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There is now a serious debate among macroeconomists about whether the United States is headed for a prolonged period of higher inflation. Interestingly, there is not much debate among investors, at least judging by market measures of inflation expectations, which have increased only moderately in recent months. In any event, the debate was largely generated by Congressional passage of two large stimulus bills that, together, will boost government spending by about 13% of annual GDP. However, not all that money will be spent in one year. Still, it is much more than the gap between current GDP and potential GDP, largely estimated to be about 5% of annual GDP. Thus, critics argue that it will cause the economy to overheat, generating shortages and bottlenecks that will lead to sustained higher inflation. Add to that 13% of GDP the already-large excess savings that resulted from last year’s fiscal stimulus. It is estimated that excess savings (savings in excess of what would normally transpire without the pandemic) are about 7% of GDP. This is money that could potentially be spent once the vaccine is fully distributed, and consumers and businesses return to normal spending behavior. Finally, the huge increase in savings has contributed to a big increase in asset prices, thereby leading to a substantial gain in wealth for a large number of households. Historically, increased wealth has a positive impact on consumer spending. As such, one can argue that there is the potential for increased spending of about 20% of GDP, far more than is needed, to bring the economy back to full employment. This could easily cause much-higher inflation, or at least force the Federal Reserve to sharply reverse policy, thereby setting the stage for another recession.
There are, however, several counterarguments. It is useful to compare the current situation to that of World War II. At that time, there was a sizable increase in personal income, much of which was saved. Interestingly, when the war ended, much of the increased savings was not spent by consumers. Rather, they continued to save, especially as many returning veterans were keen on saving for a down payment on a new home. It is not unreasonable to expect that, when this pandemic ends, consumers will not completely dip into their savings. Rather, many millennials are likely to save in order to purchase a new home (or at least borrow saved money from their more affluent parents, such as readers of this update). Moreover, recent survey data suggests that US households save about three quarters of stimulus payments. Thus, the latest large stimulus will not necessarily be quickly spent. In addition, some of the money that will be spent will drain out of the country in the form of increased imports. This, in turn, will stimulate the global economy. Indeed, the OECD estimates that the US fiscal stimulus will add 1 percentage point to global GDP growth in 2021.
Another reason to be more sanguine about inflation is that, with a dramatic boost to digital transformation during and after the pandemic, there could be a significant acceleration in productivity growth, thereby enabling the economy to grow faster than previously estimated without generating inflation. In addition, the likely passage of a bill that will increase funding for infrastructure investment could have a positive impact on productivity as well. It might also help to bring discouraged workers back into the labor force, providing more jobs for less skilled workers. And the money will be spent gradually over an eight-year period, therefore not significantly boosting demand in any given year. Thus, the next big bill will not necessarily be inflationary.
Finally, what about the Federal Reserve? Supporters of the current administration argue that, even if the fiscal stimulus turns out to be inflationary, the Federal Reserve has sufficient tools to fight inflation. It could scale back asset purchases and it could raise interest rates. Some critics, however, argue that, once the inflation genie is out of the bottle, it is difficult to stuff it back in. Once investor expectations of inflation rise, it almost requires a recession to generate lower expectations of inflation. Consider what happened in the 1970s and early 1980s. The counterargument is that episodes of Fed tightening do not always lead to recession. Consider 1995 or 2016, for example. The argument is made that the Fed can stifle incipient inflation without necessarily causing another recession.
Meanwhile, inflation has already risen modestly, largely due to shortages and bottlenecks. It is likely to get higher before it gets lower. Still, there are lots of unemployed workers and, consequently, plenty of slack in the labor market. Although money supply has increased dramatically, the velocity of money has declined dramatically, meaning that much of the added money is not being spent. My own view is that we should be less worried about the inflation genie than about the virus genie, which is not yet in the bottle.
There is growing debate about the future of high-tech supply chains. The disruptions from the pandemic, and the fear of future disruption owing to political differences between the US and China, are driving a change in policy. The United States and Japan are moving toward action that could have the effect of causing a decoupling between the United States and China. The International Monetary Fund (IMF) has warned that such a redesign of supply chains, while perhaps boosting resilience, could reduce productivity growth and, therefore, economic growth. Meanwhile, China’s president has warned against such a decoupling. Here is what has happened.
Japanese Prime Minister Suga visited Washington recently, becoming the first foreign leader to meet with President Biden in person. The two leaders announced a Competitiveness and Resilience partnership. The goal is to use government incentives to shift supply chains away from China and reduce US and Japanese dependence on Chinese supply chains. The two leaders pledged to spend more money on research for the development of new generations of mobile telephony and to “cooperate on sensitive supply chains, including semiconductors.” While not a directly protectionist policy, this plan could cause a bifurcation and have a bigger impact on trade and growth than the tariffs imposed by former President Trump. In fact, a leading IMF official, Jonathan Osprey, said that, although the US-China tariff war likely cut global GDP by about 0.5 percentage points, the tariffs did not result in a bifurcation of the global economy.
