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Cover image by: Sylvia Chang
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The outward evidence does not suggest that the United States is in recession or faces imminent recession. But strange things can happen, and recession this year cannot be precluded. Moreover, as has been noted, economists rarely know a recession has begun until well into or even after that recession. Meanwhile, there are things happening now that can cause a recession. For example, surveys indicate a growing fear of recession on the part of businesses, which could cause many to stop hiring and cancel investment spending. Consumers are clearly stricken by higher gasoline prices, which, at the least, will mean a sharp decline in spending on other things. Moreover, risk remains of further disruption, most likely due to events in Russia and Ukraine. Thus, the risk of imminent recession cannot be dismissed entirely.
PMIs are forward-looking indicators meant to signal the direction of activity in the broad manufacturing and services sectors. They are based on surveys of purchasing managers who are asked about output, new orders, export orders, employment, input and output pricing, inventories, pipelines, and sentiment. A reading above 50 indicates growing activity; the higher the number, the faster the growth—and vice versa.
For the United States, the PMI for manufacturing fell sharply, from 57.0 in May to 52.4 in June, a 24-month low, but still a level indicating modest growth in activity. However, the devil is in the details, which suggest trouble. For example, the subindex for output indicated a decline in June. In fact, the subindex for output fell at the third-fastest pace since the survey began, only exceeded in 2008 and 2020, both at the start of recession. In addition, there was a decline in new orders as well as export orders. The weakening of new orders reflected lower demand that was related to high inflation, the impact of higher food and energy prices, and weakened consumer and business sentiment. Input costs continued to soar, largely due to rising energy prices.
Meanwhile, the PMI for services in the United States fell from 53.4 in May to 51.6 in June, indicating very slow growth in activity. Output growth remained positive in June, but new orders declined. Input and output price increases eased, backlogs declined, and employment growth decelerated.
Overall, Markit concluded that the US PMI data for June signals a substantial weakening of economic activity, but not a decline. Markit commented that “the survey data are consistent with the economy expanding at an annualized rate of less than 1% in June, with the goods-producing sector already in decline and the vast service sector slowing sharply.” It said that consumer demand is weakening largely due to inflation concerns. Business demand has weakened as well, largely due to fears that monetary policy will stifle economic growth. Markit also suggested that weakened demand could help reduce inflationary pressure.
In the Eurozone, the PMI data was similar to that of the United States. The manufacturing PMI fell from 54.6 in May to 52.0 in June, a 22-month low. The services PMI fell from 56.1 in May to 52.8 in June. The rising cost of energy and the continued supply chains disruptions were blamed for weakening demand, leading to a sharp slowdown in economic activity. The slowdown was led by manufacturing, which was especially weak in Germany. Markit commented that, aside from the initial devastation of the pandemic in early 2020, “June’s slowdown was the most abrupt recorded by the survey since the height of the global financial crisis in November 2008.” It said that the latest data suggests June GDP growth at a rate of just 0.2%.
Other signs of weakness include a sharp decline in business confidence as well as a buildup of inventory. The latter suggests that manufacturers might cut output in the coming months. The European Central Bank (ECB) has so far avoided a rapid tightening of monetary policy, in part due to fears that Europe’s economy is weaker than that of the United States and more susceptible to recession.
In the United Kingdom, the manufacturing PMI fell from 54.6 in May to 53.4 in June, a 23-month low. The services PMI was unchanged at 53.4. Thus, the British economy did not decelerate to the degree that the economies of the United States and Eurozone experienced. On the other hand, Markit offered a sober assessment. It said that “the economy is starting to look like it is running on empty. Current business growth is being supported by orders placed in prior months as companies report a near-stalling of demand. Manufacturers in particular are struggling with falling orders, especially for exports, and the service sector is already seeing signs of the recent growth spurt from pent-up pandemic demand moving into reverse amid the rising cost of living.” Moreover, with inflation continuing to surge and the Bank of England tightening monetary policy, most risk remains on the downside.
