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What’s happening this week in economics? Deloitte’s team of economists examines news and trends from around the world.
The US government released its first estimate of economic growth in the first quarter, and the headline number was very strong.1 But financial markets were not terribly impressed.2 Why? Because, despite a strong headline number, the details of the report revealed weakness in the economy. Specifically, the report showed that important components of the GDP such as consumer spending and business investment grew only modestly. Rather, growth was driven by inventory accumulation and sharply falling imports. It must be noted that a decline in imports has a positive contribution to GDP growth. Moreover, the drop in imports followed a period during which imports had soared in anticipation of tariffs. If the impact of inventories and imports is excluded, underlying economic growth was quite modest in the first quarter.
Here are the details: In the first quarter, real GDP grew at an annualized rate of 3.2 percent, which is relatively strong and far better than the 2.2 percent growth of the fourth quarter. However, consumer spending grew at a modest rate of 1.2 percent, including a 5.3 percent decline in spending on durable goods. This, in turn, included a sharp decline in spending on automobiles. Moreover, real disposable personal income of households grew at a rate of 2.4 percent. Thus, it appears that consumers are intentionally holding themselves back from spending. Indeed, the personal savings rate increased to 7.0 percent in the first quarter—the highest in four quarters. The estimate also said that the partial government shutdown in January cut 0.3 percentage points from economic growth in the first quarter, mostly due to lower consumer spending.3
Business investment also grew slowly—at a modest rate of 2.7 percent, including a 0.8 percent decline in spending on structures and a 0.2 percent increase in spending on equipment. The only category that saw a significant increase was intellectual property, rising at a rate of 8.6 percent. On the other hand, new orders for non-defense, non-aircraft capital goods were up 1.3 percent from February to March, boding well for an increase in business investment in the second quarter.4 Residential investment fell at a rate of 2.8 percent, marking the fifth consecutive quarter of declining housing market activity. Thus, the core elements of domestic demand were all weak.
However, businesses accumulated inventories, accounting for 0.65 percentage points of economic growth. In addition, exports grew moderately while imports fell at a rate of 3.7 percent, including a 4.4 percent drop in imports of goods. It is worth mentioning that imports had risen sharply in the third quarter at a time the trade war with China became serious. Businesses were eager to import goods in anticipation of tariffs. Much of what was imported was held as inventory, which explains why inventories rose dramatically in the third quarter. By the first quarter, demand for imports was falling, contributing to an improvement in the trade balance which, in turn, boosted real GDP growth. Finally, while overall government purchases grew modestly, defense-related buys grew strongly.
If the effect of inventories and trade are excluded, then real final sales to domestic purchasers grew at a modest rate of 1.4 percent. Excluding the impact of purchases by the government, real final sales to domestic private sector purchasers grew at an anemic rate of 1.3 percent. This was down from 2.6 percent in the previous quarter—the slowest rate of growth since 2013. Thus, the underlying strength of the US economy came into question.
The GDP report also indicated a significant deceleration in consumer price inflation. In the first quarter, the price index for consumer spending rose at an annualized rate of just 0.6 percent, down from an inflation of 1.5 percent in the previous quarter and the lowest level since the first quarter of 2016. The weakness of inflation likely reflects, in part, the weakness of the economy. It also explains why bond yields declined. However, equity prices rose moderately as investors saw their expectation of easy monetary policy reinforced.
The fiscal health of the countries in the eurozone is improving—the result of continued economic growth combined with fiscal discipline—but the experience varies by country. For the 19-member eurozone as a whole, the European Union (EU) reported that the fiscal deficit declined from 2.0 percent of GDP in 2015 to 0.5 percent of GDP in 2018.5 This came about mainly because government expenditures fell as a share of GDP while revenues remained steady. The overall level of government debt fell from 90.1 percent of GDP in 2015 to 85.1 percent in 2018.
In the larger 28-member EU, a similar picture emerged, with the deficit dropping from 2.3 percent of GDP in 2015 to 0.6 percent in 2018. Debt fell from 84.6 percent of GDP in 2015 to 80.0 percent in 2018.6 The numbers for the eurozone are of greater importance than those for the non-eurozone countries because these 19 countries share a common currency and none of them can print their own money. Thus, fiscal discipline is critical to insure against the risk of default. Although the EU has fiscal rules that apply to the members of the eurozone, the experience of eurozone members has varied in the past few years.
The country that has been of greatest concern is Greece, which went through a debt crisis a few years ago that nearly brought down the entire eurozone edifice. In exchange for a series of bailouts from the so-called troika—the European Central Bank (ECB), the EU, and the International Monetary Fund (IMF)—Greece’s government committed to a draconian level of fiscal probity. The results are impressive. The deficit fell from 5.6 percent of GDP in 2015 to 1.1 percent in 2018. Moreover, the country is now running a primary surplus (the fiscal balance after accounting for interest payments on the debt). The drop in the deficit came about because government spending fell from 53.5 percent of GDP in 2015 to 46.7 percent in 2018. Meanwhile, revenue as a share of GDP was steady.
But positive economic growth and positive inflation returned to Greece only in the past two years. Also, with inflation remaining unusually low, Greece’s nominal GDP hasn’t grown as fast as debt. Thus, the debt/GDP ratio rose from 175.9 percent in 2015 to 181.1 percent in 2018. Still, many investors are confident that a corner has been turned. As such, the government last month successfully returned to the bond market, selling 10-year bonds at a yield of 3.9 percent. We must recall that in 2015, the yield peaked close to 20 percent.7 Of course Greece’s bond yield remains far higher than the yields of other eurozone countries.
Europe’s largest economy, Germany, has been running budget surpluses every year for the last few years, with the debt/GDP ratio falling sharply. Specifically, the budget surplus was 1.7 percent of GDP in 2018 and the debt/GDP ratio fell from 71.6 percent in 2015 to 60.9 percent in 2018. Government spending was steady as a share of GDP while revenue increased. Critics claim that Germany can afford to run budget deficits, as this would boost both domestic demand as well as demand in the rest of Europe and help to rebalance the regional economy. As for the other large economies of the Eurozone, France’s budget deficit dropped from 3.6 percent of GDP in 2015 to 2.5 percent in 2018 while its debt/GDP ratio increased. In Spain, the deficit fell from 5.3 percent of GDP in 2015 to 2.5 percent in 2018 and the debt/GDP ratio fell modestly. Meanwhile, Italy’s deficit barely budged, dropping from 2.6 percent of GDP in 2015 to 2.1 percent in 2018, with the debt/GDP ratio rising slightly to 132.2 percent of GDP. While most countries in the eurozone have seen a significant decline in bond yields, Italy’s yield has increased in the past year owing to investor concerns about a shift toward a less disciplined fiscal policy.
The two other countries that vexed financial markets during the crisis—Ireland and Portugal—have both seen significant progress. In Ireland, the deficit fell from 1.9 percent of GDP in 2015 to 0.0 percent in 2018. Both spending and revenue fell as a share of GDP, with spending falling faster. In Portugal, the deficit dropped from 4.4 percent of GDP in 2015 to 0.5 percent in 2018 as spending fell and revenue remained steady. The country’s debt/GDP ratio fell. The improvement in eurozone government finances sets the stage for a more expansive fiscal policy in the near future, should such a move be required to avert or fight recession.
