Weekly global economic update

Week of June 5, 2023

• US job market remains strong
• US inflation started with supply issues, but labor-market issues could sustain high inflation
• Discerning the impact of the recent banking crisis in the United States
• Eurozone inflation decelerates, but ECB likely raise rates further
• The impact of China’s slow growth on the global economy
• The impact of climate change on the global economy

US job market remains strong

• The latest employment report from the US government offers conflicting inferences. The US government releases two reports: one based on a survey of establishments; the other based on a survey of households. The establishment survey found stronger-than-expected job growth in May, with broad-based gains in employment. It was the second-biggest increase since September 2022. Also, the establishment survey found a deceleration in wages, which is favorable in terms of suppressing inflationary pressures.

However, the household survey found stagnant labor force participation, a decline in employment, and an increase in the number of unemployed. In fact, the unemployment rate increased to the highest level since October. The household survey includes the self-employed, which might partially explain the discrepancy between the household and establishment surveys. Moreover, although the participation rate was unchanged, the participation rate for those 25 to 54 hit a 16-year high. Finally, the household survey data tends to be more volatile than the establishment data and tends to have a larger margin of error. Thus, it should be taken with a grain of salt. Overall, the strong establishment data suggests a continued healthy job market in the United States.

Here are the details: According to the establishment survey, 339,000 new jobs were created in May. In addition, estimated employment growth for the two previous months was upwardly revised. Private sector employment growth was 283,000. There was almost no growth of employment in mining and a small decline in manufacturing. However, construction employment increased sharply.

On the services side, there was modest growth of employment in retailing and strong growth for transportation and warehousing. There was modest growth in financial services, with a decline in banking offset by an increase in other areas of finance, especially insurance. Professional and business services saw a sharp increase of 64,000 as did health care and social assistance, up 74,600. Leisure and hospitality were up a strong 48,000, largely driven by the restaurant industry. Finally, government employment was up 56,000, almost entirely driven by gains in state and local government. Thus, employment growth was a characteristic of most industries. The weakness of manufacturing stands out and is consistent with other indicators, such as the purchasing manager’s index (PMI), pointing to declining manufacturing activity.

Also, the establishment report examined wage behavior. It found that average hourly earnings of all US workers were up 4.3% in May versus a year earlier, the smallest increase since June 2021. Wage inflation had peaked in March 2022 at 5.9%. The deceleration in wages likely reflects two factors. First, inflation is decelerating, thereby reducing the need for workers to seek big pay gains. Second, increased participation by primary-aged workers has eased some of the tightness in the labor market. Decelerating wage gains mean that the labor market is still not contributing to inflation. If wages continue on this path, it will be easier for the Federal Reserve to achieve its target of 2% inflation. Yet if the tightness of the job market leads to sticky wage gains, the Fed will likely have a more difficult time in suppressing inflation.

The separate survey of households found that the labor force increased more slowly than the working-age population. It also found that the number of employed fell and those reporting being unemployed rose significantly. The result was that the unemployment rate increased from 3.4% in April to 3.7% in May, the highest since October 2022. Still, this is one of the lowest unemployment rates in the last half century. Meanwhile, most of the increase in unemployment was due to people either being dismissed or having completed temporary assignments.

Investors greeted the employment report favorably. US equity prices rose moderately on expectations that the US economy will perform well this year and potentially avoid recession. In addition, bond yields increased slightly. While some Wall Street economists still expect a recession sometime this year, our Deloitte economics team in the United States believes that there is a low probability of a recession. Of course, much will depend on what the Fed does. The general view in markets is that the Fed will soon pause monetary tightening and wait to see what happens. The employment data suggests the possibility that the United States could be in an unusually favorable position of continued economic strength and decelerating inflation. The question now is how long this can last.

