Weekly global economic update
What’s happening this week in economics? Deloitte’s team of economists examines news and trends from around the world.
Central bankers see a soft landing coming
- Recently, the world’s leading central bankers gathered for their annual meeting in Jackson Hole, Wyoming, an idyllic landscape for discussing such mundane topics as interest rates and inflation. What made the gathering notable was that it represented a pivot away from the pessimism of the last few years. No longer was fear expressed about imminent recession. Nor was there any discussion this time about troubling trade-offs between inflation and employment. Rather, the gathering exhibited general confidence that the major economies can experience a soft landing. Let’s look at what the leading central bankers had to say, beginning with Jay Powell of the US Federal Reserve.
Powell was surprisingly explicit that “the time has come for policy to adjust.” Investors were not surprised at the content of his comments, just by the fact that he said it. Thus, asset prices did not respond sharply, although bond yields fell while the value of the US dollar fell. Moreover, Powell noted that “the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks.”
Powell’s statement that interest-rate cuts are appropriate came after he reviewed the recent history of inflation in which he noted that the rise of inflation had largely to do with pandemic-related supply issues. He then asked the question: “How did inflation fall without a sharp rise in unemployment?” His answer was that “pandemic-related distortions to supply and demand, as well as severe shocks to energy and commodity markets, were important drivers of high inflation, and their reversal has been a key part of the story of its decline.” He added that “our restrictive monetary policy contributed to a moderation in aggregate demand.” Plus, he said that this moderation eased demand for labor while rising labor supply brought “the labor market to a state where it is no longer a source of inflationary pressures.” He concluded that expectations of inflation are well anchored, thereby allowing the Fed to cut rates.
The Fed has a dual mandate from the US Congress to minimize inflation and maximize employment. Until recently, it was largely focused on inflation, especially at a time when the labor market was very tight and likely contributing to inflation. Now, things have changed, with job growth having eased in recent months. Powell said that the Fed does not “seek or welcome further cooling in labor market conditions.” While he appeared confident that the economy will experience a soft landing, he said that the Fed has “ample room to respond to any risks we may face, including the risk of unwelcome further weakening in labor market conditions.”
Meanwhile, the European Central Bank (ECB) sent its chief economist, Philip Lane, to the gathering in Jackson Hole. Lane expressed some hesitation about further rate cuts. He said that “the return to target is not yet secure. The monetary stance will have to remain in restrictive territory for as long as needed to shepherd the disinflation process towards a timely return to the target.”
Recall that the ECB became the first large central bank to cut rates back in June. Moreover, investors are pricing in a likelihood of two more rate cuts this year. Still, services inflation in the Eurozone has been persistent while the labor market has remained relatively tight. Hence the hesitation. On the other hand, Lane said that “a rate path that is too high for too long would deliver chronically below-target inflation over the medium term and would be inefficient in terms of minimizing the side effects on output and employment.” Thus, he appeared to suggest that rate cuts are coming.
Finally, Bank of England (BOE) Governor Andrew Bailey said that he is “cautiously optimistic” about inflation. The BOE has already cut rates one time and investors are pricing in further rate cuts. The United Kingdom has made significant progress on inflation while the economy continues to grow. Bailey said, however, that it is “too early to declare victory” over inflation. Notably, Bailey appeared to embrace a soft-landing scenario, saying that “the economic costs of bringing down persistent inflation—costs in terms of lower output and higher unemployment—could be less than in the past.”
Overall, the Jackson Hole meeting exuded a sanguine attitude toward the major economies. However, one participant offered a note of caution. The president of the Federal Reserve Bank of Chicago, Austan Goolsbee, said that monetary policy tends to act with a long and variable lag. This raises “the question of how long are the lags in monetary policy, and the longer you think the lag is, the more concerned we should be about whether the Fed could make a rapid pivot.” In other words, we might not yet have experienced the negative consequences of the recent tightening of monetary policy. Moreover, it is unclear if the negative effects can be offset by a quick easing of policy. Time will tell.
Is US monetary policy tight or not?
- Recently, it has been said that the US Federal Reserve needs to cut interest rates because monetary policy has become tighter in the past year. That is because, with declining inflation, real (inflation-adjusted) interest rates have risen, thereby having a more negative impact on economic activity. It could be argued that, absent an imminent easing of monetary policy, the Fed risks allowing recessionary conditions to develop. And indeed, the Fed has been explicit in its intention to start cutting rates in September.
But there is another point of view. Adam Posen, president of the Peterson Institute and a former member of BOE’s policy committee, says that Fed policy is not tight. His reasoning is that financial market conditions remain relatively favorable. Thus, he says, the tightness or looseness of monetary policy should not be judged by the level of interest rates. Rather, it should be judged by the impact on financial market conditions. Moreover, he notes that the evident resilience of the US economy, due in part to productivity gains and strong immigration, also demonstrates that monetary policy has been relatively easy rather than tight. A tight policy would have led to a sharp deceleration in output.
Still, Posen does not argue that the Fed should leave interest rates in place. He supports a cut, especially given that inflation is down considerably and that the labor market is clearly weakening. However, he thinks that, ultimately, interest rates will land significantly higher than previously.