Nonetheless, Osprey said that measures meant to change supply chains could be more impactful. Specifically, he said, “We don't see much evidence of this bifurcation, and we do take comfort in that. Because the risk of this—these trade tensions morphing into technology tensions and technological decoupling—would inflict a much larger cost on the global economy, maybe an order of magnitude larger in extreme situations, than the ones wrought by the tariff tensions.” In addition, Osprey said that effect of US restrictions on interaction with China “would be not only a chilling effect on trade in high-tech products. There would also be a move to much less efficient production across the world. These are our recipes for poor productivity and growth performance going forward and we very much hope they can be avoided.”
Still, the US government’s argument is that many US industries are heavily reliant on concentrated production of key products, such as semiconductors—and not just in China. For example, the automotive industry is highly dependent on semiconductors produced in Taiwan. The US is concerned that if China and Taiwan were to go to war, the indirect impact on US industry could be huge. The United States is also concerned that the US mobile network is too dependent on inputs from China. Hence, the desire to boost production of key technologies outside of China. Moreover, the United States has already imposed export restrictions meant to prevent Chinese companies from advancing in certain technologies. It is pressuring Japan to do likewise.
Meanwhile, in a speech at the Boao Forum in China, China’s president warned against a decoupling and offered a renewed endorsement of traditional globalization. Specifically, he said, “There is no fundamental change in the trend toward a multi-polar world; economic globalization is showing renewed resilience; and the call for upholding multilateralism and enhancing communication and coordination has grown stronger.” In addition, he proposed that the world’s leading nations work together to support a rules-based global system of trade and cross-border investment. He said countries should “uphold the multilateral trading system with the World Trade Organization at its core. World affairs should be handled through extensive consultation, and the future of the world should be decided by all countries working together. We must not let the rules set by one or a few countries be imposed on others, or allow unilateralism pursued by certain countries to set the pace for the whole world.” However, he did not address the specific concerns raised by the United States and Japan. In any event, global economic growth and growth in both China and the United States would likely be hurt by a decoupling. Consequently, there appears to be a basis for a negotiated settlement of grievances.
China’s economy grew at a record pace in the first quarter of 2021, but that masked a serious slowdown in China’s economy. Real GDP was up 18.3% in the first quarter of 2021 versus a year earlier. This was the fastest annual GDP growth on record. However, real GDP was up only 0.6% from the fourth quarter of 2020 after having grown 3.2% in the previous quarter. This was one of the slowest quarterly rates of growth on record. This slowdown is not entirely surprising given that China’s policymakers have shifted toward reducing debt, slowing credit growth, and averting a property price bubble. In addition, the government has begun to remove fiscal stimulus in order to stifle the growth of government debt, both at the central government level and at the provincial level. Finally, recent outbreaks of the virus have led to isolated instances of economic restrictions. In a statement, the government acknowledged that the economy continues to face headwinds, despite a robust recovery from the doldrums of early 2020. It noted that “the economic recovery in the first quarter of this year continued, and positive factors are accumulating. At the same time, we must also see that the Covid-19 epidemic is still spreading globally, the international landscape is complicated and severe, the foundation for domestic economic recovery is not yet solid, and some service industries and small and micro enterprises are still facing more difficulties in their production and operation.”
By sector, agricultural output was up 8.1% from a year earlier; industrial output was up 24.4% from a year earlier; and output in the service sector was up 15.6% from a year earlier. The strength of industry was driven, in part, by a very sharp 49% rise in exports. To the extent that there was a weakening, it appeared to take place in March. Specifically, the government reports that, after rising 35.1% in January and February, industrial production was up only 14.1% in March versus a year earlier. There was a sharp slowdown in the production of textiles, chemicals, metals, transport equipment, and communications equipment.
In contrast, consumer spending appears to have accelerated slightly in March, with retail sales up 34.2% compared to an increase of 33.8% in January and February. The retail sales increase was the biggest since 1995. Of course, these numbers are quite large owing to the near catastrophic decline in activity in the first quarter of 2020 when the economy largely shut down. Still, there were some interesting surges in consumer spending in March. For example, spending on clothing was up 69.1%, on jewelry was up 83.2%, and on cosmetics was up 42.5%. Evidently, many people are planning to be out and about and, consequently, are concerned with their appearance.
So, having erased the pandemic-related decline in economic activity, where does China go from here? It is clear that the country now faces headwinds from a shift in government policy aimed at reducing imbalances, continued weakness in some service sectors owing to fear of the virus, and relative slowness in rolling out a program of vaccination. Then again , China has begun to speed up vaccination with the goal of vaccinating about 40% of the population by June. As vaccination unfolds, it will likely have a positive impact on those service enterprises that have been disrupted by fear of the virus.
Michela Coppola, senior economist at Deloitte’s EMEA Research Center, discusses our latest survey of European CFOs.