Turkey is increasingly at risk, in part due to the apparent reluctance of the central bank to raise interest rates in the face of a falling lira, rising prices, and declining currency reserves.8 The central bank revealed that reserves fell by US$1.8 billion last week. This sent the lira plummeting by 1.5 percent against the US dollar in a single day last week, hitting a level not seen since October 2018. Under such circumstances, the central bank of an emerging market would be expected to boost interest rates to stabilize the currency and engender investor confidence. The latter is important if it wants to avert capital flight.
However, Turkey’s central bank did nothing. This raises the question whether the government is determining policy at the central bank—a key fear after the administration took steps to weaken the bank’s independence last year. Although the central bank had dramatically raised rates last year, the fact that inflation is running at about 20 percent per year means that monetary tightening has not been adequate to quell inflation. The high rate of inflation is largely related to the sharp decline in the value of the currency, which has contributed to rising import prices.
If the central bank were to raise rates, it might stabilize the value of the currency and help suppress inflation. Yet if investors lack confidence in the central bank, there could be a surge in capital outflow, thereby putting further downward pressure on the currency. For many Turks with large foreign currency denominated debts, this could be very problematic. And for European banks that hold much of this debt, it could be a problem as well.
The continuing rise in the value of the US dollar has created new risks for many emerging markets, including Argentina. The Argentine peso has fallen sharply in recent times and the yield on Argentine government bonds has increased commensurately.9 This was part of a larger selloff of emerging market assets, but the Argentine situation is particularly worrisome, in part owing to investor uncertainty about the country’s ability to stifle the crisis and the concern about the high level of inflation.
Meanwhile, Argentina is preparing for a new election. Although many investors favor incumbent President Mauricio Macri due to his support for market-oriented reforms, polls indicate that former President Cristina Fernandez is growing in strength.10 Macri said, “The world is worried that Argentines may want to go backwards.” He suggested that this explains the selloff of Argentine assets.
The problem is that although the government has abided by the fiscal constraints required to obtain a very large loan from the IMF, Argentina now faces a combination of declining economic activity and relatively high inflation, lately hitting 55 percent.11 Concerns about the potential outcome of the election are likely contributing to the capital flight that results in currency depreciation. This, in turn, is boosts inflation, which requires further monetary tightening, leading to a further decline in economic activity. It is essentially a vicious cycle that is difficult to break, even with the best policy mix.
Meanwhile, President Macri has implemented some price controls. In the past, Argentine policies meant to inspire confidence have sometimes backfired. When, early in his term, Macri supported a sharp rise in interest rates with a view to convince investors that the authorities were taking strong action, it resulted in alarming investors that things were worse than they thought. Thus, for Argentine policymakers, a key ingredient for success is to manage expectations well. Meanwhile, the sharp drop in the currency means greater risk of default for those with foreign currency debts. The cost of insuring against default has risen dramatically.
The United States and Japan have recently initiated talks aimed at liberalizing trade between the two countries. But the talks already seem to have been hit by a snag: The US side wants any trade agreement to include measures that can prevent currency manipulation.12 That is, the US side, being concerned about the size of the US trade deficit with Japan, wants to prevent a substantial depreciation of the yen, which would boost the competitiveness of Japanese exports to the United States. However, Japan is adamant that a trade deal should not include provisions on the currency.
Japanese Finance Minister Taro Aso said, “Japan cannot agree to any debate linking trade policy with monetary policy. Japan won’t discuss exchange rate matters in the context of trade talks.” Meanwhile, the value of the US dollar has been rising, mainly because of the easy monetary policies of its trading partners, including Japan. The United States has suggested that some countries, including Japan, have actively attempted to manipulate their currency values, perhaps through central bank intervention in the currency markets. Yet in the case of the yen, the weakness is primarily due to Japan’s easy monetary policy of low interest rates and asset purchases.
The issue of currency manipulation was included in the US-Mexico-Canada Agreement (USMCA), which is now under consideration by the US Congress. South Korea and China have also agreed to avoid currency manipulation. Chinese President Xi said, “China will not engage in any beggar-thy-neighbor currency devaluation.”13 South Korea has agreed to allow the United States to examine the details of its central bank’s interactions in currency markets. However, Japan might not be amenable to such measures.
In the United States, the massive Social Security system provides income for retirees, the disabled, and survivors, and is funded by a payroll tax paid by workers and employers. The program is essentially an intergenerational transfer system in which working-age people pay into the system and, mostly, the elderly receive the benefits. Since 1982, revenue into the system has exceeded expenditure. The surplus has been invested in US government securities, helping partially offset the deficit in the rest of the government. This has resulted in a massive US$3 trillion “trust fund” that collects interest on its holdings of government debt, with a view to ensure that even if the system goes into deficit, there will be sufficient income to pay the beneficiaries.
That day has arrived. The US government reported that, starting next year, revenues will be lower than expenditure for the first time since 1982.14 Interestingly, the government had previously expected the deficit to commence in 2018 but revenues have been better than anticipated despite an unusually low level of unemployment. Still, a deficit is imminent.
Thankfully, because of the interest income from the trust fund, the retirement system will remain solvent until 2035 as will the part of the program meant for disabled recipients. After 2035—barring a change in the system—retirement benefits will decline by 25 percent. A similar outlook holds for the government’s Medicare program, which provides healthcare to the retired and is also funded by a payroll tax.15
The main reason for the imminent trouble is demographics. The huge baby-boom generation has already started to retire and will retire in even bigger numbers in the coming decade. Meanwhile, the working-age population is barely growing. What can be done? There are several potential solutions to the problem, but all of them could be politically challenging. These include boosting the payroll tax, cutting benefits, raising the age at which retirees receive full benefits, changing the formula by which benefits are indexed to inflation, and allowing more immigration.
Last year, the Turkish lira suffered a sizable depreciation which set off a sharp rise in inflation and compelled the central bank to substantially boost interest rates, with the benchmark rate tripling in one year.16 The result is that the economy is now sinking into a recession.17 Yet the currency has been stable lately, likely owing in part to investor confidence that the central bank has sufficient firepower to protect the lira should there be downward pressure again.
The firepower stems from a stabilization in the volume of foreign currency reserves, yet it is now apparent that the reserves have received a boost by substantial use of currency swaps.18 This essentially means that the central bank has been borrowing reserves, mostly on a very short-term basis, from Turkish banks that have sizable dollar deposits from investors who have fled to the safety of the US dollar.
The problem is that should Turkey face another currency crisis, the central bank will probably want to sell the reserves to stabilize the lira. But it will still have to repay its dollar-denominated debts, which could be problematic. It has been reported that although Turkey’s reported reserves are roughly US$28 billion, the true value, excluding short-term borrowing, is just US$16 billion.19 While the central bank acknowledges this, it says it is in full compliance with international standards.20 Still, this suggests that the bank has attempted to ease investor concerns by signalling that its foreign reserves are strong.
There are now several conflicting estimates of the potential economic effect of the US-Mexico-Canada Agreement (USMCA), the planned successor to the North American Free Trade Agreement (NAFTA). The Office of the United States Trade Representative, which negotiated the deal, claims there will be a modest positive impact and predicts there will be 76,000 new automotive jobs in the United States within five years. However, the International Trade Commission (ITC), an independent arm of the US government, says there will be only 28,000 new automotive jobs.21 It adds that within six years, the real GDP of the United States will be 0.35 percent higher than otherwise—an extremely modest increase.
It also predicts that overall US employment will rise by 176,000 jobs within six years, an increase of 0.12 percent from now. Interestingly, the ITC report acknowledges that the USMCA will boost the prices of cars sold in the US, thereby bringing down sales. It adds that there will be a net benefit nevertheless, because the deal, by reducing the role of arbitration in disputes between investors and governments, will discourage US companies from investing in Mexico. This will result in more investment in the United States and, consequently, more job creation.
