Weekly global economic update

Week of November 11, 2024

• Does the US budget deficit matter?
• Federal Reserve continues to ease monetary policy
• US labor productivity continues to grow strongly
• Bank of England cuts rates once again

Does the US budget deficit matter?

• Interestingly, during the US election campaign that ended recently, almost nothing was said by either candidate about America’s burgeoning public sector debt. Rather, much was said about immigration, inflation, abortion, and trade—all important issues. But how the government finances (or fails to finance) its expenditures, which is a hugely important issue, did not attract much attention. Meanwhile, the issue has been of concern to business leaders, judging by the questions I’ve received when presenting the economic outlook. Is this concern warranted? 

First, some facts. In the fiscal year that just ended, the Federal government’s budget deficit (expenditures minus revenues) is estimated by the Congressional Budget Office (CBO) to have been 6.7% of GDP. This is an unusually high number given that the economy is running close to full capacity, with an historically low unemployment rate. The only times in our history that the deficit/GDP ratio was higher was either during deep recession or during and immediately after World War Two. Moreover, given the tax and spending plans of both candidates for president, it is likely that the deficit will remain relatively high in the years to come, if not higher.

Meanwhile, the level of debt is also historically high. There are three ways to measure the debt. First, there is the total debt, regardless of who holds that debt. By that measure, the debt/GDP ratio by end of fiscal year 2022 was 123.4%. This was down from an historic peak of 127.7% in FY2020, at the peak of the pandemic. During World War Two, it never reached this level. 

The second measurement is debt held by the public. This excludes debt held by government accounts such as the Social Security Trust Fund. By this measure, the debt/GDP ratio was 97% in FY2022, and likely 99% by the end of FY2024. In FY2020, this ratio was 99.7%. Prior to that, it had only been higher in FY1945 and 1946 at 103.9% and 106.1%, respectively. Moreover, under either candidate, it will likely go significantly higher in the years to come. 

Finally, the third, and likely most important, measurement is debt held by the public excluding that held by the Federal Reserve. Fed holdings increased significantly in 2010 during the global financial crisis and again in 2020 during the pandemic. These increases were part of the policy of quantitative easing in which the Fed purchased government bonds and other securities to boost liquidity. The idea was to avert a decline in the money supply (which happened during the Great Depression) because banks were not lending. This measure is important because it reflects the true impact of government debt on the private sector. By this measure, the debt/GDP ratio was 74.5% in FY2022, down from 78.7% in FY2020. The only time it had been higher than this was in the period 1944 through 1948, when it peaked at 95.6% in 1946. Again, under either candidate, this ratio is expected to rise in the years to come. 

Thus, the deficit and the level of debt are both historically high, although not yet catastrophically so. Should we be concerned? Yes and no. Normally, a large amount of government borrowing is worrisome because, as the government competes with private investors for scarce funds, it drives up borrowing costs, thereby stifling investment and economic growth. That has not been the case in recent years. In addition, if investors are wont to purchase government debt, then central banks could monetize the debt, thereby fueling ruinous inflation. That has not been the case either. 

Also, the existence of a large volume of debt, combined with expectations that it will grow, might spook investors who are fearful of default or inflationary monetization. This could lead to a financial crisis. So far this has not happened. Moreover, Japan offers an interesting case in that its debt/GDP ratio is far higher than that of the United States. Yet its borrowing costs and inflation have been much lower. This suggests that a developed economy can manage a large amount of debt without onerous consequences. 

On the other hand, there must be a limit to how far any government can go. After all, we know from the experience of some countries that excessive debt and government borrowing does lead to weak economic growth and/or very high inflation. Consider the case of Germany during the 1920s or, more recently, Greece during the 2010s. Plus, countries such as Venezuela, Argentina, and Zimbabwe offer extremely worrisome examples. 

Still, the United States is different from these countries. The United States issues the world’s dominant currency. As such, it has what has been described as an “exorbitant privilege.” Not only is its external debt in its own currency. Global investors crave US dollars, especially during uncertain times. The market for US government debt is huge, liquid, transparent, and reliable. Thus, the United States can likely engage in a more expansive, fiscal policy than other countries without noticeable consequences. 