With strict lockdown measures still in place across Europe, vaccines being distributed slowly in many countries, and still-high levels of new COVID-19 infections, it would be easy to be gloomy about European economic prospects. But financial executives across the continent take a quite different view.
The latest Deloitte European CFO survey, which garnered responses from over 1,550 CFOs across 19 countries, reveals great levels of optimism across the region.2 In all the countries surveyed, CFOs who feel more optimistic about their company’s financial prospects outnumber those who are less optimistic, so that the net balance of sentiment is positive everywhere. The overall share of respondents who feel optimistic is at its highest since the beginning of the series. The improvement in business confidence is evident too when looking at the results across different industries. Even in sectors hit hard by the pandemic, such as tourism and travel, and still much affected by the restrictions in place, a vast majority of CFOs feel more optimistic than three months ago and view the future confidently.
CFOs’ views on when their revenues will return to prepandemic levels also point to overall improvement. More than 40% of CFOs report that they are already at or above precrisis levels—almost twice as many as last autumn, when this figure was only 23%.
There are, however, large differences among countries, with a smaller share of CFOs reporting that they are already at or above their prepandemic level in economies that took a harder hit. For example, while almost two-thirds of CFOs in Denmark and Russia say that their revenues are already at precrisis levels, less than 30% do in Spain, Greece and the United Kingdom.
Despite the general rise in optimism, some CFOs see a long road to recovery. While, on average, about a quarter of respondents expect to return to the precrisis activity level by the end of 2021, another quarter expect full recovery will have to wait until 2022, and about 10% of respondents expect a full recovery even later than that.
Although two in three CFOs consider the current level of economic uncertainty as high and the overall state of the economy remains one of the top concerns, investment intentions have surged. This seems more than a rebound from last year’s depressed levels, when many cut their spending plans. COVID-19 brought with it new demands related to workers’ and customers’ safety as well as a need to increase digital interaction. All of this requires investment in new equipment, automation, and digital technologies. At the same time, the pandemic has also increased the attention paid to environmental issues. The increasing pressure on companies to achieve sustainability goals means, in turn, more investment in analytics, efficient equipment, or environmentally friendly buildings. The combination of the two trends, digital and environmental, means future investment levels are likely to be higher than in the recent past.
You can visit our website to download the full report and explore the data by country on our interactive dashboard.
The world is full of surprises. The frequency of low-probability/high-impact events seems to be greater than one might expect. Consider the last 40 years. About every 10 years, a big event has significantly changed the landscape in which businesses must operate. In the late 1970s, the Iranian Revolution caused a doubling of oil prices. Plus, the rise of Deng Xiaoping in China led to the biggest decline in poverty in human history and the emergence of China as a global power. In 1989, the Cold War ended. Central Europe ultimately became part of the European Union and NATO. The Soviet Union ceased to exist. US military spending fell sharply. In 2001, the 9/11 terrorist attack against the United States led to US wars in Afghanistan and Iraq. In 2008-09, the global financial crisis changed the financial services environment and led to slow economic growth, thereby undermining popular support for market-oriented economic policies. This contributed to a populist backlash which was manifested by Brexit and the election of populist governments in various countries. Then in 2020, there was the global pandemic, the long-term effects of which we are still debating. The point is that big things can happen by surprise. Thus, it is worth asking: What low-probability/high-impact risks do we face today? Here are a few that come to mind:
When Brexit happened, some analysts wondered which other EU country would be next. Instead, the European Union held together, largely on the basis of popular support. However, there is now a significant possibility that France will elect populist Marine Le Pen as president in the 2022 election. She previously supported “Frexit,” in which France would exit the European Union. However, she has lately downplayed that view. Still, if she is elected and her party takes control of the Parliament, France could choose to exit the European Union. This would be a far greater existential threat to the European Union than the British exit. It could embolden populists in other countries such as Italy, Hungary, and Poland. A more likely scenario is that France remains in the European Union but acts to weaken it from within. Further efforts at integration would likely stall, thereby hurting the European Union’s ability to respond to the next economic crisis.
There has been growing discussion among analysts about whether China will take military action to implement unification with Taiwan. It is clear that unification is a high priority in Beijing. Yet it never happened in the last 70 years because China lacked the military power to challenge the US defense of Taiwan. That has changed. With a now massive economy, China has been able to invest in expanding the size and improving the quality of its military. It has repeatedly been flying military aircraft close to Taiwan. Leading US military figures have lately suggested that the United States would not be able to prevent a takeover of Taiwan absent the use of nuclear weapons—and that won’t happen. After all, Lyndon Johnson once said that “the only power I’ve got is nuclear and I can’t use that.” Thus, if China acts, the United States must decide whether to go to war (and possibly lose) or accept the takeover as a fait accompli. Until now, the US policy on Taiwan has been one of “strategic ambiguity.” Some analysts are suggesting a transition to “strategic clarity” so that China knows the risk it faces. If China took control of Taiwan, absent a US military response, it would surely pay a price in terms of economic sanctions from the United States and its allies. However, it might be willing to accept this given its likely ability to maintain economic strength through domestic demand and trade with other nations. Other Asian countries, especially Japan, might be compelled to boost military spending and possibly go nuclear. At the least, this scenario could accelerate the decoupling of China and the United States, boost China’s geopolitical footprint in the Asia-Pacific region, force other countries in the region to take sides, and likely result in slower global economic growth as businesses are forced to invest in shifting their supply chains. Given the potential economic cost to China, this scenario remains low probability for now.