What’s distinguishing about these two US government analyses is that they both suggest imposing new restrictions on trade will have a positive—albeit modest—impact on economic growth and employment. This is the opposite of the conventional view within the economics profession, which is based on considerable historical evidence that trade restrictions usually limit growth. Still, the US administration’s chief economic advisor, Kevin Hassett, claims that the ITC report doesn’t go far enough in estimating the benefits of the deal.22 He says it ignores the positive impact of intellectual property protection.
It is important to understand that the main difference between NAFTA and the USMCA is in the realm of automotive trade. One of the principal goals of the USMCA is to reduce automotive imports into the US from Mexico and Canada. This is accomplished by boosting the domestic content requirement of automobiles sold in the US, by capping the volume of imports and by imposing a requirement that a minimum share of autos sold in the US are assembled by workers earning more than US$16 per hour. Failure to comply with these rules would mean higher tariffs for companies operating in North America.
Thus, an important effect of the deal is its impact on prices as well as the potential diversion of trade. The independent Peterson Institute for International Economics (PIIE) estimates that the net effect of the agreement will be to significantly boost the prices of cars sold in the US, thereby reducing demand.23 Moreover, by increasing the cost of producing cars in North America, the agreement will boost the competitiveness of cars made in Europe and Asia. Unless the US imposes tariffs on those automobiles (which it has threatened to do), the USMCA could lead to an increase in the share of the US market held by European and Asia imports. Thus, the net effect of the USMCA is likely to be lower employment in the US automotive industry, higher prices for consumers, and lower purchasing power for US consumers, leading to an overall decline in employment and economic growth.
Meanwhile, the USMCA will not become a law until it is approved by both houses of the US Congress. The main issue now is whether—and how soon—the House of Representatives will pass the USMCA. The Democratic leadership wants to assure that Mexico enforces the labor standard provisions of the agreement and is waiting for Mexico to pass an enabling legislation.24 At the same time, Republicans in the House are concerned that labor and environmental standards will be too onerous for US businesses.
The Chinese government released several data points that were better than expected, but still indicated relative weakness in the economy compared to recent years. Most notably, the government reported that real GDP was up 6.4 percent in the first quarter versus a year earlier. This was the same rate of growth as in the previous quarter and was slightly better than market expectations. The two most recent quarters experienced the slowest growth in 27 years.
Moreover, real GDP growth was 6.8 percent in the first quarter of 2018, 7.4 percent in the first quarter of 2014, and more than 12 percent in the first quarter of 2010.25 Thus, there has been a steady erosion of growth that is not likely to be significantly reversed. But this is not necessarily a bad thing. China’s growth has been fuelled by a sharp rise in debt. Consequently, a more subdued but normal rate of growth is desirable. Still, some observers have been worried that growth will decline quickly. The latest data suggests that their worries are not warranted—at least not yet.
Meanwhile, other indicators also pointed to an improvement in Chinese economic performance. In March, industrial production in the country surged 8.3 percent versus a year earlier—the fastest rate of growth since July 2014.26 It was up from 5.3 percent in the previous month. Output of manufacturers was up 9.0 percent in March, including 13.6 percent for makers of transport equipment (although automotive output fell 2.6 percent) and 15.2 percent for machinery. These two categories likely reflected the impact of government stimulus measures aimed at boosting infrastructure investment. Indeed, steel output was up 10.0 percent and cement output was up 22.2 percent.27
Retail sales in China were up 8.7 percent in March versus a year earlier—the best performance since September 2018.28 Despite the acceleration, it is worth noting that retail sales have been growing far more slowly than in recent years. For example, for much of 2016 and 2017, growth ranged from 10.0 percent to 11.0 percent, and it was even stronger prior to that. Still, the current rebound is welcome and likely reflects the positive impact of stimulus measures undertaken by the government.
In the first three months of 2019, fixed asset investment in China was up 6.3 percent from the same period a year earlier.29 This was an improvement from the 6.1 percent growth in the first two months of the year.
Finally, house prices in China accelerated in March, with prices in the top 70 cities rising 10.6 percent versus a year earlier, up from an increase of 10.4 percent in the previous month. The price rise was most pronounced in second tier cities. Meanwhile, prices were up only 3.2 percent in Beijing, 1.2 percent in Shanghai, and 0.3 percent in Shenzhen.
The revival of growth in China is due to the stimulatory measures implemented by the government, including easing of monetary policy, tax cuts, encouragement of banks to lend to private business, and increased infrastructure spending funded by the issuance of regional government bonds.30 These measures were meant to offset the negative impact of the ongoing trade war. If a trade deal between the US and China is reached in the near future, this would add to the positive effect on the economy.
The decision by the IMF to increase its forecast for economic growth in China (as opposed to its downgrading of forecasts for most other large economies) was warranted. Meanwhile, the Chinese authorities are clearly in two minds. On one hand, they want to prevent a further significant slowdown in growth while on the other, they want to avoid a further build-up of debt that might threaten financial stability. Hence the somewhat cautious nature of the current stimulus.
The slowdown in the Chinese automotive industry is having global ramifications. In 2018, automotive sales in China fell for the first time in 28 years; in the first two months of 2019, sales were down 15 percent from a year earlier.31 In March, sales were down 5.2 percent from a year earlier.32 This came about because the industry hit a combination of market saturation, weak domestic demand, and uncertainty owing to the trade dispute with the US.
The slowdown has sent shockwaves through the German automotive industry, which is heavily dependent on exports to the world’s largest auto market. Shares in German auto and parts companies fell as earnings projections were slashed. German automotive production fell 10 percent last year as compared to the previous year. Although domestic demand was flat, exports were down sharply. This is one of the factors contributing to the sharp slowdown in the German economy and, by extension, the Eurozone economy.
Going forward, the Chinese government is keen to revive demand for automobiles.33 It has cut taxes significantly, boosted fiscal spending, and eased monetary policy.
On the other hand, until the trade war with the United States is resolved, there is concern that consumer demand in China will remain muted. The government reports that overall consumer spending in China is weak. In nominal terms (not adjusted for inflation), spending in the first quarter was up 7.3 percent from a year earlier, slower than the 8.0 percent growth in the fourth quarter of 2018 and the 7.6 percent growth in the first quarter of 2018.34
Although retail sales accelerated in March, this is only one part of the consumer spending picture, and it also includes some government purchases. As such, it is not an optimal measure of consumer behavior. Consumer spending is a better measure, as it incorporates spending on both goods and services. It evidently shows continued caution on the part of Chinese consumers. It remains to be seen whether the stimulus measures will cause an acceleration in spending.
Japanese exports fell 2.4 percent in March versus a year earlier, compared to a decline of 1.2 percent in February.35 This was the fourth consecutive month of declining exports. The fall is attributed to weak global demand and the negative impact of the US-China trade war. The impact of the latter is evident in the pattern of Japanese exports. While exports to the US increased 4.4 percent in March, exports to most Asia-Pacific nations fell sharply. Indeed, exports to China were down 9.4 percent.
Among the weakest categories were textile machinery (down 22.6 percent), medical products (down 20.7 percent), metalworking machinery (down 16.9 percent), and nonferrous metals (down 12.9 percent). The decline in exports is a matter of concern given that Japanese domestic demand too has exhibited weakness lately. Evidently, the country can’t depend on its traditional export powerhouse to fuel strong economic growth.