Nevertheless, this cannot necessarily go on forever. Absent a shift in policy, there will likely come a time when the United States will pay a price for its largesse. We just don’t know when that time will be. It could be a long time from now. After all, I’m old enough to remember stark warnings about US fiscal policy in the 1980s when deficits were relatively high following big tax cuts and increases in defense spending. Pundits warned that a crisis was imminent. It never came. 

So, what can be done? The ugly trajectory of future deficits stems in large part from demographics. That is, an aging population means more spending on entitlements for the elderly, such as Social Security and Medicare. A slow-growing working-age population means inadequate growth of government revenue, absent tax increases, to fund these programs. To address this issue, there are several things that could be done. For example, the retirement age could be increased, taxes could rise, benefits could be cut, other types of government spending could be cut, or immigration could be boosted (thereby raising the ratio of workers to retirees). None of these would be politically easy, but a combination of them would likely solve the problem.

Also, a big chunk of Federal government spending goes to health care (such as Medicare, Medicaid, and veteran’s benefits). The hope is that new technologies such as gen AI will likely boost the productivity of health services, thereby lowering costs. If that were to happen, it would likely have a big impact on government deficits. This remains a big unknown.

In any event, government leaders will not likely be willing to take the risk of addressing this long-term problem until it becomes a short-term problem, fueled by investor concern. Recall that, in the 1990s, political consultant James Carville said: “I used to think that if there was reincarnation, I wanted to come back as the president or the Pope or as a 400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.” Once the bond market intimidates politicians about the debt situation, then action will become likely.  

Federal Reserve continues to ease monetary policy

• After having initiated the easing of monetary policy by implementing a 50-basis-point rate cut in September, the US Federal Reserve followed up recently with an expected 25-basis-point cut in the Federal Funds rate. This was widely expected. The target Federal Funds rate will now be in a range of 4.5% to 4.75%. The decision was unanimous.

The Fed action comes on the heels of the US election. Following the election there was a sharp rise in US equity prices on expectations of fiscal stimulus from a potential tax cut. There was also a rise in bond yields on expectations of higher inflation, the latter due to anticipated tax cuts and tariffs. As such, investors have revised their expectations for Fed policy going forward, anticipating slower monetary easing than previously. For example, futures markets are now pricing in a 67.8% probability that there will be another 25-basis-point rate hike in December, down from 78.3% a month ago. In addition, investors see a 32.2% probability that the rate will not be cut in December, up from 14.3% a month ago. Interestingly, the Fed did not provide any forward guidance about the direction of future policy, only saying that it will be data driven. 

The Fed action was based on a view that inflation is largely under control, although the Fed said that inflation remains “elevated,” mainly due to persistent inflation in services. Moreover, although the economy is strong and the labor market relatively tight, the Fed is concerned that a continuation of tight monetary policy could damage the economy as the lagged impact of high interest rates takes their toll. Plus, the Fed is likely pleased that labor productivity continues to grow rapidly, thereby offsetting the inflationary impact of a tight labor market. 

The Fed judges current interest rates to be reflective of a tight monetary policy. The goal is to bring rates down to a point where monetary policy is neutral rather than tight. However, Fed Chair Powell said that, although the goal is to bring monetary policy toward neutrality, “nothing in the economic data suggests that the committee has any need to be in a hurry to get there. We are seeing strong economic activity. We are seeing ongoing strength in the labor market.”

When asked how the policies of the new administration might influence monetary policy, Fed Chair Powell refused to comment, saying that it is too early to judge the specifics of any new policy. On the other hand, he said that the Fed would take into account any future changes in government borrowing costs that might stem from changes in fiscal policy. In addition, Powell said that he intends to retain his position until the end of his term as Chairman in May 2026. At that time, a new Chairman could be appointed. 

• The Federal Reserve has a dual mandate from the US Congress: to minimize inflation and maximize employment. Yet there is implicitly a third mandate, which is to maintain financial stability. As such, the Fed pays close attention to stress in financial markets and the factors that create stress. Currently, one area of concern is the market for commercial property mortgages, principally those backing office property. 

