation. More importantly, the FOMC is evidently pivoting from a focus solely on inflation to a focus on both inflation and employment. Remember, the US Congress has mandated that the Fed target both. The recent statement said that “the committee is attentive to both sides of its dual mandate,” whereas over the past two years it has described policy as “highly attentive” to inflation. Also, Fed Chair Powell said, “We have made no decisions on future meetings,” adding that “the economy is moving closer to the point where it will be appropriate to reduce our policy rate.” Investors can reasonably interpret these statements as boosting the likelihood of a rate cut in September. 

The newly stated focus on employment comes at a time when the unemployment rate is up and job growth has receded. Plus, there are reports of rising financial stress for households, consumers trading down, and consumer-oriented companies facing weaker revenue and earnings. On the other hand, economic growth was strong in the second quarter, consumer spending was strong in June, and business investment has been strong despite high interest rates. Regarding inflation, the numbers have been favorable, but service inflation remains far too high.

Productivity growth offers hope for lower inflation

• In the United States, the principal reason to worry about persistent inflation is that the labor market has been tight, which has been driving up wages. Yet if labor productivity (output per hour worked) rises, it can offset the impact of higher wages. That is, in an environment where productivity is rising, businesses can boost wages without necessarily raising their prices. That is because they are getting more output from workers, commensurate with the increase in wages. An important indicator is unit labor costs (ULCs), which is measured as the ratio of hourly compensation to labor productivity. If productivity grows commensurately with hourly compensation, then ULC doesn’t change. This implies no inflationary pressure from the labor market. Thus, for the Federal Reserve, the holy grail of monetary policy is an increase in productivity. 

Recall that, in 2023, there was a significant rise in labor productivity, even as wages were rising. This likely contributed to an easing of inflation. Then, in the first quarter of 2024, productivity barely grew. This raised fears that inflationary pressure will not abate. However, we have recently learned that productivity rose strongly in the second quarter, boding well for further progress on inflation. Here are the details.

In the second quarter, non-farm business output was up at an annualized rate of 3.2% from the previous quarter. The number of hours worked was up at a rate of 1.1%. Consequently, labor productivity was up 2.1%—a strong number. In the first quarter, productivity had been up at a rate of 0.5% from the previous quarter. Thus, productivity has accelerated significantly. Also, the second-quarter growth of productivity was largely due to services rather than manufacturing. Indeed, manufacturing productivity was up at a rate of only 1.1% from the previous quarter, implying even faster growth of productivity for services. This is very important given that the remaining inflation problem is in services.

Meanwhile, the government reports that, in the second quarter, hourly compensation was up at a rate of 3.2% from the previous quarter. This means that ULCs were up at an annualized rate of only 1.1% from the previous quarter. Recall that ULC increased 3.7% in the first quarter. Also, manufacturing ULC was up at a rate of 3.2% in the second quarter, implying that services ULC was up even slower than 1.1%. This is very good news from an inflation perspective. The Federal Reserve has been explicit in saying that strong productivity growth could lead to an easing monetary policy sooner and faster than otherwise. 

Separately, the government reported on employment costs, including both wages and benefits. The employment cost index (ECI) is published every three months and offers insight into the tightness of the job market. The latest ECI for June was up 4.1% from a year earlier. In March, the ECI had been up 4% and in June of last year it was up 4.5%. Thus, pressure on employment costs has eased. Still, employment costs are rising faster than inflation. The government estimates that real (inflation-adjusted) employment costs were up 1.1% in June versus a year earlier. However, given that productivity was rising in the second quarter, this doesn’t necessarily imply more inflationary pressure. In any event, the fact that real wages are rising implies that the labor market is relatively tight. 

However, one indication that the tightness in the US labor market is easing is that initial claims for unemployment insurance have been rising. It is reported that, two weeks ago, the number of initial claims hit 247,000, up 14,000 from the previous week and the highest level since August 2023. If this continues, it will likely remove pressure on wages. 

Eurozone growth recovers

• The Eurozone economy is not strong, but it is clearly rebounding from a near recession last year. That is the inference to be drawn from last week’s release of second-quarter GDP numbers. The European Union (EU) reported that real GDP in the 20-member Eurozone increased 0.3% from the first to the second quarter, the same as in the previous quarter. Real GDP was up 0.6% from a year earlier. Recall that, in the third and fourth quarters of 2023, real GDP was unchanged on a quarterly basis. 