Japan’s experience is part of a larger trend in which exports from other major Asian nations are declining. This includes Singapore, Malaysia, Taiwan, and South Korea.36 Much of the regional decline is related to the US-China trade war and the negative impact on trade flows between these two economic giants. The smaller economies of Asia are highly integrated into supply chains that are linked to US-China trade. In addition, Asia’s weak exports are likely related to the global slowdown in demand for smartphones.
Meanwhile, the Bank of Japan has so far failed to boost inflation in line with its target of 2.0 percent, despite years of effort involving historically low interest rates and massive central bank purchases of government bonds. The latest data indicates that in March, consumer prices in Japan were up 0.5 percent from a year earlier, and unchanged from the previous month. When volatile food and energy prices are excluded, core prices were up 0.8 percent from a year earlier.37 This was up from the previous monthly reading of 0.7 percent, and the highest rate of core inflation since November. Still, in the past decade, core inflation has never exceeded 1 percent, except for a brief period in 2014 following a sharp increase in the national sales tax.
The failure of the monetary policy to significantly boost inflation might be reflective of the negative impact of Japan’s demographics. A declining labor force and an aging population mean that Japan’s consumer demand has been failing to keep up with supply. At the same time, global demand has been weak. Excess supply suppresses prices, mitigating higher inflation. Meanwhile, the seriously aggressive monetary policy has resulted in suppression of the market supply of government bonds as the government has purchased these bonds on a massive scale. Bond yields are thus artificially suppressed. Bank profitability has been hurt and businesses have less incentive to invest efficiently. There is concern that the long-term effect of the monetary policy has been to create distortions in the Japanese economy.38
Industrial production in the United States exhibited weakness in March.39 The government reported that overall output was down 0.1 percent from February to March and was up only 2.8 percent from a year earlier, the slowest increase in 10 months. The manufacturing component was unchanged from February to March and has not grown since December. Compared to a year earlier, manufacturing output was up only 1.0 percent, the smallest increase since January 2017. In addition, manufacturing capacity utilization remains below its long-term average. The only bright spot in the report was that production of business equipment increased 0.4 percent from February to March and was up 3.8 percent from a year earlier. This bodes well for a modest increase in business investment in the coming months.
The weakness of industrial production indicates that the US economy is likely facing headwinds, perhaps triggered by overseas weakness as well as the impact of trade tensions on investment and trade flows. There are reports that some US manufacturers are suffering as a result of the rise in tariffs in the past year.40 The weakness in industrial output, combined with weak inflation and consumer spending, are among the factors that have led the Federal Reserve to pause the process of interest rate normalization.
Meanwhile, after several months of weakness, retail sales in the United States rebounded strongly in March. The government reports that overall sales were up 1.6 percent from February to March, and up 3.6 percent from a year earlier.41 Sales were especially strong at automotive dealerships (up 3.1 percent from the previous month) and at gasoline stations (up 3.5 percent from the previous month). Excluding these categories, retail sales were up a more modest—but still robust—0.9 percent from February to March, an increase of 3.6 percent from a year earlier. Most categories saw strong monthly growth.
So, what explains the rebound? One explanation is that after holding back on spending due to various negative events—government shutdown, weaker than expected tax refunds, declining asset prices— in recent months, consumers were ready to shift their behavior in March. After all, asset prices were up once again; incomes continued to grow with wages accelerating; trade tensions appeared to have abated; and the Federal Reserve signaled an end to monetary tightening. Plus, having rebuilt their savings in recent months, consumers may have felt financially healthier and, therefore, more comfortable making discretionary purchases. Still, one month does not make a trend.
Although China runs a large bilateral trade surplus with the United States, what really matters is China’s overall balance with the rest of the world. Notably, after decades of large surpluses, China is now on the verge of shifting toward deficits. The principal reason for this is that there is rising domestic demand and declining saving. Demographics is playing a key role in this shift. An aging population means less saving and more consumption, as older households shift from saving to spending, while the successor generation of savers is much smaller. As saving declines, the country imports more. The shift is reflected in the change in China’s current account balance, which is essentially the trade balance combined with net income from overseas assets. The current account surplus fell from 9.9 percent of GDP in 2007 to 1.3 percent in 2017 and 0.4 percent in 2018.42 The current account was last in deficit 25 years ago. Some analysts now expect a deficit in 2019, and possibly beyond. At the least, most analysts expect that large surpluses will be a thing of the past.
What are the implications for the global economy if China no longer runs large surpluses?
First, China would no longer be a major source of capital for the rest of the world. There has been a symbiosis between China and the United States, with China funneling excess savings to the United States, a country with strong investment and only modest savings. Going forward, it might be the case that the United States will need to obtain capital from elsewhere. Or, perhaps US deficit will shrink due to higher borrowing costs and/or a cheaper currency. This could mean slower growth of consumer spending in the United States, with the Unites States playing less of a role as an engine of global growth.
Second, China would have to import capital to meet its investment needs, likely putting downward pressure on its currency. That would likely annoy US policymakers, thus fueling greater economic tension between the two countries. Or, very likely, China would have to reduce investment. That would not necessarily be a bad thing given that China has engaged in excessive investment in the past decade, rendering a massive amount of excess capacity in heavy industry and plenty of unoccupied commercial properties. If China were to invest less, but invest more efficiently, it could actually have a positive impact on growth.
Finally, China will increasingly be a consuming nation, with improved living standards for its households. It would become an engine of growth for the rest of the world. Its rising middle class could fuel major global industries such as automotive, electronics, and tourism. Notably, China’s government has just cut the tax that households pay on imported consumer goods.43 This was likely meant to assuage concerns of the US government, but will also play a role in shifting China more toward consumer-driven growth. Thus, a smaller Chinese surplus will help to rebalance the global economy.
A research arm of the Chinese government reports that the country’s pension system will run out of money by 2035 due to the decline in the working age population. The Chinese Academy of Social Sciences (CASS) says that the reserves of the Urban Worker Pension Fund, which is the principal vehicle for supporting the urban retired, will shrink from the current value of US$714 billion to zero by 2035.44 In addition, the gap between revenues and expenditures of the pension system will continue to grow. Currently, there are two workers contributing to the system for each recipient. By the year 2050, that will decline to one worker for each recipient. Thus, in order to avoid insolvency for the system, either individual contributions will have to rise dramatically or benefits will have to decline dramatically. Notably, the government recently cut the employer contribution to pensions in order to stimulate business activity.45 This will reduce revenue to the system. Another option is to boost the retirement age. Currently, Chinese men can obtain full benefits at the age of 60.
Yet another option that has been proposed is to dip into the government’s massive volume of foreign currency reserves, currently in excess of US$3 trillion, in order to support the system. The overall problem stems from the lagged impact of the one-child policy. Although that policy was lifted in 2014, the birth rate has not shifted commensurately. As for the economic impact of the pension situation, it is a long-term problem. It will not have much of an impact right away, but over time it will have a big negative impact on government finances. Plus, the continuing decline in the working-age population will likely slow economic growth and boost labor costs. Nonetheless, China still has room to move people from rural to urban areas, thereby achieving productivity gains and boosting the potential size of the middle class. Thus, China could see strong domestic demand-oriented growth in the coming decade, despite a longer-term pension problem.
A group of indicators published by the Brookings Institution, a leading think tank, points toward a synchronized slowdown of the global economy.46 The Brookings report notes weak business and consumer sentiment in multiple countries leading to dampened business investment. The latter bodes poorly for strong future economic growth. It points out that, after a period of “uneven recovery” across the globe, the world now faces problems in most of the major developed and emerging markets.