Banks often allow troubled borrowers to extend mortgages rather than allowing them to default. Yet it is reported that the number of borrowers at risk of a “second default” has risen sharply, reaching the highest level in a decade. The volume of mortgages that are delinquent has risen sharply since late 2022. The rise in delinquencies followed the tightening of monetary policy by the Federal Reserve. The hope now is that, as interest rates come down, the number of mortgage holders facing trouble will likely decline. However, if the easing of monetary policy slows, it could spell trouble for some borrowers.

Clearly, the underlying problem has been the adoption of hybrid work practices by office workers. The share of workers spending part of each week at home is much higher than prior to the pandemic. This means reduced demand for office property and, in some cases, reduced valuations of office property. Meanwhile, the Federal Reserve Bank of New York reported that the practice of extending mortgages for troubled borrowers could cause a “buildup of financial fragility.” That is because this practice can mask the underlying problem, leading to a misallocation of credit.  

US labor productivity continues to grow strongly

• In the United States, productivity has been rising strongly for the past two years, thereby putting downward pressure on inflation while boosting GDP growth. Recently, the US government reported that this continued in the third quarter. Moreover, overall growth of labor productivity was faster than growth of productivity in the manufacturing sector. This is interesting as it is the opposite of what has happened for many years. It implies that productivity in the services sector is growing strongly, something we have not seen before. This suggests that service-oriented businesses are taking advantage of labor-saving and labor-augmenting technologies to boost output without boosting employment commensurately. This is necessary at a time when there is a shortage of labor. Let’s look at the details.

In the third quarter of 2024, labor productivity (output per hour worked) in the non-farm business sector of the United States was up at an annualized rate of 2.2% from the previous quarter and up 2% from a year earlier. In the manufacturing sector, productivity was up at an annualized rate of 1% from the previous quarter and up 0.7% from a year earlier. By inference, service sector productivity grew especially strongly. If that continues, it can be a game changer given the vast size of the services sector.

The increase in overall productivity took place because output grew rapidly (up at a rate of 3.5% from the previous quarter) while hours worked grew more modestly, up 1.2% from the previous quarter. Meanwhile, compensation was up at an annualized rate of 4.2%. As a result, unit labor cost (ULC, or the labor cost of producing an additional unit of output) was up at an annualized rate of 1.9% in the third quarter versus the previous quarter. ULC is an important measure that reflects the impact of both productivity and wages. If ULC grows slowly, as was true in the third quarter, it has a dampening effect on inflation. That is because productivity growth is partly offsetting the inflationary impact of rising wages. From the perspective of the Federal Reserve, this is good news.

The big question now is whether this surge in productivity will continue in the coming year and beyond. The Federal Reserve has indicated that continued strong productivity growth would provide room for an easier monetary policy than otherwise. Notably, the United States appears to be alone among major industrial countries in experiencing strong productivity growth. This has been a source of concern in many countries, with plenty of debate about how to boost productivity growth.  

Bank of England cuts rates once again

• The Bank of England (BOE) implemented the second interest rate cut in this cycle. It cut its benchmark interest rate by 25 basis points to 4.75%. The decision by the committee was eight to one. The first rate cut took place in August. The BOE chose not to move rates at the last meeting in September. BOE Governor Bailey said that “we need to make sure inflation stays close to target, so we can’t cut interest rates too quickly or by too much.” 

British inflation has decelerated sharply since peaking two years ago. In September consumer prices were up 1.7% from a year earlier, below the BOE’s target of 2%. However, that partly reflected a sharp decline in energy prices. Once energy prices stabilize, the BOE expects inflation to rebound slightly in the months to come. Bailey said that he expects the BOE to cut rates gradually in the months to come, provided that the economy evolves as expected.

Meanwhile, the BOE is likely evaluating the impact of the British government’s latest budget plan. Central banks in the United Kingdom, Eurozone, Canada, Japan, and the United States conduct monetary policy independently. However, their decisions are often taken with an eye of government fiscal policy, which can affect such things as borrowing costs, economic growth, and inflation.

Week of November 4, 2024

• US economic performance remains stellar
• US jobs market faces temporary constraints
• Eurozone economy picks up speed
• Eurozone inflation continues to ease
• Germany resists EU tariffs on Chinese EVs
• Mexico increasingly central to the US-China conflict

US economic performance remains stellar

• In the third quarter, the US economy continued to exhibit considerable strength, and the GDP report incorporated evidence of declining inflation. There are a few negative signs, but not sufficient to drive a significant slowdown.