Second-quarter growth in the Eurozone was held back by Germany where real GDP declined 0.1% from the first to the second quarter. In two of the last three quarters, German real GDP declined. The German government said that the weakness was due to a drop in business investment in equipment and structures. Investment in Germany has been hurt by several factors including relatively high energy costs, weak demand in China, weak domestic demand, and intense competition from China and the United States. 

Meanwhile, other Eurozone economies performed better. In Spain, real GDP was up 0.8% from the first to the second quarter. This followed growth of 0.8% in the first quarter and 0.7% in the fourth quarter of 2023. In other words, Spain’s economy is on fire. The Spanish government reported that all major components were up strongly including consumer spending (up 0.3%), investment (up 0.9%), and exports (up 1.2%). It reported that the unemployment rate in Spain has dropped to the lowest level since 2008. Meanwhile, Spanish inflation has decelerated, largely due to declining electricity prices. That, in turn, likely helped consumer spending. 

In the rest of the Eurozone, growth was mostly moderate. In France, real GDP was up 0.3% in the second quarter versus the first quarter while real GDP was up 0.2% in Italy. The better-than-expected growth in France was largely due to strong export growth. On the other hand, the current political climate in France threatens to undermine business confidence and, consequently, investment. 

The big question on the minds of investors is what the European Central Bank (ECB) will do in September. There is a widespread expectation that the ECB will continue to cut interest rates. The latest GDP numbers do not likely change the trajectory of monetary policy. They indicate modest GDP growth, with strength in Spain and weakness in Germany offsetting one another. This, combined with recent data showing favorable inflation trends will likely allow the ECB to feel comfortable in cutting rates. However, the future trajectory of rates will depend on whether inflation continues to decelerate.

Eurozone inflation might be stuck

• Until very recently, there had been a strong expectation that the European Central Bank (ECB) would cut interest rates in September. Yet after the release of inflation data for July, it is a bit less certain. Rather, the modest acceleration in headline inflation suggests a possibility that the ECB will wait a bit longer. Let’s look at the data.

The EU reported that, in July, consumer prices in the 20-member Eurozone were up 2.6% from a year earlier, an increase from 2.5% in June. Moreover, headline inflation appears to have gotten stuck. It was 2.6% in February and as low as 2.4% last November. Still, prices were unchanged from June to July, which bodes well for a reduction in annual inflation in the months to come. 

When volatile food and energy prices are excluded, core prices were up 2.9% in July from a year earlier. This is the same rate of increase as in March, May, and June. As such, inflation appears to have stabilized higher than the ECB’s target of 2%. Still, core prices fell 0.2% from June to July, indicating shorter-term progress. 

Looking at the details, goods prices are tame while service prices continue to rise. The prices of non-energy industrial goods were up only 0.8% in July from a year earlier. Moreover, they fell 2.6% from June to July. Energy prices accelerated in July while food price inflation remained tame. Meanwhile, prices of services were up 4% from a year earlier and were up 1.2% from June to July. The service price situation is the principal conundrum facing the ECB. Services inflation has not decelerated, having been 4% as far back as November. Real wages are rising while productivity is falling. That is likely why service prices continue to rise faster than desired.  

By country, annual inflation in July was 2.6% in Germany, 2.6% in France, 1.7% in Italy, 2.9% in Spain, 3.5% in the Netherlands, and 5.5% in Belgium. On a monthly basis, prices fell in Italy, Spain, and Belgium, suggesting that annual inflation is likely to recede further in these countries. 

All of this leads to the decision-making of the ECB. On the one hand, headline inflation is at a desirable level while Europe’s largest economy (Germany) remains very weak. Plus, monthly inflation data in July was quite favorable. On the other hand, service inflation is stable and too high, while some European economies exhibit considerable strength. Thus, the ECB must undertake a balancing act. It does not want to keep interest rates high for too long lest it weaken a fragile recovery. Yet it doesn’t want to cut rates too soon lest it fail to get inflation under control. Finally, until recently futures markets were pricing in an 80% probability of a rate cut in September. That is now down to 65%. After the ECB undertook the initial rate cut in June, it said that the path of interest rates in the months to come would be bumpy.  