With respect to the massive US economy, the report notes that the fiscal stimulus from the tax cut enacted in late 2017 is already wearing off and that the near inversion of the yield curve suggests that, despite fiscal stimulus, there is likely weakness ahead.
As for Europe, the report says that Germany, traditionally Europe’s engine of growth, is “visibly losing steam” and that business and consumer confidence across the continent has significantly weakened, boding poorly for growth.
The report notes weakness of key indicators for China, despite a government effort to stimulate the economy. However, it says that “continued credit misallocation” is creating financial risk and bodes poorly for growth of productivity and output.
Finally, the report notes that, although emerging markets might obtain relief from an easing of monetary policy in major economies, they face increased trouble as a result of the weakness of China’s economy. It says that, in 2019, major economies such as Brazil, Mexico, and Russia will only grow about 2.0 percent while Turkey slides into recession. Only India among large emerging economies will grow rapidly. Even that growth is threatened by weak investment and declining trade.
Meanwhile, as expected, the International Monetary Fund (IMF) cut its benchmark forecast for global economic growth in the coming two years, down from 3.7 percent for 2019 to 3.3 percent,47 with an especially sharp drop in expectations of growth in Europe. However, it upwardly revised its expectations for China, based on the country’s economic stimulus program. The IMF noted that global growth slowed considerably in the second half of 2018 due to a variety of headwinds and uncertainties. While the IMF is no better at predicting economic growth than other economic institutions, its forecasts are important in that they reflect the preponderance of sentiment in financial markets and institutions, as well as having an impact on that sentiment. As such, a shift in IMF forecasts might have an impact on credit market conditions as well as on the willingness of businesses to invest.
IMF Managing Director Christine Lagarde says that one reason for pessimism is that global business investment is barely growing at all. However, the latest Purchasing Managers’ Index (PMI) for Chinese manufacturing shows a surprising rebound into very modest growth territory.48 In addition, the services PMI increased sharply to a level reflecting moderate growth. These PMIs suggest that China could be turning the corner, perhaps the result of recent government stimulus. This is important given the huge footprint of China in the global economy.
The news from Europe remains troubling. For example, German exports fell 1.3 percent in February from a year earlier and imports fell 1.6 percent.49 The German export engine is sputtering due to certain problematic events. These include significant trade tensions between the United States and Europe, uncertainty over Brexit, and the weakness of demand in China. In addition, new orders for German manufacturing fell in February at the fastest pace in two years, boding poorly for an increase in output.
The minutes of the US Federal Reserve’s latest meeting in March indicate that the Fed is amenable to a significant shift in policy. The policymakers are concerned about “significant uncertainties” and, consequently, expect that their outlook for the US economy could “shift in either direction.”50 It implies that they could be amenable to a cut in interest rates later this year. Indeed, the interest rate futures market now predicts that there is more than a 60 percent chance that rates will be cut in 2019. At the very least, it appears that rate hikes are off the table for a while.
Meanwhile, the tightness of the US labor market eased in February. The government’s Job Openings and Labor Turnover Survey (commonly called JOLTS) indicated that the number of available jobs fell by about half a million from January to February, and the job openings rate (the share of available jobs that are unfilled) fell from 4.8 percent in January to 4.5 percent in February.51 This was the lowest rate in about a year. The rate fell especially sharply in such industries as real estate, wholesale trade, transportation, mining, hotels, and education. Notably, the job openings rate increased in manufacturing.
Consumer price inflation in the United States accelerated in March,52 largely due to strong growth in food prices. The consumer price index was up 1.9 percent versus a year earlier, up from 1.5 percent inflation in the previous month. Still, inflation remained well below the levels seen through most of the past year. In March, prices were up 0.4 percent from February, compared to monthly inflation of only 0.2 percent in the previous month. Compared to a year earlier, food prices were up 2.1 percent, with prices of food away from home up 3.0 percent. However, when volatile food and energy prices are excluded, core prices were up 2.0 percent from a year earlier. This was the lowest rate of core inflation since early 2018. Core prices were up only 0.1 percent from the previous month. Thus, it appears that underlying inflation is actually declining. The modest level of core inflation in March was due, in part, to the fact that energy prices were up strongly and were not included in core inflation. The fact that underlying inflation is abating likely reflects the weakness of the economy. This is likely one of the reasons that the Federal Reserve is shifting its approach to monetary policy.
Nominal wage increases in the United States have remained relatively steady lately. Yet because inflation accelerated in March, real (inflation-adjusted) average hourly earnings of US workers declined 0.3 percent versus February.53 However, real earnings were up 1.3 percent in March versus a year earlier. This is lower than the increase of 1.9 percent in the previous month. Thus, American workers are seeing smaller increases in real purchasing power as a result of a modest acceleration in inflation.
The European Union (EU) has agreed to a six-month extension to the Brexit deadline for the United Kingdom. Under the new agreement, Britain will exit the EU on either Halloween of this year, May 31 if the United Kingdom chooses not to participate in the European Parliamentary elections starting on 23 May, or yet a third date if the negotiated deal is approved sooner. Prime Minister May has seen the deal she negotiated with the EU rejected by the Parliament on three occasions, and she has had to endure two extensions by the EU. She said, “The UK should have left the EU by now and I sincerely regret the fact that I have not yet been able to persuade parliament to approve a deal. But the choices we now face are stark and the timetable is clear.” Yet the timetable might not actually be clear. It seems that no one wants Britain to exit without a deal, a view driven by the tremendous uncertainty as to what a no-deal exit would entail. Yet Britain’s Parliament, having engaged in a series of “indicative” votes on various proposals, cannot agree on how Britain should leave. Thus, uncertainty remains, a fact that is likely to have a negative impact on investment.
As for the EU, its leaders debated vigorously as to whether to offer the extension, with France’s Emmanuel Macron said to be the least amenable. His view was that Europe would be best off letting Britain go so that it could move on to other important issues. Germany’s Chancellor Angela Merkel, on the other hand, took a more conciliatory view. She said of the extension that “it gives the British more time and space to decide what they want to do. From our point of view it was important not to put pressure on [the UK].” European Council President Donald Tusk urged Britain to take full advantage of the extension, saying “please do not waste this time.” But what might change between now and October? The British Parliament was clear in its rejection of the principles of the first agreement, and the EU was clear that it will not go much further than that deal. Thus, uncertainty remains.
In the 19-member eurozone, inflation continued to be restrained in March.54 The consumer price index was up 1.4 percent in March versus a year earlier. This matched the lowest level seen since April 2018. When volatile food and energy prices are excluded, core prices were up 0.8 percent from a year earlier, the lowest level seen since April 2018 and well below the levels seen in the past couple of years. Thus, it appears that underlying inflation in Europe is abating. The weakness of inflation likely reflects the weakening of the eurozone economy, despite the strengthening of the job market. This provides justification for the European Central Bank to continue with its very easy monetary policy. Italy recently fell into recession and Germany just skirted recession. Exports and investment have weakened owing to trade wars and weak demand in China.
In the eurozone, the job market continues to improve.55 In February, the unemployment rate dropped to 7.8 percent, the lowest since 2008. The number of unemployed workers fell by 77,000 from the previous month and was down by more than a million workers from a year earlier. The highest unemployment rates in Europe were in Greece (18.0 percent), Spain (13.9 percent), Italy (10.7 percent), and France (8.8 percent). This included three of the largest economies in the region. The lowest unemployment rates were in Czech Republic (1.9 percent), Germany (3.1 percent), the Netherlands (3.4 percent), and Hungary (3.5 percent).