US inflation started with supply issues, but labor-market issues could sustain high inflation

• In a recent paper, former Fed Chair Ben Bernanke says that, although supply problems were the principal contributor to the surge in inflation that began two years ago, persistent tightness in the labor market will hurt the ability to further suppress inflation. Specifically, Bernanke (and his co-author Olivier Blanchard) say that “contrary to early concerns that inflation would be spurred by overheated labor markets, most of the inflation surge that began in 2021 was the result of shocks to prices given wages, including sharp increases in commodity prices and sectoral shortages.”

However, although tight labor markets have thus far not been the primary driver of inflation, the effects of overheated labor markets on nominal wage growth and inflation are more persistent than the effects of product-market shocks. Controlling inflation will thus ultimately require achieving a better balance between labor demand and labor supply.

Bernanke and Blanchard expressed surprise that, despite a very tight labor market in the United States, labor-market conditions played only a minor role in initially generating inflation. However, so long as labor markets remain tight, the impact of labor-market conditions on inflation are likely to grow, thereby sustaining inflation at a level above what is desired. Consequently, they say that “the portion of inflation which traces its origin to overheating of labor markets can only be reversed by policy actions that bring labor demand and supply into better balance.” In other words, continued tightness of monetary policy is warranted.

Does that mean further rate hikes? Not necessarily. It could be the case that the actions taken so far by the Fed are sufficient. Moreover, monetary policy acts with a lag. That means the Fed might have to wait to see the fruits of its labor. Given Bernanke’s esteemed position among economists, and his successful reign at the Fed, his words will likely carry some weight.

Discerning the impact of the recent banking crisis in the United States

• When Silicon Valley Bank (SVB) failed in March, there were fears that this could lead to a larger financial crisis that would cause credit markets to seize up. That did not happen. Instead, the US Federal Reserve and the US Treasury took steps to provide liquidity to banks and to reassure depositors and investors, thereby avoiding a ruinous credit crisis. However, although only a handful of banks failed during the crisis, and although risk spreads have reverted to normal levels, the crisis did take a toll on credit markets in a way that weakens the US economy. Indeed, Federal Reserve Chair Powell has said that the negative impact of the crisis on bank lending will likely influence Fed decisions in the months ahead. It is widely expected that the Fed will soon pause rate increases, in part due to a belief that the banking crisis weakened credit markets sufficiently to suppress inflationary pressure.

What has been the impact of the crisis on the US banking sector? The Institute of International Finance published a report showing that US bank deposits fell sharply after the SVB failure but have stabilized during the past two months. That stabilization suggests that the crisis was relatively short-lived and that the banking sector is starting to revert to normal.

Meanwhile, bank lending growth has been very slow, especially compared to the rapid growth a year earlier, as well as compared to the period just prior to the failure of SVB. Since March, there has been a decline in commercial and industrial lending, offset by a modest rise in consumer lending. On the other hand, lending for both commercial and residential property has risen modestly since the crisis began.

We can infer that the brief banking crisis, while slightly weakening credit markets, has not significantly increased the risk of recession as had been feared.

Eurozone inflation decelerates, but ECB likely raise rates further

• Inflation in the Eurozone is receding. Moreover, not only is headline inflation declining, largely due to a drop in energy prices, but core inflation (excluding the impact of energy and food prices) is also decelerating.

Let’s look at the details. In May, consumer prices in the 20-member Eurozone were up 6.1% from a year earlier. This is down from an increase of 7% in April and a peak rate of inflation of 9.2% in December. Moreover, prices were unchanged from the previous month. Meanwhile, energy prices were down 1.7% from a year earlier and down 2.2% from the previous month. On the other hand, food prices were up 12.5% from a year earlier and up 0.4% from the previous month. When food and energy are excluded, core prices were up 5.3% from a year earlier, down from 5.6% in April. Core prices were up 0.2% from the previous month. In part, the drop in core inflation can be attributed to the introduction of transport subsidies in Germany.

The principal driver of Eurozone inflation is now food, accounting for roughly half of the overall inflation. The good news is that agricultural commodity prices are falling, thereby setting the stage for a further decline in Eurozone inflation. The situation in Europe is different than in the United States where inflation is now largely driven by the services sector, especially shelter.