Bank of Japan action leads to a sharp rise in the value of the yen

• In the past year, much ink has spilled as pundits attempted to predict when the Bank of Japan (BOJ) would start to meaningfully tighten monetary policy, especially as Japanese inflation has been at or near a 40-year high in recent years. Now, the time has come. The BOJ increased the benchmark interest rate from 0.10% to 0.25%. This followed an increase in March from –0.1% to 0.1%. In addition, the BOJ announced that it will slow the pace of asset purchases by half. 

While investors had expected a shift in asset purchases, they did not expect the rise in the benchmark interest rate, according to a survey of investors. As such, they reacted strongly by pushing up the value of the yen. In recent days it reached close to 148 yen per US dollar, having bottomed just a few weeks earlier at 161 yen per dollar. This is a significant change. 

In his comments following the announcement, BOJ Governor Ueda said: “The policy rate is still very low even after a hike to 0.25. It is still negative after inflation is taken into consideration. We do not view this as a strong brake on the economy.” This sets the stage for further rate hikes. Ueda said that “I do not necessarily view 0.5% as a barrier.” He said that the BOJ would continue to raise the rate depending on the inflation data. 

For now, there is likely a broad expectation of further rate hikes by the BOJ. There is also a widespread expectation that the US Federal Reserve will start to gradually cut rates in September. Unless actions by either central bank turn out to differ from current expectations, there is no reason for a further sharp appreciation of the yen. Of course, unexpected events could disrupt currency values. 

What will be the impact of the higher valued yen? First, a rising currency can be disinflationary, which is precisely what the BOJ desires. In fact, Ueda said that the exchange rate was a factor in the BOJ’s decision. Second, a higher yen will cut prices of imported commodities, potentially boosting the purchasing power of Japanese households. Third, a higher yen could reduce the competitiveness of exports. Fourth, if investors expect a further rise in interest rates and/or a rise in the value of the yen, this will likely suppress the carry trade. Indeed, it has been reported that investors have been unwinding carry trade positions.

China’s currency is becoming more international, but not by much

• China aspires to internationalize its currency, the renminbi. Internationalization means that the renminbi would be used often as a transaction currency, as a store of wealth for foreign nationals, and as a reserve asset for major central banks. For China, the benefit of internationalization is that it reduces currency risk for Chinese exporters and importers. In addition, it gives China soft power in dealing with other countries. For the United States, the dominance of the dollar has been called “an exorbitant privilege” that lowers the cost of borrowing money for the US government and US nationals. It also allows the US government to restrict access to the dollar as a weapon in international relations. China is keen to avert this tactic of the US government.

Lately, there is evidence that the global role of the renminbi is rising, although it remains low. Renmin University in China releases a yuan (renminbi) internationalization index, which is meant to measure how the Chinese currency performs globally. The index is based on measures of renminbi usage in trade settlement, financial transactions, and use as a reserve currency by central banks. In 2023, the index was up 22.9% from a year earlier, indicating a sharp increase in usage. On the other hand, the internationalization score in 2023 was 6.7. In comparison, the score was 51.5 for the US dollar and 25.0 for the euro. However, China’s score exceeded that of the British pound (3.8) and the Japanese yen (4.4). 

The government in Beijing has taken various steps to boost usage of the renminbi. A professor in China said that “cross-border financial settlement platforms established by various provinces have effectively attracted many financial institutions, improving the efficiency of corporate payments and receipts, expanding investment and financing channels, and advancing the internationalization of the yuan.”

Going forward, China’s government is expected to continue to promote the renminbi, including through the negotiation of currency-swap arrangements with emerging country governments. However, it seems unlikely the renminbi can challenge the role of the US dollar anytime soon. That is because China continues to retain capital controls. This enables China to target the currency value and to maintain interest rates at a rate lower than a free market rate. This is sometimes known as financial repression, undertaken to enable favored companies to borrow cheaply, even at the cost of low returns for holders for renminbi-denominated assets. Unless China is willing to remove capital controls, the role of the renminbi is likely to be suppressed.