Another trigger point in the global landscape is the border between Russia and Ukraine. Lately, there has been concern that, having supported rebels in Ukraine, Russia might choose to invade Ukraine. There are reports of a surge of Russian military personnel and equipment near the Ukraine border. The United States and European Union have already implemented significant economic sanctions due to Russia’s previous takeover of Crimea, and more sanctions would likely follow an invasion. Given Russia’s nuclear status, it is highly unlikely that the United States or NATO would take military action to stop Russia. In the aftermath of an invasion, new Western sanctions could be substantial and would not easily be offset by more Russian engagement with China. Thus, Russia would pay an economic price, but such action might be politically popular, thereby boosting the regime’s legitimacy. Moreover, a successful invasion might affect the calculus for other countries in the region, including those in Central Asia and Central Europe.
Having exited the European Union, the United Kingdom now faces internal stress. There could be a scenario in which, due to issues related to the border, Northern Ireland leaves the United Kingdom and joins the Irish Republic. Or a scenario in which Scotland attempts to exit the United Kingdom and, then, join the European Union. There will soon be local elections in Scotland which could boost the power of secessionists. There could be new demands for a second referendum on independence. At the least, this could create significant political and social tensions within the United Kingdom.
Now that the pandemic has been with us for more than nine months (which is the gestation period for humans), we can see what it has meant for live births. It is now clear that the pandemic led to a sharp decline in births. What is not clear is whether this is a sustained acceleration of an existing trend or a one-off change in behavior that will soon be reversed once the pandemic ends. If sustained over a long period, this decline in the birth rate could have dire consequences for how economies function. Within a generation, it would mean a sharp decline in the size of the working age population, thereby leading to slower economic growth absent immigration or an acceleration in productivity growth. It could mean greater difficulty in servicing the needs of an aging population as it would lead to a lower ratio of workers to retirees.
Meanwhile, not only have births declined, but deaths have gone up due to the virus and migration has declined. The result is that, in major economies, it is likely that the population in 2021 will have grown very slowly versus 2020. One respected analyst says that, in 2021, US population growth will be at the slowest rate since 1918, the year that the last pandemic began.
Here are some examples of what has happened. In January, births were down 56% versus a year earlier in Hong Kong, down 23% in Taiwan, down 14% in Japan, and down 6% in South Korea. In Europe, births were down 22% in Italy (in December), down 20% in Spain (January), and down 13% in France (January). We don’t yet have national data for the United States, but some US states are reporting sharp declines. For example, Connecticut reported a decline of 14% in January versus a year earlier.
The decision to avoid having children was likely affected by economic circumstances. A large number of young people lost jobs or income during the pandemic. Many remain either unemployed or are facing uncertainty given that the pandemic remains a reality.
The People’s Bank of China (PBOC), China’s central bank, has released a study warning that China’s low birth rate could be an impediment to achieving the country’s economic goals. Consequently, it recommends ending all restrictions on births. Recall that, until 2016, China had a one-child policy in urban areas. It changed the policy in 2016 to a limit of two children per household, although there has not yet been a commensurate increase in births. The study says that, unless China ends restrictions on births, the population will decline by 32 million by 2050 while the US population will increase by 50 million. In addition, the study says that the country will have a lower ratio of workers to retirees than the United States by 2050. Currently, China’s ratio is significantly higher. Such a change will make it more difficult to finance the needs of an aging population. In addition, fewer births will lead to a smaller working age population and, consequently, slower economic growth. Until about a decade ago, the working age population was rising, contributing to very strong economic growth. The very frank study said that “the birth liberalization should happen now when there are some residents who still want to have children but can’t. It’s useless to liberalize it when no one wants to have children. On the other hand, we need to create a birth friendly environment and solve the problems that women encounter during pregnancy, childbirth, nursery and school enrolment.”
There was a spate of positive news about the US economy last week. Retail sales soared in March to a degree far beyond what analysts had expected; initial claims for unemployment insurance fell sharply to the lowest level since the pandemic began; and industrial production grew strongly in March. The rise in retail spending likely reflected not only the large government stimulus payments but also the impact of increased vaccinations, reduced economic restrictions, and much better weather than in February. Investors reacted, not surprisingly, by boosting equity prices.