The US government reported that, in the third quarter, real GDP grew at an annualized rate of 2.8% from the previous quarter. This was a bit slower than the 3% growth in the second quarter, but certainly far faster than the long-term ability of the economy to grow. 

Notably, real consumer spending grew at a stellar rate of 3.7%. This included an increase in spending on durable goods of 8.1%, nondurable up 4.9%, and services up 2.6%. Meanwhile, business investment remained robust. Nonresidential fixed asset investment grew at a rate of 3.3%. This included a 4% decline in investment in structures. However, this was more than offset by an 11.1% increase in investment in equipment but only a 0.6% increase in intellectual property. On the other hand, residential investment fell at a rate of 5.1%, the second consecutive quarterly decline.

Also, exports of goods and services grew rapidly at 8.9%, led by goods more than services. Imports were up at a rate of 11.2%, evidence of strong domestic demand. Finally, government purchases were up 5%, led by defense spending at 14.9%. Overall, the report indicated underlying strength. 

Going forward, there are a couple of reasons to expect real GDP growth to decelerate modestly. First, the delinquency rate on credit card debt is now relatively high. This will likely restrain the ability of consumers to continue making purchases of durable goods. Second, the GDP report indicated that real disposable personal income grew slower than real consumer spending. Consequently, the personal savings rate fell. This cannot go on forever. Third, the restrictiveness of monetary policy has resulted in a sharp increase in business bankruptcies. Although monetary policy is now easing, it remains tight. Bankruptcies can hurt investment and employment. Also, growing government debt, especially if the next US president implements a fiscal expansion, if perceived by investors as unsustainable, could lead to higher borrowing costs, thereby hurting investment. Finally, implementation of more trade restrictions would reduce consumer purchasing power and might ignite higher inflation, leading to tighter monetary policy than otherwise.   

Lastly, the GDP report included quarterly data on the Federal Reserve’s favorite measure of inflation: the personal consumption expenditure deflator, or PCE-deflator. In the third quarter, it was up from the previous quarter at an annualized rate of only 1.5%. This included declining prices of goods offset by only a 3% increase in the price of services. Moreover, the core PCE-deflator (excluding energy and food) was up at a rate of only 2.2%. 

• Following on its strong GDP report for the third quarter, the US government released data on personal income and consumer spending for September. It is the most recent picture we have of the consumer economy. Moreover, it includes data on the Federal Reserve’s favorite measure of inflation. Let’s look at the details.

In September, real (inflation-adjusted) disposable income (after taxes) was up only 0.1% from the previous month. Yet real consumer spending was up 0.4%. This means that households saved less in September than in August. That is, the personal savings rate fell from 4.8% of income in August to 4.6% in September. The savings rate has been steadily falling since a recent peak of 5.4% in January. It is not clear how long this trend will continue. The September rate is the lowest since last December. However, both real disposable income and real consumer spending were up 3.1% in September versus a year earlier. Thus, in the longer term, income and spending have moved together at a healthy pace.

Regarding consumer spending, real spending on durable goods was up 0.4% in September from the previous month, nondurables up 0.8%, and services up 0.2%.

Finally, the government released data on the Fed’s favorite measure of inflation. The PCE-deflator was up 2.1% in September versus a year earlier, the lowest level of headline inflation since February 2021. There was a decline in the prices of goods that was more than offset by a rise in the prices of services. Specifically, the price of durable goods was down 1.9% from a year earlier while the price of nondurables was down 0.8%. Meanwhile, the price of services was up 3.7%, the same as in July but down substantially from the recent past.

One reason for the low level of headline inflation was a sharp decline in energy prices in September. When volatile food and energy prices are excluded, the core PCE-deflator was up 2.7% from a year earlier, roughly unchanged over the past five months. Thus, underlying inflation has stabilized at a level slightly higher than the Fed’s 2% target. Still, the target is not meant to be a ceiling, but rather an average. As such, inflation appears to be under control. 