Lastly, Japan defied the trend seen in the other major advanced economies. Japan’s PMIs suggested some improvement. Markit commented that Japan saw the “strongest rise in private sector output in seven months.” Japan has experienced weakness due, in part, to voluntary and government-imposed restrictions related to COVID-19. Restrictions have been eased and activity is rebounding modestly. Moreover, inflation is relatively low and the central bank and the government both maintain easy monetary and fiscal policies, respectively.
Thus, Japan’s manufacturing PMI fell slightly from 51.5 in May to 51.0 in June. More notably, the services PMI increased from 52.6 in May to 54.2 in June as the economy continued to reopen. Meanwhile, as China reopens, it is likely that this will have a positive impact on Japan’s economy.
Consequently, it has been reported that factories are cutting back on production and dismissing workers. Moreover, China’s government says that the export sector accounts for about 180 million jobs in China, or about one-third of all nonfarm jobs. Thus, a weakening of the manufacturing export sector has the potential to further weaken an already troubled economy. The troubles for manufacturing have shown up in some data. For example, the urban unemployment rate has risen, the unemployment rate among young workers has hit a record high, and the PMI for manufacturing remains in negative territory (although it did improve slightly in May), meaning declining activity. Many urban manufacturing workers are migrants from China’s smaller towns and rural areas. The loss of jobs could lead to a reverse migration that could be socially disruptive.
There has been an expectation that, once China removed lockdowns and other restrictions, there would be a surge in cross-Pacific shipping of goods that would lead to higher transport costs. Yet, that has not happened. Instead, the cost of shipping containers from China to the West Coast of the United States continues to fall. This is likely confirmation of declining US demand for imported goods.
The spot rate for shipping containers across the Pacific fell 3% last week and 17% in June. It has been declining since March. It has been reported that, on the US end, there has been an increase in inventories, thereby leading to a decline in orders from US retailers. Moreover, it is reported that port congestion in Shanghai is minimal, which is not what had been previously expected.
Several inferences can be made from this information. First, US consumer demand is rapidly weakening, possibly setting the stage for a substantial economic slowdown. US retail purchases account for roughly half of the merchandise shipped from China to the United States. On the other hand, there is evidence that declining consumer demand for goods is being partly offset by stronger demand for services such as restaurants or airline flights. Second, Chinese output is likely to be stifled, thereby having a negative impact on Chinese economic growth and employment. Third, lower transport costs and weakened demand will likely have a salutary impact on US inflation. Moreover, commodity prices are also declining, especially those related to Chinese production and construction. That, too, can have a beneficial impact on US and global inflation.
Russia hopes to squeeze Europe until it relents and drops sanctions. Europe, however, is rapidly shifting to other sources of gas in hopes that Russia will eventually lack the revenue needed to fight a war. Indeed, Russian gas has gone from 40% of European consumption before the war to roughly 20% now. Imports of liquefied natural gas (LNG) from other countries have increased substantially. Yet this supply is at risk following a major fire at an LNG plant in the United States that accounts for 20% of US liquefaction capacity. Meanwhile, there is even talk in Europe about reverting to burning coal in order to avert shortages.
In addition, European governments are encouraging energy efficiency in the hope that excess natural gas can be stored until the winter, thereby avoiding shortages or sharp further price increases. The fear is that a combination of very high gas prices and/or rationing in the winter could lead to a reversal of Europe’s economic recovery. While the ECB and others expect positive growth in the Eurozone this year, they also believe that a significant further disruption of energy supplies would likely cause a modest recession.
Indeed, the International Energy Agency (IEA) is warning that Russia might choose to completely cut deliveries of natural gas to Europe during the winter months. The IEA said that, having already partially cut off gas to Germany and Italy last week, Russia might choose to go further to gain “leverage” in its dispute with Europe. A cutoff, which could temporarily hurt Russia’s finances, would be very serious for Europe and could cause a recession. Fatih Birol, who heads the IEA, said that “the nearer we are coming to winter, the more we understand Russia’s intentions. I believe the cuts are geared towards avoiding Europe filling storage and increasing Russia’s leverage in the winter months.”