What was a bit surprising, however, was a sharp decline in bond yields. After all, strong retail sales and a much better job market suggest the possibility of more inflationary pressures which, normally, would result in higher bond yields. Moreover, the government’s inflation report released earlier this week signaled a big increase in inflation. On the other hand, core inflation remained tame. Plus, Fed Chair Powell said last week that the Fed will reduce asset purchases long before it raises interest rates. Just the fact that he was even discussing the means by which the Fed will eventually begin to reduce monetary stimulus was probably music to the ears of investors. It means that, despite dismissing inflation worries, the Fed is actually focused on what it will have to do to stifle inflation. That evidently pleased investors, contributing to lower bond yields. In any event, here are the details of last week’s economic data:
In March, retail sales in the United States were up 9.8% from February, the biggest increase since May 2020 when the economy began to reopen after collapsing in April. The increase in March was the second biggest on record. In addition, sales were up 27.7% from a year earlier, bringing sales well above the prepandemic level. Among the retail categories that experienced big monthly increases in spending were automotive (up 15.1%), electronics stores (up 10.5%), home improvement products (up 12.1%), department stores (up 13.0%), restaurants (up 13.4%), and clothing stores (up 18.3%). The latter was also up 101.1% from a year earlier. Evidently, people are leaving their homes again and care about how they look. The boost in restaurant sales was notable as it meant that people were eating out again in significant numbers. Indeed, sales at grocery stores increased a very modest 0.5%. Also notable was that sales by online retailers were up a more modest 6.0%. This means that a disproportionate share of the increase in retail sales was due to people actually going to stores rather than shopping online.
There are two important questions. First, what share of the increase was due to the stimulus money and what share was due to a reduction in consumers’ fear of the virus? The answer is that we don’t know. However, the fact that spending at stores increased faster than spending online suggests that the former played a significant role in the increase, thereby indicating a decline in consumer fear. The second question is this: Will this be a one-off surge due to stimulus, or will spending continue to rise in the months to follow? Again, we do not know. It would not be surprising if spending falls in April. However, it would not be surprising if it grows strongly thereafter as increased vaccinations make people feel more comfortable about the virus, leading them to dip into their massive savings. Recall that, based on Federal Reserve survey data, it is believed that consumers initially saved about three quarters of their stimulus money. Thus, once they are more comfortable, they will have the means to spend with abandon. It is also likely that, when this happens, they will spend on categories they have largely avoided over the past year such as restaurants, entertainment venues, airlines, and hotels. The major risk now is that, with an increase in the rate of infection in 25 of 50 US states in the past week, a continued surge could stymie the economic recovery. Thus, there is effectively a race between vaccinations and infections.
Last week, there were 576,000 initial claims for unemployment insurance in the United States. In the previous week, there had been 769,000 initial claims. Thus, the number fell quite dramatically, signaling a marked improvement in the job market. Today’s figure was the lowest in 13 months. Still, this was a very high number historically and the number of people that continue to receive unemployment benefits remains very high. The job market still has a long way to go.
Industrial production in the United States was up 1.4% in March versus February and up 1.0% versus a year earlier. The manufacturing component of industrial production was up 2.7% from February to March and was up 3.1% from a year earlier. The automotive component of manufacturing increased 2.8% from February to March and was up 29.7% from a year earlier. The utility component of industrial production fell 11.4% from February to March, mainly due to much improved weather following terrible storms in February. Notably, output of business equipment was up 2.7% from February to March and up 5.7% from a year earlier. This bodes well for increased business investment in the months ahead.
As noted above, Fed Chair Powell discussed how the Fed will eventually approach a reduction in monetary stimulus. He is evidently intent on avoiding a so-called “taper tantrum” similar to what happened about a decade ago when the Fed began to taper asset purchases. That surprised investors and led to a dramatic, if temporary, surge in bond yields and a sharp decline in equity prices. Last week, Powell said: “We will taper asset purchases when we’ve made substantial further progress toward our goals, from last December when we announced that guidance. That would in all likelihood be before—well before—the time we consider raising interest rates.” Although he said that it is unlikely the Fed will raise interest rates before 2023, he did acknowledge that the zeitgeist of the market had shifted. Specifically, he said: “For quite some time, many people were saying, ‘Well, you’ll never get above 2%,’ because it [has] been very hard to get back to 2%. Now more of the discussion is on the other side.” He acknowledged that inflation is likely to rise temporarily for transitory reasons such as supply chain disruption, but he continues to expect inflation to revert to a level consistent with the Fed’s target.
There is lots of activity among major economies concerning the taxation of corporations. First, US President Biden proposed to increase the US corporate tax rate from 21% to 28%, and then he and some key Senate Democrats have also proposed significantly increasing what is essentially a US minimum tax on income earned by US-owned foreign corporations. Then US Treasury Secretary Yellen said the United States would support the adoption of a global minimum corporate tax in order to reduce tax arbitrage and create a more level playing field—a position being negotiated with 139 countries through an OECD/G20 process. A global minimum tax would also reduce the competitive disadvantage the United States could face by raising its corporate tax rate. Now it is reported that the United States has offered a new plan meant to unblock a separate part of those multilateral negotiations, proposing that the world’s 100 largest multinationals pay taxes to each country based on the market for their goods or services in that country.