This latest report offers further support for the soft-landing scenario. Consumer spending remains healthy, although income growth has decelerated. Meanwhile underlying inflation is close to the Fed’s target. Consequently, it is reasonable to expect a continued easing of monetary policy, but at a moderate pace. It is also reasonable to expect some deceleration in economic activity. However, a recession is very unlikely.

US jobs market faces temporary constraints

• The October employment report from the US government indicated almost no job growth. Yet investors were not disturbed as there were special circumstances that led to the weak job growth. Specifically, there were two hurricanes in the Southeast region of the United States. In addition, there was a major labor strike at Boeing. The result was slow job growth of only 12,000. Yet this was not unexpected. Just a few weeks ago, Fed Governor Christopher Waller said that the hurricanes and strike “may reduce employment growth by more than 100,000 this month.” Evidently that is what happened. Moreover, investors failed to react, with bond yields and equity prices not moving significantly today. Let’s look at the details.

The US government produces two reports on the job market: one based on a survey of establishments; the other based on a survey of households. The establishment survey found that only 12,000 new jobs were created in October. More importantly, job growth in the previous two months was revised downwardly. Regarding the October numbers, there was a decline in manufacturing employment of 47,000, largely due to the strike at Boeing and its spillover effect on suppliers. In addition, employment fell modestly at retailing, leisure and hospitality, and transportation and warehousing. These declines were likely related to the hurricanes in the Southeast. Employment fell 47,000 in the professional services industry, mainly due to a drop in hiring at temporary help services, also related to the hurricane. Meanwhile, health care employment was up 52,300 while government employment increased by 40,000. 

The establishment survey also found that average hourly earnings were up 4% in October versus a year earlier, a jump from the previous month and the biggest increase since July. The acceleration in wages was likely due to the disruption from the hurricane, which reduced employment in low wage professions such as retailing and leisure and hospitality. The loss of these jobs boosted the average wage of existing workers. Even at 4%, wage growth is not a big contributor to inflation, especially given that productivity has been rising, which offsets the impact on prices from rising wages.

Also, the separate survey of households, which includes data on self-employment, found a sharp decline in the number of people participating in the labor force. In addition, employment declined commensurately, thereby allowing the unemployment rate to remain steady at 4.1%. This implies stability of the job market. 

It will take at least another monthly jobs report or more before we can make reasonable inferences about the state of the job market. 

• In the United States, the job openings rate continued to decline in September. This is the share of available jobs that are unfilled. It is a measure of the tightness or looseness of the job market. During the pandemic, the job openings rate soared as demand for labor remained robust while the supply of labor fell due to declining participation and immigration. In the past two years, the rate of participation by prime working-age people (25–54) has increased to the highest rate in a quarter century. Plus, immigration has risen. The result has been a sharp rise in the supply of labor, thereby causing the job openings rate to fall from a peak of 7.4% in March 2022 to 4.5% in September 2024. This is the lowest level since December 2020.

Notably, the current rate of 4.5% is relatively high compared to the prepandemic period. Prior to the pandemic, the highest job openings rate on record was 4.8%. Thus, one can reasonably state that the job market remains relatively tight. That, in turn, is consistent with the strong job growth seen in September. 

By industry, the highest job openings rate was in professional services (our industry), at 6.2%. Other high rates were found in hotels and restaurants as well as health care. Low rates were found in wholesale trade, retail trade, and manufacturing.

Eurozone economy picks up speed

• GDP growth in the Eurozone picked up speed in the third quarter. Real GDP was up 0.4% from the previous quarter, the fastest growth since the third quarter of 2022. To compare it to US growth, this was an annualized rate of 1.7% while US growth was 2.8%. The rebound is most welcome after a long period of sub-par growth. Now, with the European Central Bank (ECB) loosening monetary policy, there is hope that growth in 2025 will be significantly better than in 2024. 

By country, quarterly real GDP growth in the third quarter was 0.2% in Germany, 0.4% in France, 0% in Italy, and a stunning 0.8% in Spain. The latter is the fastest-growing large economy in Europe. Meanwhile, the slow growth in Germany remains a concern given Germany’s role as an engine of growth for Europe. Germany evidently has longer-term issues, especially given that real GDP is no higher than just prior to the pandemic. Finally, France’s strong growth was likely attributable to the impact of the Olympic Games during the summer.  