As for financial market conditions, there are several favorable indicators. Risk spreads remain historically low, equity valuations are historically high, and a Federal Reserve Index of Corporate Bond Market distress is historically low. In addition, consumer finances are in good shape. Although levels of debt, debt service payments, and delinquencies have risen, they remain relatively low by historical standards. Plus, the creditworthiness of most household borrowers is far better than before the global financial crisis. Thus, Fed policy has not had the effect of weakening credit market conditions or suppressing asset prices.
US household data is consistent with expectations for a rate cut
- In July, real (inflation-adjusted) disposable income grew modestly while real consumer spending grew rapidly. That divergence cannot go on indefinitely, but for now it is leading to strong economic performance. Meanwhile, the Federal Reserve’s favorite measure of inflation remained steady in July. Let’s look at the details.
The US government reported that, in July, real disposable personal income (household income after inflation and taxes) was up a modest 0.1% from the previous month. This reflected continued growth of employment and rising real wages. Meanwhile, real consumer expenditures were up 0.4% from June to July. This difference was possible because the personal savings rate continued to decline, falling from 3.1% in June to 2.9% in July. Recall that the savings rate had been as high as 4% in January, falling steadily ever since. It should be noted that the savings rate falls when the debt/income ratio rises.
As for the details of consumer expenditures, real spending on durable goods was up 1.7% from June to July, spending on non-durables was up 0.2%, and spending on services was up 0.2%. The considerable strength of spending on durables is notable, especially at a time when activity in the housing market remains stagnant. Housing often fuels purchases of home-related durable goods.
The report also included data on the personal consumption expenditure deflator (PCE-deflator), which the Federal Reserve favors over the better-known consumer price index (CPI) as a measure of inflation. The PCE-deflator was up 2.5% in July versus a year earlier, the same as in June, but also the same as in January and February. Thus, headline inflation appears to have stabilize slightly above the Fed’s 2% target. When volatile food and energy prices are excluded, the core PCE-deflator was up 2.6% in July versus a year earlier, the same as in May and June. However, core inflation decelerated from earlier in the year, having been 2.9% in January.
The data indicates that the prices of durable goods fell 2.5% in July versus a year earlier, prices of non-durables were up 1.3%, and prices for services were up 3.7%. Regarding services, prices have decelerated from April when they were up 4%. Still, services inflation remains too high, driven by a tight labor market. This has been the principal concern of the Fed. However, the labor market has clearly eased in recent months. Consequently, the Fed has signaled a strong intention to start cutting interest rates in September. The latest data do nothing to change that expectation. Indeed, equity prices and bond yields moved very little in response.
Eurozone inflation data is consistent with a September rate cut
- Inflation in the 20-member Eurozone was very low in August, boding well for the ECB to renew rate cuts in September. Specifically, the CPI was up only 2.2% in August versus a year earlier, down from 2.6% in the previous month and the lowest rate since July 2021. Prices were up 0.2% from the previous month. The low level was due, in part, to a sharp decline in energy prices.
When volatile food and energy prices are excluded core prices were up 2.8% in August versus a year earlier, down from 2.9% in July. However, core inflation has been steady throughout this year. Notably, service inflation increased to 4.2% in August, the highest since last October. That is likely the most worrisome aspect of the latest inflation report. On the other hand, the surge in services inflation could have been a temporary reaction to the Olympic games in France.
By country, annual inflation was 2% in Germany, 2.2% in France, 1.3% in Italy, 2.4% in Spain, 3.3% in the Netherlands, and 4.5% in Belgium. Financial market reaction to today’s report was relatively muted. Investors were evidently not surprised.
Now that there is a high anticipation that the US Federal Reserve will start cutting interest rates in September, and with many investors expecting the Fed to implement a 50-basis-point rate cut, the environment is now more favorable for the ECB to engage in a second rate cut (the first took place in June).
Usage of Chinese renminbi is rising
- China wants to reduce dependence on the use of US dollars in trade. Doing so would reduce currency risk and would increase the influence of China in dealing with its trading partners. Now it is reported that usage of the Chinese renminbi in China’s bilateral trade has grown significantly. The Chinese government reported that, in July, the renminbi accounted for 53% of China’s inbound and outbound transactions, up from 40% three years ago.
Partly, the increase reflects the surge in Chinese trade with Russia. Russians are restricted from using US dollars due to sanctions imposed following Ukraine-Russia war. Russia is eager to engage in renminbi-based transactions as it helps to offset the negative impact of Western sanctions.
In addition, the rise of renminbi transactions reflects an increase in the number of currency swap agreements that China has with several other countries. These include Saudi Arabia, Argentina, Mongolia, and Brazil, among others. In the case of Saudi Arabia, China has become the biggest purchaser of oil and prefers to transact in renminbi. Saudi Arabia has a trade surplus with China, which means that the kingdom is accumulating renminbi, which are not easy to invest outside of China. Thus, the Saudis are likely selling renminbi in exchange for dollars and euros.
Moreover, China has intervened in currency markets to stabilize the exchange rate between the US dollar and the renminbi. This helps to encourage others to transact in renminbi as it enables them to sell their renminbi in exchange for dollars at a reliable rate. If China were to remove existing capital controls, then it would become less risky for others to invest renminbi in China, thereby making renminbi transactions more attractive. Yet there is no indication that this will happen anytime soon.
Despite the rise in renminbi usage, the renminbi still only accounts for less than 5% of global transactions.