This latter proposal may be seen by other leading nations to both give and take. It would likely create a less complicated and less subjective system than has been discussed within the OECD talks to date, targeting a smaller number of companies but expanding the scope beyond what had previously been contemplated—from consumer-facing and digital only to all sectors—and likely capturing more companies headquartered outside of the United States. To many other countries, the goal of this global agreement (also called Pillar 1 of the talks) is to collect taxes from some of the high-tech giants—which are largely US-based—that are able to make money in jurisdictions without necessarily having any physical nexus. To address this and ease political pressure from their constituents while these global negotiations occur, a number of countries, especially in Europe, have imposed digital services taxes (DSTs). The United States has been staunchly opposed to these DSTs, and a condition of any agreement through the OECD is expected to be the repeal of such unilateral measures.
France’s Finance Minister said he is “delighted” about the proposal. The Dutch government also expressed support for the proposal as did the British government. The US proposal sets the stage for a renewed set of negotiations.
The related talks around a global minimum tax (the so-called Pillar 2) likely also will get a second wind, both because of Yellen’s explicit support and because some countries don’t want to talk about Pillar 2 without also dealing with Pillar 1. Ireland, for example, has benefited from a low corporate tax rate and is far from enthusiastic about a global minimum that could be set higher than its own 12.5% rate and make it less attractive to investors. However, its government this week expressed willingness to engage in discussions. Notably, Italian Prime Minister Draghi has endorsed the new US proposal support for a minimum tax. Given that Italy has a DST, Draghi’s support could be important in driving European amenability to the proposal.
The US proposal mentions “We wish to end the race to the bottom over multinational corporate taxation and establish a tax architecture in which countries work together towards more equitable growth, innovation, and prosperity.” The United States hopes that the proposal would severely undermine so-called tax havens.
Meanwhile, it seems unlikely that the Biden administration will get the 28% corporate rate that it has sought because there is resistance within his own Democratic Party. Moderate Democrats have expressed willingness to consider a 25% rate. Yet that means that, if the administration wants to generate sufficient revenue to pay for a large share of its infrastructure investment plan, it will have to look elsewhere. This might entail higher tax rates on upper-income households (which is already likely to be used for funding Biden’s next spending plan), or perhaps some kind of taxation of energy. Biden said that he was willing to negotiate on the details.
The worst damage to the global economy in the past year was due to the closure of and aversion to consumer-facing industries. The necessity of social distancing led governments to halt or restrict the operation of such industries. In addition, the fear of social interaction led many consumers to avoid such industries. The result was mass unemployment, declining revenue, and the need for government support. Even as such support led to economic recovery and a substantial increase in consumer and business spending, periodic outbreaks of the virus and periodic implementations of economic restrictions kept activity of consumer-facing services below the prepandemic level. This included such sectors as restaurants, pubs, movie theaters, shopping centers, entertainment venues, cultural institutions, airlines, hotels, and personal services.
Now, the hope is that, with mass vaccination under way, we will ultimately get to the point where most consumers are no longer fearful of the virus and where most governments can feel comfortable in relaxing most restrictions. When that happens, there could be a surge in expenditure on consumer-facing services. This will be helped by the fact that consumers in rich countries saved an enormous share of their incomes during the pandemic, thereby setting the stage for them to easily fund a substantial increase in spending. The extra money provided by government stimulus, especially in the United States, will play a significant role in fueling this incremental expenditure.
Last week, IHS Markit released its purchasing managers’ indices (PMIs) for services in multiple countries in March. Based on these numbers, the evidence suggests that the rebound in services is already under way in some locations. PMIs are forward-looking indicators meant to signal the direction of activity in the broad services industry. Services includes such sectors as retailing, wholesaling, transportation, warehousing, telecoms, finance, professional services, hospitality, tourism, utilities, education, and health care. PMIs are based on sub-indices such as output, new orders, export orders, employment, pricing, pipelines, and sentiment. A reading above 50 indicates growing activity; the higher the number, the faster the growth—and vice versa. The latest PMIs mostly improved from February to March. The global PMI increased from 52.8 in February to 54.7 in March, a 79-month high and a level suggesting strong growth of global services activity. Moreover, the data shows that consumer services and business services surged in March, while financial services were stable after having surged several months earlier.
Markit found that there was exceptionally strong growth of activity in the United States, moderately strong growth in China, and a continued decline in the Eurozone. However, the rate of decline in Europe eased from February to March. Here are the details.
In the United States, the services PMI increased from 59.8 in February to 60.4 in March, a seven-year high. This was largely driven by a surge in new orders as well as an increase in export orders. That being said, a sharp rise in input costs was passed onto consumers in the form of higher output prices. Markit commented that “while consumer demand is rising especially strongly for goods, the surveys are now also showing rising activity in the consumer services sector, linked to the vaccine roll-out, looser virus containment measures and the fresh injection of stimulus in March.” Markit also noted that strong growth of financial services was largely due to the strength of the US housing market. The strong numbers in February and March, combined with strong numbers for manufacturing, bode well for rapid economic growth in the first quarter. Nonetheless, bad weather in February had a negative impact on some industries, thereby temporarily slowing the US economy.