By country, annual inflation was 6.3% in Germany, 6% in France, 8.1% in Italy, 2.9% in Spain, 6.8% in the Netherlands, 2.7% in Belgium, 4.1% in Greece, 5.4% in Ireland, and 5.4% in Portugal. Annual inflation decelerated from the previous month in 18 of the 20 countries.

Although the sharp decline in inflation is good news for the European Central Bank (ECB) as it ponders its next move, ECB President Lagarde made clear that further monetary tightening is coming. In a speech delivered after the release of the inflation data, she said that “inflation is too high and it is set to remain so for too long. We are determined to bring it back down to our 2% medium-term target in a timely manner.” She added that “we have made clear that we still have ground to cover to bring interest rates to sufficiently restrictive levels.” She said that further tightening is “still in the pipeline.” She concluded that “we need to continue our hiking cycle until we are sufficiently confident that inflation is on track to return to our target in a timely manner. At the same time, we need to carefully assess the strength of monetary policy transmission to financing conditions, the economy and inflation.”

Further monetary tightening in the Eurozone will likely weaken credit markets and slow economic growth. Already Germany is in recession and other countries are at risk of recession. German industry has been especially hurt by weakness in China. On the other hand, declining energy prices and increased government subsidies help to reduce the risk of recession.

The impact of China’s slow growth on the global economy

• China’s weaker-than-expected economic performance is having an impact on global commodity markets. Prices of copper, iron ore, steel, nickel, and other metals have all fallen sharply since early March. Some analysts point to declining commodity prices as evidence of a weak global economy. Yet it might simply be evidence of a weak Chinese economy given China’s huge demand for mineral commodities.

What are the indications of economic weakness in China? They include decelerating retail sales, declining industrial production, decelerating credit activity, and declining housing starts. Private sector business investment has stagnated while export growth has slowed markedly. In addition, youth unemployment has hit a record high level.

However, many observers were especially shaken by the unexpected decline in the PMI in May. PMIs are forward-looking indicators meant to signal the direction of economic activity. The government said that the manufacturing PMI for China fell from 49.2 in April to 48.8 in May, signaling a continued and accelerating decline in manufacturing activity. A reading below 50 indicates declining activity. The subindices for output, new orders, and raw material inventory all declined. Markit suggested that this indicates weakness of export demand as well as weak demand for capital goods. The separate PMI for services was above 50. Thus, the economy continued to grow in May, but was held back by the weakness in manufacturing. And, of course, it is the manufacturing sector in China that purchases commodities on a large scale.

The impact of climate change on the global economy

• Last summer, heat waves around the world led to declining water levels and disruption of agriculture, inland transportation, and energy production. It was especially bad in China where the Yangtze River’s water level fell sharply, leading to disruption of hydroelectric and nuclear power generation. An electricity shortage ensued, having an impact on industrial activity while leading the government to reopen closed coal mines.

Now, it appears, that China is facing something similar again. In March, April, and now May, temperatures in China have hit record levels. On Monday, the temperature in Shanghai hit a May record of 36.1 degrees Celsius (96.7 degrees Fahrenheit). Shanghai is not alone. Many cities in China are hitting records, having also seen records in the previous two months. The result is a shortfall of rain and a decline in water levels. Also, power grids are facing additional stress. In Guangdong Province in southern China, demand for electricity has lately surged due, in part, to additional usage of air conditioning. If this continues throughout the summer, there could be electricity shortages again.

There have been unusually high temperatures in Southeast Asia as well. Meteorologists are predicting that global temperatures will hit records this year and next year. Thus, climate change is now having a disruptive impact on human life and on the global economy. As governments and the private sector struggle to accelerate the transition to clean energy, demand for carbon-based fuels continues to rise. Moreover, climate change will continue to disrupt the ability to produce clean energy such as hydroelectric power and nuclear power. While China is currently experiencing the brunt of this problem, it is not a Chinese problem. Rather, the global economy is facing a new era of periodic disruption that will influence multiple industries—energy, agriculture, manufacturing, finance (especially insurance), health care, and construction.