European governments are already taking emergency measures meant to reduce their consumption of Russian natural gas. This includes reviving coal-powered plants, increasing purchases of LNG produced outside of Russia, and encouraging consumers and businesses to be frugal in their use of gas (including telling consumers to take shorter showers). The use of coal will cause a temporary setback in efforts to reduce carbon emissions, but the IEA said that this is warranted and that continued investments in clean energy might ultimately offset this temporary shock. However, the IEA says that there is not currently enough European investment in clean energy.
The question remains as to whether current measures by European governments will be sufficient to avoid shortages in the winter. Mr. Birol from the IEA says that governments will need to do more. For example, he suggested that governments postpone the decommissioning of nuclear power plants, clearly a statement meant for Germany, which continues to move toward ending its reliance on nuclear power.
Meanwhile, oil prices fell in the past week due to investor worries about a weakening global economy. This proves the old adage that the best antidote to higher prices is higher prices. That is, as high prices eat into consumer purchasing power, demand weakens, thereby ultimately leading to lower prices.
Why should we expect inflation to ultimately peak this year? There are several reasons. First, monetary and fiscal policy are both in the process of being tightened, thereby slowing aggregate demand. Moreover, wages are not keeping pace with inflation, thereby leading to a decline in real incomes. For example, average hourly earnings were up 5.2% in May from a year earlier while consumer prices were up 8.6%. These factors are expected to weaken pressure on prices. In addition, assuming that the war-related surge in commodities prices is mostly over, then commodity prices will likely stabilize or possibly decline, thereby removing one of the key factors that led to accelerating inflation in recent months. Finally, weakening consumer demand combined with easing of supply chain bottlenecks will remove another important factor that drove inflation. Indeed, the current easing of lockdowns in China should help boost supply chain efficiency.
Meanwhile, let’s look at the inflation numbers. In May, consumer prices in the United States were up 8.6% from a year earlier, the highest in more than 40 years. Prices were up 1% from the previous month, the second highest in 14 years. When volatile food and energy prices are excluded, core prices were up 6% from a year earlier, the lowest since January. Thus, core annual inflation has been declining slightly for a few months. Core prices were up 0.6% from the previous month, the same as in four of the last six months. Energy prices remained the principal problem, rising 34.6% from a year earlier and up 3.9% from the previous month. Prices of food eaten at home were up 11.9% from a year earlier and up 1.4% from the previous month. The war in Ukraine played a dominant role in these very large increases in energy and food prices. The path of the war and sanctions in the coming months will likely influence the path of inflation, both in the United States and elsewhere.
There were also sizable increases in prices of some other categories, most notably automotive. Prices of used cars were up 16.1% from a year earlier and up 1.8% from the previous month. Prices of new cars were up 12.6% from a year earlier and up 1% from the previous month. This reflects strong consumer demand combined with constraints on production related to shortages of semiconductors and key metals produced in Ukraine. Prices of airline tickets surged 37.8% from a year earlier and were up a stunning 12.6% from the previous month. This reflected people returning to traveling in droves while airlines struggle to put planes and pilots back to work. On the other hand, some categories experienced only modest inflation, including medical commodities, physician’s fees, prescription drugs, education services, and consumer electronics, which saw declining prices.
One reason that inflation surged last year was the rapid rise in consumer demand for durable goods for which businesses struggled to meet demand. Now it appears that inflation for durables is decelerating while inflation for services is accelerating. This implies that consumers are shifting back toward a prepandemic pattern of spending. Specifically, prices of durable goods were up 11.4% in May versus a year earlier. This is a sharp drop from the 18.7% rise clocked in February. Moreover, durables prices were up only 0.1% from the previous month. Meanwhile, prices of services were up 5.7% from a year earlier, higher than the 4.9% increase clocked in February. Service prices were up 0.8% from the previous month. Meanwhile, there was a sharp surge in prices of nondurable goods, up 14.3% from a year earlier, mainly due to the surge in energy and food prices.