In the Eurozone, however, the services PMI increased from 45.7 in February to 49.6 in March. Thus, having contracted sharply in February, service activity was almost stable in March. The continued weakness reflects economic restrictions related to recent surges in infections. However, the improvement since February reflects new optimism. As Markit noted, “the hard-hit service sector has come close to stabilizing as optimism about the outlook improved further during the month. Firms’ expectations of growth are running at the highest for just over three years amid growing hopes that the vaccine roll-out will boost sales in the coming months.” In addition, Markit said that the survey indicates that lockdowns have not been as onerous as previously believed because companies and consumers have “increasingly adapted to life with the virus.” Still, as lockdowns are lifted in the coming months, it is likely to have a positive impact on growth. Of the four major Eurozone economies, only Germany showed growth in services (the PMI was 51.5 in March). France and Spain also saw improvement in the PMI but continued decline in service activity. Italy showed no improvement due to continued economic restrictions.
Markit reports that the services PMI for China improved from 51.5 in February to 54.3 in March, a level indicating strong growth. Markit noted that both domestic supply and demand were strong, although export orders remained weak. The easing of new outbreaks of the virus helped to improve consumer interaction. Inflationary pressures were up due to increased prices of raw materials, labor, and energy.
In the United States, there have been three instances in the past year in which households received relatively large stimulus payments from the Federal government. First, a large share of Americans received payments of US$1,200 starting in April of 2020. Then in December, about 85% of Americans received US$600. Finally, last month payments of US$1,400 started to be sent to 85% of Americans. The immediate economic impact depends, in part, on what share of these payments are spent versus saved or used to pay down debts. Any incremental saving, of course, sets the stage for increased spending once the pandemic subsides, possibly in the second half of 2021. In addition, the degree to which the stimulus payments are inflationary also depend on the timing of spending versus saving. Consequently, it is helpful to know more about the behavior of households. The Federal Reserve Bank of New York has been studying this based on survey data and has some interesting findings.
The New York Fed found that households spent 29.2% of their stimulus payments early last year and 25.5% of their December payments, and they intend to spend 24.7% of the most recent payments. Thus, behavior has been relatively steady. The part not spent was roughly evenly divided between direct saving and paying off debts (which itself is a form of saving). In addition, the Fed found that lower-income households were far more likely to use the money to pay off debts and were slightly less likely to directly spend the money. Likewise, less-educated households were slightly less likely to directly spend the money. However, when it comes to spending on essential goods, lower-income households were far less likely to spend than upper-income households. Overall, the survey found remarkable stability in household behavior. In addition, it suggests that the pool of household savings is increasing rapidly in response to stimulus money. This means that, once a large share of the population is vaccinated and people are feeling safer, this money could play a major role in funding a revival of spending on consumer-facing services, such as restaurants, theatres, airlines, and hotels. If businesses are not prepared to a wave of increased demand, the result could be a temporary surge in inflation.
Around the world, there are an increasing number of stories about shortages and supply chain disruptions leading to a surge in prices of goods. In China, this is clearly the case. The government reported that, in March, factory gate prices (producer prices) were up 4.4% from a year earlier, the fastest in two years. In addition, factory gate prices were up 1.7% from the previous month. This surge in wholesale prices has not yet translated into a surge in consumer prices. The government also reports that consumer prices were up a modest 0.4% in March versus a year earlier. This was the biggest increase since October. Prices were down 0.5% from the previous month. Core consumer prices (which exclude the effect of volatile food and energy prices) were up 0.3% in March versus a year earlier. The difference was due to a big increase in energy prices. Food prices, however, fell.
Although consumer price inflation in China remains tame, the surge in producer prices has evidently alarmed officials. In fact, the Financial Stability and Development Commission, which is headed by Vice Premier Liu He, issued a statement saying that “We must keep the basic stability of prices and pay particular attention to the trend of commodities prices.” This seemingly innocuous statement was widely viewed by analysts as a warning about an impending acceleration in inflation and the disruptive impact it could entail. In addition, the Commission stated that “the primary target of macroeconomic policies is to protect jobs and market entities. We must pay attention to ‘adding water to farm fish’, providing relief for corporations and better invigorating market entities.” In other words, the role of policymakers is not only to quell inflation but to ensure that the economy remains on a stable path, led by the private sector. For the central bank, it means finding the right balance between averting a significant acceleration in inflation and maintaining steady employment growth. This is a balancing act that many central banks will likely attempt in the coming year, especially given the rise in inflation related to supply chain disruption.