Retail sales in Europe accelerated in February.56 Real, or inflation-adjusted, retail sales were up 0.4 percent in the eurozone from January to February; they were up 2.8 percent from a year earlier, the best performance since late 2017. Real retail sales in the larger European Union (EU) were up 0.4 percent for the month and up 3.3 percent from a year earlier. Compared to a year earlier, the volume of retail spending was up 4.8 percent in Germany, 2.0 percent in France, 1.6 percent in Spain, and 3.9 percent in the United Kingdom. Among the countries with very strong retail spending growth were Croatia, Slovenia, Hungary, and Ireland. Growth was weak in Denmark, Finland, and Bulgaria. The strong number for Germany, Europe’s largest economy, is especially significant as Germany’s economy has been weak lately.57 Having fallen in December, real retail sales in Germany grew strongly in both January and February, suggesting that the German economy is likely recovering from its doldrums.
The Organisation for Economic Co-operation and Development (OECD) is concerned about the fiscal outlook for Italy.58 Italian bond yields rose sharply in the past year as the Italian government embarked on a fiscal expansion (increased spending) meant to boost economic growth. The view of the Italian government was that a temporary increase in spending would jumpstart a weak economy, thereby setting the stage for a decline in the already high debt/GDP ratio. It did not happen. Rather, Italy fell into recession as weakened business sentiment and higher borrowing costs hurt investment. Now, the OECD says that under current fiscal policy, the ratio of government debt to GDP will likely rise to 144 percent in 2030 (from the current level of 133 percent), assuming no change in the spread of Italian bond yields over German bunds. If the spread rises, however (perhaps due to investor pessimism about Italian fiscal policy), the debt/GDP ratio could rise to 156 percent. For the short term, the OECD noted, “Given slow growth, low inflation and rising interest costs and a larger deficit, the public debt ratio will cease to decline and increase to 135 [percent] of GDP in 2020.” The head of the OECD said that for Italy to achieve stronger growth, it must address certain structural issues such as labor market reform, fiscal probity, and market regulation. He said, “Tackling them requires a multi-year reform package to achieve stronger, more inclusive and sustainable growth, and revive confidence in the capacity to reform.”
The US government reported that job growth rebounded in March, following a very weak February.59 The government’s survey of establishments indicated that 196,000 new jobs were created in March, far above the 33,000 created in February, but below the 312,000 created in January. The number of new jobs was far above that needed to absorb new entrants into the labor force. There was a decline of employment in manufacturing after barely any growth in February. Evidently, the industry is now facing headwinds. In addition, the retailing industry continued to see a sharp drop in employment. Job growth was strong, however, in professional and business services as well as health care. There was also relatively strong growth in leisure and hospitality. Average hourly earnings were up only 0.1 percent from February to March, lower than many analysts had expected, especially given the strength of the job market. Earnings were up 3.2 percent from a year earlier. The separate survey of households indicated that the unemployment rate remained steady at 3.8 percent.60 Survey results revealed that job market participation fell for the first time since August, although the participation rate remains elevated relative to much of the past year. Overall, the data offer mixed signals—on the one hand, job growth was strong, but on the other, wages were soft and participation fell. For the Federal Reserve, which watches job market data closely as part of its deliberations, the report offers justification for whatever it decides to do.
Retail sales in the United States fell in February.61 In fact, sales have fallen in two of the last three months, and have only risen in two of the last seven months. It is not clear if this represents a shift toward weakness in consumer behavior, or if there are temporary factors that are causing volatility in the numbers. For example, tax refunds have been surprisingly small for many households, thus possibly hurting spending in February.62 In addition, the sharp drop in equity prices late in 2018, combined with uncertainty fueled by the partial government shutdown and continuing trade wars, might have led to the sharp drop in retail spending in the last months of the year. At the same time, it could be that the consumer boom is simply over and that, given the various headwinds facing the economy, consumers are changing their behavior accordingly. In any event, we do know that personal saving has increased as consumers have cut back on spending relative to income.
Meanwhile, here are the retail sales numbers: retail sales fell 1.6 percent from November to December, rose 0.7 percent in January, and then fell again by 0.2 percent in February. In February, sales excluding motor vehicles were down 0.4 percent, while spending at automotive dealerships was up 0.7 percent. Sales were down sharply at stores specializing in furniture, electronics, home improvement, groceries, clothing stores, and at department stores. Sales were up at drug stores, restaurants, and non-store retailers.
In 2017, global trade grew by 4.6 percent from the previous year. In 2018, however, trade growth decelerated to 3.0 percent growth. Moreover, the World Trade Organization (WTO) predicts that in 2019, trade might grow as slowly as 1.3 percent if the current tensions persist and if trade restrictions are expanded.63 Nonetheless, the WTO says that if trade restrictions are lifted, trade could grow as rapidly as 4.0 percent. Robert Azevedo, Director General of the WTO, said, “With trade tensions running high, no one should be surprised by this outlook. Trade cannot play its full role in driving growth when we see such high levels of uncertainty. It is increasingly urgent that we resolve tensions and focus on charting a positive path forward for global trade which responds to the real challenges in today’s economy—such as the technological revolution and the imperative of creating jobs and boosting development.” In addition, Azevedo urged that members of the WTO safeguard the rules-based system of multilateral trade.
Currently, the US administration is refusing to allow the appointment of new members to the WTO’s dispute-resolution body. This body is meant to adjudicate disputes between countries and thereby enforce the rules-based trading system. If the number of members will fall below a certain threshold, the appellate system will cease to function. This could happen by the end of this year. At that point, the WTO would effectively become a paper tiger. The United States says that its goal is to compel other members to accept reforms of the WTO. The EU has offered reforms that the US has refused. Thus, some EU leaders have suggested that the real goal of the US is to undermine multilateral trade rules so that the world can revert to a system of bilateral relationships.64 The US view is that bilateral trade negotiations give the US the upper hand because of the massive size of its market. Yet from a business perspective, a shift away from global rules to a system of bilateral deals would mean greater complexity of global supply chains and, very likely, less efficiency and higher costs.
One of the complaints made by the United States about the WTO is that China is classified as a “developing country” and, consequently, is entitled to be exempt from rules against agricultural subsidies and rules against relatively onerous trade restrictions. However, China wants to retain its classification, claiming that it remains a developing country and, therefore, it ought to be given preferential treatment. A spokesman for the Chinese government noted, “China’s position on WTO reform has been very clear. China is the largest developing country in the world. We do not shy away from our international responsibilities and are willing to assume obligations in the WTO that are compatible with our own economic development level and capabilities. In fact, we do the same and will continue to do this.”65
In contrast, Brazil has agreed to forgo the “developing country” status in exchange for US support for Brazilian membership in the OECD. The US objection to China is that the exemption allows China to engage in practices that distort the market and give US companies a competitive disadvantage in China.66 However, the former Governor of China’s central banks recently said, “We have substantially reduced market distortions, but because this is a process of transformation, it is necessary that it has taken many years, so some distortions will remain. The Chinese government is very willing to speed up the reform process to eliminate this distortion, so these distortions will eventually disappear.”