In response to the latest inflation report, bond yields increased while equity prices fell. This reflected investor expectations that the Federal Reserve would tighten policy rapidly (which it later did). Interestingly, the 10-year breakeven rate, which measures bond investor expectations of inflation over the next 10 years, increased only modestly. This means that investors expect the Fed to get inflation under control in the near future. The rise in bond yields thus is not related to rising expectations of inflation. Rather, it reflects expectations of tightness in the bond market owing to Fed sales of government bonds combined with continued strong demand in the economy. Indeed, the inflation problem is due, in part, to the strength of the economy. That is why the Fed is attempting to weaken demand.
On the other hand, despite strong demand, many consumers are evidently very fearful. The latest index of consumer sentiment published by the University of Michigan hit a record low in June. Almost half of respondents attributed their pessimism to concern about inflation. The index came close to the level reached in 1980 when the economy was in the midst of a recession. Moreover, the May reading was a sharp decline from April. This was likely due to concern about the sharp rise in gasoline prices that was mentioned by a rising share of respondents. Many economists have long debated whether indicators of sentiment have an impact on consumer spending patterns. One thing to consider is that, despite serious headwinds, many consumers have a significant buffer in the form of vast savings. During the pandemic, many consumers significantly increased the share of income they saved. As a result, they have a substantial amount of money in the bank, which can help soften the blow of declining real wages.
The Fed downwardly adjusted its growth forecasts for the US economy. It now expects real GDP to increase by only 1.7% this year and next. It is not predicting the timing of the next recession. In addition, it predicts that inflation as measured by the personal consumption expenditure deflator will be 5.2% this year and will fall to 2.6% next year. Essentially, the Fed is saying that its actions, combined with other major headwinds, will sufficiently slow the economy to bring inflation down while not engineering a recession. Obviously, there are risks that could easily drive a different outcome.
Meanwhile, the Fed has begun the process of reducing the size of its balance sheet. It has already stopped purchasing assets. Now it will stop reinvesting the proceeds of maturing bonds. As such, its portfolio of bonds will shrink. However, the Fed has not yet chosen to take the more aggressive path of directly selling bonds. Still, the Fed’s balance sheet is now set to decline by about US$95 billion per month. The Fed’s total balance sheet currently exceeds US$8 trillion. In any event, anticipation of this has already disrupted bond markets, leading to a sharp increase in yields, which, in turn, have led to soaring mortgage interest rates. It is not clear what the impact will be once the policy is implemented.
In his press conference following the announcement, Fed chairman Powell said that he and his colleagues are looking for signs that inflation is decelerating. He said that the principal reason for the large increase is that the latest data suggested that inflation is not decelerating and that, consequently, a faster return to an above-neutral interest rate is warranted. He also said that, since the Fed began to tighten monetary policy, there has already been a weakening of credit markets that Powell deemed to be appropriate. He said that the committee would like to see a moderately restrictive policy in place by year-end.
In any event, most market commentary suggested a reduced likelihood of a soft landing, or an increased likelihood of recession. That may explain why bond yields fell after the announcement. That, in turn, led to a drop in the value of the US dollar against some other currencies. Market sentiment is not simply based on the Fed’s action. Very importantly, the Fed also published the so-called “dot plot,” which is the range of interest rate predictions of the members of the policy committee. The dot plot has shifted since the last Fed meeting, with most members now expecting the benchmark interest rate to peak sometime in 2023 in the range of 3.5% to 4%. This would be the highest level since early 2008 just before the global financial crisis, but still an historically low level. Is it a level that would suppress inflation and avoid recession? Time will tell. Meanwhile, with last week’s action, the Federal Funds rate is now targeted at between 1.5% and 1.75%. In inflation-adjusted terms, rates are still negative.
Another important thing to note is that monetary policy is known to influence the economy with a variable lag. That is, we don’t know how long it will take for this monetary policy shift to significantly influence inflation or economic activity. One possibility is that the current sentiment that recession is imminent will stifle business investment, thereby accelerating a slowdown. Alternatively, if weakening demand quickly causes a deceleration in inflation, the Fed might adjust accordingly, thereby reducing the risk of recession. That’s the most optimistic scenario. A reasonable scenario is that, sometime over the next two years, there could be back-to-back quarters of declining GDP (a technical recession), but not necessarily a dramatic slowdown. But for now, it is all speculation. If I’ve learned anything in more than three decades as an economist, it is that economists are very bad at predicting the timing of recessions.