Eurozone inflation continues to ease

• Inflation in the Eurozone rebounded slightly in October but remained quite low. The consumer price index was up 2% in October versus a year earlier. While up slightly from the surprisingly low 1.7% inflation in September, it otherwise was the lowest level since June 2021. October prices were up 0.3% from the previous month. For the ECB, the rise to 2% should not be concerning. After all, the ECB’s target is 2%. It has evidently been achieved. 

Meanwhile, energy prices were down sharply. Thus, when volatile food and energy prices are excluded, core prices were up 2.7% in October versus a year earlier. Core prices were up only 0.2% from the previous month. In addition, while the prices of non-energy goods were up only 0.5%, prices of services were up 3.9% from a year earlier, the same as in September and not down much over the past five months. 

The persistence of service inflation, likely related to rising wages in a tight labor market, has been a source of concern for the ECB. Moreover, the absence of labor productivity growth in Europe has meant that wage gains quickly turn into price increases. Still, the ECB has begun to ease monetary policy, likely concerned that persistent tight monetary policy will weaken the economy. On the other hand, the relatively strong growth of GDP in the third quarter means that the Eurozone has achieved low inflation while the economy has started to rebound.

• One of the factors that held back Eurozone growth in recent years was reticence on the part of consumers. Despite having accumulated a large pool of excess savings during the pandemic, households have been very cautious. The European Union (EU) reports that, in the second quarter, real disposable household income per capita increased 0.4% from the previous quarter. Yet real consumer spending per capita increased only 0.1%. As a result, the savings rate increased from 15.3% in the first quarter to 15.6% in the second quarter. The savings rate increased in Germany, France, and Italy but fell in Spain. If, going forward, European households have greater confidence in the economy, they might start to boost the growth of spending—especially as interest rates come down.  

Germany resists EU tariffs on Chinese EVs

• The EU is implementing severe tariffs on imported electric vehicles (EVs) from China. This is an effort to protect Europe’s burgeoning EV industry, especially given the very low prices charged by Chinese producers. The EU says that Chinese producers are subsidized by their government. The Chinese producers say that they have achieved scalar efficiency through massive investment. Consequently, their costs are relatively low.

Meanwhile, Germany’s car makers are not happy. They indicate that the EU tariffs create the risk of a trade war. Moreover, they fear that such a war might be waged against them. Major German car makers are active in the Chinese market and want to retain their access to that market. Yet weak domestic demand in both Germany and China have led to declining earnings. A trade war could make things much worse. 

Mexico increasingly central to the US-China conflict

• Mexico is fast becoming an important factor in the ongoing tension between the United States and China. Mexico is party to the USMCA (US Mexico Canada Agreement), a free trade agreement that is the successor to NAFTA. As such, producing goods in Mexico offers easy access to the vast US market. Meanwhile, the United States has imposed substantial trade restrictions on China and could impose more going forward. Consequently, an increasing number of Chinese companies are setting up shop in Mexico, hoping to gain access to the US market. Moreover, they and other companies are taking advantage of Mexico’s relatively low labor costs and low costs of transporting goods to the United States. 

The Mexican Chinese connection has been growing rapidly. Chinese foreign direct investment (FDI) into Mexico was US$3.77 billion in 2023, double that of the year before. Also, by 2020, 21.2% of Mexican exports to the US had Chinese content, up from just 5% in 2002. To gain free access to the US market, the USMCA requires a minimum level of domestic content for Mexican exports. A Chinese company cannot simply reexport Chinese made goods to the United States through Mexico without facing tariffs.

As global companies reduce exposure to China and shift production to Mexico, there has been a shift in trade patterns. Today, Mexico is the largest exporter to the United States, having superseded China just last year. Going forward, the USMCA must be renegotiated in 2026. The role of Chinese companies in Mexico is likely to be a major issue in these negotiations. This must be of concern to Chinese companies currently investing in Mexico as well as those already active in Mexico. If the renegotiation results in restrictions on US-Mexico trade involving Chinese-made products, there would have to be a major unravelling of existing supply chains.