Ratification of the US-Mexico-Canada Agreement (USMCA), the successor to NAFTA, is not assured.67 The Democratically controlled US House of Representatives is reluctant to approve the deal “as is,” and leaders in the House have sought changes and clarifications, especially regarding enforcement of labor standards as well as rules regarding protection of drug-company patents. In addition, the agreement cannot obtain a vote in the House unless Speaker Nancy Pelosi schedules a vote. Moreover, many members of Congress in both parties are unhappy that the president will not remove the punitive tariffs on imports of steel and aluminum. These tariffs are seen as damaging to the competitiveness of manufacturing companies in the Midwest and South. Yet the president has so far not budged on this issue. In addition, Canadian Foreign Minister Chrystia Freeland has said that Canada’s ratification of the USMCA cannot be taken for granted as long as the tariffs remain in place. Thus, it now appears highly unlikely that the USMCA will be ratified early this year as the US administration had hoped. The president has threatened to simply exit NAFTA if the Congress fails to ratify the USMCA, but that would likely have a hugely disruptive impact on the US economy.
In the past week, President Trump threatened to shut down the border between the United States and Mexico unless Mexico took steps to stem the tide of refugees streaming into the United States from Central America. Many members of Congress as well as business leaders have urged against such a drastic step, saying that it would wreak havoc with the US economy. So late last week, the president said that rather than shut down the border, he might impose severe tariffs on automobiles coming in from Mexico. He said, “Before we close the border, we'll put the tariffs on the cars. I don't think we'll ever have to close the border, because the penalty of tariffs on cars coming into the United States from Mexico, at 25 percent, will be massive.”68 Yet such action would go against the trade agreement—the USMCA—that the United States just finalized with Mexico and Canada. The USMCA has a side agreement, which has been in effect since November, that exempts Mexico and Canada from any future automotive tariffs the United States might initiate based on national security considerations. Recall that the United States has threatened to use such considerations to impose new tariffs on all automotive imports. Of course, the United States could decide to ignore the side agreement, but that would likely damage its credibility with trading partners, and might jeopardize Congressional approval of the USMCA. At the same time, Trump recently said that border security “is more important to me than [the] USMCA.” For its part, the Mexican government is taking the position that the side agreement is safe. A Mexican official said, “What has been agreed on the car industry is firm, is not under threat, and we're sticking to that.”
It is reported that the United States and China are close to a trade agreement.69 They have resolved the main disputes regarding structural issues and trade flows. The structural issues involve China’s rules regarding foreign investment and technology transfer. The trade flow issue involves China’s promises regarding imports from the United States. However, two central issues remain unresolved: how to enforce the agreement and the speed at which existing tariffs will be removed. Regarding the former issue, the United States wants the right to impose punitive tariffs should China not abide by the deal, and it wants to restrict China’s right to retaliate. China is not amenable to the US proposal. As for the latter issue, reduction of existing tariffs is considered crucial to China. It wants the United States to immediately reduce tariffs once an agreement is reached. The United States, however, wants to wait until it is clear that China is abiding by the new agreement. Negotiations are taking place with the goal of resolving these remaining issues. The hope is that once resolved, the presidents of the two countries can meet and sign the agreement. If an agreement is not reached during the current talks, an extension of the talks might be agreed upon. Alternatively, if the two sides cannot resolve the remaining issues, the talks could break down and the United States could decide to boost existing tariffs as previously threatened. Thus, uncertainty remains.
One impact of the existing trade war between the United States and China is that China is expanding investment in other Asian countries, possibly in order to boost capacity to produce in those countries and, thereby, avert tariffs. The Asian Development Bank (ADB) reported that China’s outbound greenfield investment in Asia’s other emerging economies tripled in 2018 versus the previous year.70 The ADB noted, “China has been tightening its investment links with the rest of developing Asia in recent years, but the trend seems to have accelerated under the trade conflict in 2018.” In addition, US greenfield investment in non-China Asian emerging countries also increased sharply, rising 71 percent in 2018 versus the previous year. Evidently, US companies are also boosting capacity outside China in order to avert tariffs. The ADB said that the outcome of the current trade negotiations between the United States and China has “the potential to shape [foreign direct investment] flows into high tech over the medium term.”
The yield on the US government 10-year Treasury bond fell below 2.4 percent last week for the first time in 15 months.71 This is a continuation of the trend seen since the Federal Reserve recently indicated a preference for keeping short-term rates steady. Many investors saw the Fed inaction, combined with other indicators, as suggesting the strong possibility of a downturn or, at least, a slowdown. The result was an inversion of a yield curve for the first time in a decade, which is often a good predictor of recessions. Moreover, a sharp drop in German bond yields also reflected deepening pessimism about the German economy,72 especially in light of the sharp drop in the purchasing manager’s index for German manufacturing. Also, the volume of global debt that has a negative yield has risen above US$10 trillion.
The sharp drop in US yields comes at a time when the US government is increasing the sale of bonds, due to the big rise in the budget deficit that followed last year’s tax cut. Indeed, last month the US government had its biggest monthly deficit ever. Revenue from the corporate income tax has plummeted following the steep decline in the corporate tax rate.73 Proponents of the tax cut had argued that the tax cut would so boost economic growth that it would pay for itself. Yet even with a large amount of government borrowing, bond yields have fallen. This means that private sector demand for credit is weak. The tax cut did, of course, boost economic growth in 2018 temporarily, but the impact has already started to wane, and other factors are now conspiring to restrain the US economy. These include the impact on credit markets from the Fed’s monetary policy tightening over the past two years, the impact of the trade wars on trade volumes and business investment, and the slowdown overseas. The movement in bond yields clearly reflects investors’ dampening expectations for economic growth.
That being said, investors often tend to panic in the face of alarming movements in asset prices, while more sober voices tend to think things through. Former Fed Chairman Janet Yellen, for example, says that, although the US economy is slowing, it is not likely at risk of recession. She said, “I don’t see a recession in the [United States] as particularly likely.74 The [United States] is certainly experiencing a slowing of growth and that is something that was long expected.” She noted that the economy was boosted by the tax cut and that the effects of that are now waning. She added, “Forecasts from the Fed’s policy committee meeting show growth would slow to something close to 2 percent, which is near [sic] the rate of growth of potential output in the [United States]. That is not a dangerous situation.” She suggested that there was never any reason to expect the acceleration in growth in 2018 to last. She said that, in the past, recessions were often caused by the Fed tightening excessively in response to accelerating inflation. She added that inflation remains low and that Fed action has not been excessive. Her comments were in line with those of Charles Evans, President of the Federal Reserve Bank of Chicago, who sees only a 25 percent chance of a recession.
Last week, the US government released the latest data on personal income and expenditures. Due to the recent government shutdown, some data were not available. So, the government released February data on personal income, but only January data on personal expenditures and price inflation. Here is what the data indicates.75
Disposable personal income, having risen strongly in December (up 1.0 percent from the previous month), fell 0.2 percent in January and rose only 0.2 percent in February. Over those two months, there was a sharp drop in interest and dividend income and a modest increase in wages. The government did not report on real (inflation-adjusted) increases in disposable personal income for February. However, it reported that real disposable income was down 0.2 percent in January versus December, and up 3.0 percent in January versus a year earlier. The latter figure was down from 3.9 percent growth in December. Thus, income growth is decelerating. The surprisingly weak job growth reported in January may account for this.
Consumer spending decelerated at the end of 2018 and the start of 2019. The government reports that real (inflation-adjusted) personal consumption expenditures were up 0.1 percent from December to January. Real expenditures were up 2.0 percent in December versus a year earlier, and up 2.3 percent in January versus a year earlier. These were the lowest rates of growth since early 2014 with the exception of one month in 2017. Spending on durable goods grew especially slowly, falling 1.6 percent for the month and up only 1.0 percent from a year earlier. With the exception of a brief decline in 2014, this was the slowest growth since 2010. It seems like American consumers are in the midst of a sharply negative shift in spending patterns. This comes at a time when income is decelerating. In addition, personal saving declined commensurately with the decline in personal income. In fact, the personal savings rate fell only modestly from 7.7 percent in December to 7.5 percent in January. It had been as low as 6.2 percent in November. Thus, it appears that consumers are being more cautious with their income.