The gap between the yields on German and Italian bonds has doubled in the past year. The ECB leadership has previously expressed the view that the sharp and rising divergence between the yields on bonds issued by different member countries is not acceptable and that the ECB has sufficient tools to challenge this divergence. Yet, until last week, the ECB was not specific about how it will address this issue. The sharp rise in the bond yields of some countries has caused concern that governments will face rising fiscal stress, potentially leading to cutbacks in spending, tax increases, and/or rising risk of default.
Moreover, Isabel Schnabel, a member of the ECB’s policy committee, said that rising yields in some countries represent “an impairment in the transmission of monetary policy that requires close monitoring.” Ideally, the solution is for the ECB to purchase bonds of high-yield countries and sell bonds of low-yield countries. This would leave the ECB’s balance sheet unchanged while helping to remove the disparity between yields and, especially, to reduce yields on such countries as Italy, Spain, and Greece.
Following the ECB meeting last week, the committee announced that it will “apply flexibility in reinvesting redemptions coming due in the PEPP portfolio (which is the portfolio of government bonds previously purchased by the ECB), with a view to preserving the functioning of the monetary policy transmission mechanism, a precondition for the ECB to be able to deliver on its price stability mandate.” In other words, as bonds in the ECB portfolio mature, the ECB will likely reinvest bonds issued by high-yield countries while halting reinvestment of other bonds. In addition, the ECB said that it will work toward designing instruments meant to avert future bond yield fragmentation.
So far, it appears that the policy is a modest success in that bond yields in key countries have fallen. In Italy, the yield on the 10-year bond has fallen sharply, from 4.3% on June 14 to 3.7% on June 17. In Spain, the yield fell from 3.1% to 2.7%. Italy, of course, is of greatest concern given its massive amount of sovereign debt. A fiscal or financial crisis in Italy would represent an existential threat to the Eurozone. As such, the new ECB policy, although still not clearly specified, was likely needed to reassure markets that the fragmentation of bond markets in the region will not get worse.
First, Chinese retail sales were down 6.7% in May versus a year earlier. This was slightly better than the 11.1% decline in April. It was the third consecutive month of decline. Some spending categories had especially sharp reductions. These included automotive (down 16%), clothing (down 16.2%), jewelry (down 15.5%), and furniture (down 12.2%). The continued weakness of retail sales was likely due to the lingering effects of lockdowns in multiple cities as well as troubles in the residential property market. Although lockdowns have been partially lifted, some restrictions remain. They are likely having a dampening effect on consumer shopping behavior. Moreover, there are reports of people attempting to withdraw funds from bank accounts and being turned away. This sort of thing can cause panic and lead people to avoid certain types of spending.
Meanwhile, the government reports that industrial production was up 0.7% in May versus a year earlier. Some analysts had expected a continued decline after April’s drop of 2.9%. The increase likely reflected the positive impact of revived activity as lockdowns were eased. Manufacturing output was up 0.1% from a year earlier while mining output was up 7%. Utility output was up 0.2%. By industry, automotive output was down 7% while equipment output was down 6.8%. On the other hand, chemical output was up 5% while communication output was up 7.3%.
The Chinese government also reported robust growth of fixed asset investment as well as exports. Still, there are signs of trouble. The rise in investment was mainly due to state-owned enterprises and government infrastructure projects. A recent survey conducted by a Beijing-based think tank found a sharp decline in business confidence. In addition, a survey conducted by the American Chamber of Commerce in Shanghai found that the vast majority of respondents have cut their revenue projections for this year. In addition, only one-third of the manufacturing companies among the respondents are operating at full capacity. Meanwhile, although the country’s unemployment rate fell slightly in May, unemployment among youth increased to a record level. Thus, China’s industrial sector may not be out of the woods.
Cover image by: Sylvia Chang