The Federal Reserve’s favored measure of inflation is the personal consumption expenditure deflator (commonly called the PCE-deflator). It is what the Fed watches most intently as it deliberates on policy. The latest data indicates that overall prices were up only 1.4 percent in January versus a year earlier, a sharp drop from recent months and the lowest since 2016. That decline likely reflects the impact of falling energy prices, which were down 6.4 percent in January versus a year earlier. When volatile food and energy prices are excluded, core prices were up 1.8 percent—just slightly below core inflation in recent months. Thus, underlying inflation appears to be relatively steady. From the Federal Reserve’s perspective, a combination of steady or declining inflation, combined with weakening consumer spending, provides strong justification for its policy of “patience” regarding interest rate movements.
It is reported that some Republican members of the US Senate are urging President Trump not to impose tariffs on imported automobiles, which he has threatened to do. It is also reported that the president has not been amenable to their arguments.76 The senators have told the president that such tariffs would hurt automotive employment in key battleground states in the Midwest— the very states that helped elect Trump and where the next presidential election is likely to be fought. They have also warned him that such tariffs could push the US economy into recession. Yet Trump is said to like tariffs as a negotiating strategy, meant to compel the Europeans to make concessions. Senator Lamar Alexander of Tennessee noted, “The president likes tariffs as a threat. I hope he understands that the auto tariffs damage the autoworkers in the Midwestern states and the Southeastern states.” Rand Paul of Kentucky too said, “People will be happy if there's an agreement and it actually opens some markets. If there's no agreement and the tariffs get worse, my worry is that you could have a recession.”77 Related to this, it has been reported that European Union (EU) officials proposed that all automotive tariffs for the United States and the EU be cut to zero. Currently, the United States has a 2.5 percent tariff on cars and a 25 percent tariff on sport utility vehicles (SUVs). The EU has a tariff of 10 percent on all vehicles. The United States is said to be reluctant to go to zero, and especially reluctant to cut the tariff on SUVs. Rather, it wants the EU to cut its tariff to 2.5 percent.
Meanwhile, Senator Grassley of Iowa, who leads the Senate Finance Committee, said that he urged Trump to drop the tariffs on steel and aluminum in order to obtain Congressional passage of the US Mexico Canada Agreement (commonly called the USMCA), but he said that Trump rejected his proposal. Grassley said that he and a group of senators told Trump, “We've got to get rid of the tariffs or nothing's gonna happen.” Finally, Grassley is working on legislation meant to remove the ability of the president to permanently impose new tariffs on the basis of national security concerns. Such concerns formed the basis for tariffs on steel and aluminum, and would form the basis for the proposed tariffs on automobiles.
Trade negotiations continue between the United States and China. Yet there is no longer as much pressure to reach a deal as there had been before President Trump removed the March 1 deadline. Prior to that, he had threatened to significantly boost tariffs if a deal was not reached by the deadline. Then, he removed the deadline and said that talks were going well and that a deal would soon be reached. But for now, the Chinese have less incentive to finalize a deal, given that there is no deadline hanging over their heads. From their perspective, it makes no sense to conclude an onerous deal if the alternative is the status quo. Thus, it is reported that negotiations have slowed down and that significant disagreements remain.78 White House Advisor Larry Kudlow says the talks could go on for months. Still, the US side is likely more eager for a deal, having started the process in the first place. Moreover, the United States—having threatened tariffs in the absence of a deal—would likely have to boost tariffs if a deal cannot be reached, thus doing damage to the US economy. That is why some observers expect the US side is likely to be willing to accept a less-than-perfect deal. The Chinese side understands this and, consequently, is avoiding making too many concessions.
Martyn Davies of Deloitte South Africa comments on the move toward economic integration across the African continent.
“Recently Ethiopia joined the African Continental Free Trade Area (AfCFTA)—the continent’s ambitious plan to liberalize markets across Africa’s 54 countries.79 This puts the total number of government ratifications at 22, the number needed to bring the AfCFTA into action. The AfCFTA is intended to boost intra-African trade, liberalize services, and address barriers to trade. I was in Addis Ababa very recently and was positively surprised by the free trade rhetoric from almost all African public sector officials. This was almost unimaginable a few short years ago. Ethiopia’s official endorsement of the AfCFTA sends a strong signal to other African markets that are slow to sign up to the free trade agenda, most notably Nigeria. Due to Nigeria’s relative economic size in West Africa, the move toward freeing trade is predominantly a southern and eastern African trend. China’s investment into economically enabling infrastructure in the East Africa region is also expected to support growth in trade going forward.”
Peter Ireson, an economist with Deloitte UK, summarizes the latest happenings related to Brexit.
Last Monday, for the first time in over a century, British members of Parliament (MPs) voted to seize control of the parliamentary timetable from the government in a bid to break the deadlock over Brexit.80 This led to a series of indicative votes on eight different Brexit options, none of which secured a majority. A proposal for putting any withdrawal agreement to a referendum gained the greatest support, followed by a proposal to remain permanently in a customs union with the EU. Remaining in a customs union would prevent the United Kingdom from seeking new trade deals related to goods with other non-EU countries.
By the end of last week, Prime Minister Theresa May held a third vote, but this time seeking to approve only the legally binding withdrawal agreement in her deal and not the non-binding political declaration (which sets out the aims of a future relationship). This failed to pass by a substantial margin. May had offered to resign if MPs approved her withdrawal agreement last week. Despite the loss, speculation is rife that she might eventually resign, with bookmakers’ odds suggesting Michael Gove, Boris Johnson, Jeremy Hunt, and Dominic Raab, all proponents of Brexit, as frontrunners in a potential leadership contest. In her closing remarks in parliament today, May said, “We’re reaching the limits of the process in this house.” Some have interpreted this as a sign she may call a new election. Simulation performed by one pollster suggests that, as things stand, an election is likely to return a hung parliament, meaning consensus would still be required to pass legislation.
The latest events failed to resolve the current impasse or eliminate any of the wide-ranging potential outcomes of Brexit. The United Kingdom is now technically set to exit without a deal on April 12 unless a further extension can be agreed with the EU (which would require UK participation in the upcoming European elections) or Article 50 is revoked. It is far from certain that the EU would agree to a longer delay, with Germany thought to be more accommodative while France remains skeptical.
In Japan, only a few thousand university graduates each year are proficient in the science of artificial intelligence (AI). The government wants to change that, saying that it will mandate that all university students take a beginner course in AI. It hopes that, eventually, about 250,000 graduates each year will be proficient in AI.81
In Japan, about 600,000 students graduate from university each year, but Japan faces a shortage of data scientists currently. The government wants to solve the problem by shifting the mix of education. The global war for scientific and engineering talent has resulted in a surge in salaries, both in Japan and in other countries with substantial technology sectors. For Japanese companies, one solution is to employ scientists in other countries. It is reported, for example, that a large Japanese automotive company set up an AI subsidiary in the United States, headed by a former technology company executive.82 From a public policy perspective in Japan, this is seen as a loss of competitiveness for the country. Hence, the need to train more scientists domestically. Moreover, the salaries offered by US companies far exceed those by Japanese companies.83 As a result, US companies can effectively recruit in Japan. This difference reflects the stickiness of tradition-bound pay scales in Japan, although it is reported as starting to change.