As previously discussed in these pages, the massive US fiscal stimulus is having a disruptive impact on many emerging markets. Specifically, anticipation of higher inflation generated by the boost to US demand has fueled a rise in US bond yields. This, in turn, has generated capital outflows from emerging nations, putting downward pressure on their currencies. In order to avoid depreciation and/or depletion of foreign currency reserves, many emerging country central banks have boosted interest rates. This has the potential to cause a slowdown in growth.
One major emerging nation, however, has so far avoided disruption. That is India. The reason is that India has accumulated a massive pile of foreign currency reserves in the last few years. Reserves have doubled since 2014 and have increased by roughly 50% since 2018. This means that, unlike many of its peers, India can afford to allow a decline in reserves in order to stabilize its currency without resort to raising interest rates. In fact, India probably has room to cut rates. In the past, Indian business investment has been stymied, in part, due to high costs of capital. India is now in a good position to change this and allow for an acceleration in investment.
Still, this does not mean that India’s outlook is entirely rosy. After a period in which many observers were confident that India was on the verge of herd immunity, the country faces yet another serious outbreak of the virus which is likely to hurt economic growth. Although vaccinations are under way, the speed of distribution has not been sufficient to offset the transmission of new variants. In a country where urban areas are densely populated and where a large share of the urban population works in service enterprises, it is difficult to contain the spread. In addition, new restrictions have been implemented this month which are likely to temporarily stifle growth.
Then again, not only does India benefit from a high level of reserves, it also is lucky to have relatively low inflation and, as a result, low bond yields. India is in the midst of a strong economic recovery, with growth this year widely expected to be in double digits. The latest PMI for services in March was 54.6, a level indicating strong growth in activity. Output and new orders were up strongly. Business optimism was evident in the survey.
As an economist, I often find working in a business environment to be exhilarating. One frequently hears exciting predictions about the revolutionary impact of new technologies, lifestyles, demographics, or geopolitical trends and how they will create new business opportunities and improve how we live and work. Sometimes these predictions turn out to be true. Still, as an economist, my job involves throwing cold water on optimistic predictions and providing a viewpoint about downside risks. This is one such time. With light at the end of the pandemic tunnel, one could be forgiven for thinking that all will be well within a year. And it might be. Yet even after the pandemic ends in major economies, there will likely remain significant problems that could postpone a full return to normalcy around the world. Here are three that come to mind:
The COVID-19 situation on the European continent is worsening despite a significant increase in the number of people being vaccinated. French President Macron announced a new nationwide 30-day lockdown meant to quell the outbreak at a time when hospitals are being inundated with new patients. The lockdown, which polls indicate is popular, will involve an evening curfew, the shutting down of nonessential retail venues, closure of schools, and restrictions on travel. Among major Eurozone economies, France now has the highest number of daily infections—the highest rate seen since November. France is not alone. Lately there have also been sizable increases in the number of daily infections in Italy, Belgium, and the Netherlands. There have lately been more modest increases in the infection rate in Germany and Spain. It is worth noting, however, that the death rate in all these countries has remained muted. Moreover, the number of people being vaccinated each day has risen sharply in each of these countries, with an especially high number in Spain. However, all these countries currently have a daily vaccination rate that is less than half that of the United Kingdom. The European Union (EU) has been slow to ramp up its vaccination program and, as a result, is far behind the United Kingdom and the United States in immunizing its population. Thus, it is a race against time as new variants of the virus propagate. Meanwhile, aside from France, economic restrictions of varying degrees continue in some other European countries. Thus, the rebound in the large service sector of the economy is likely to be postponed, thereby suppressing economic growth in both the first and second quarters of this year.
Despite the bad news regarding the virus, Europe’s manufacturing sector continues to perform exceptionally well. This is according to the final purchasing managers’ indices (PMIs) for March released last week by IHS Markit. PMIs are forward-looking indicators meant to signal the direction of activity in the manufacturing sector. They are based on sub-indices, such as output, new orders, export orders, input and output pricing, inventories, pipelines, employment, and sentiment. A reading above 50 indicates growing activity; the higher the number, the faster the growth. The latest PMIs suggest that manufacturing activity in the Eurozone is growing at a record pace. The Eurozone manufacturing PMI increased from 57.9 in February to 62.5 in March, a record. Moreover, although Germany was the star performer, the strong growth was consistent across the region. The PMIs were 66.6 in Germany (a record high), 64.7 in the Netherlands (also a record), 59.3 in France (a 20-year high), 59.8 in Italy (a 21-year high), and 56.9 in Spain (a 14-year high).
The performance was especially strong for producers of investment goods and intermediate goods. The high PMIs were driven by record increases in output, new orders, and export orders. This reflected strong domestic and external demand. In fact, demand was so strong that supply chains were stretched, thereby leading to long lead times and shortages of inputs and components. This, in turn, led to the biggest increase in input prices in 10 years. Still, Markit expects the inflationary impulse to ultimately ease. Current levels of demand reflect the rebound from lockdowns. Strong demand also led to a surge in hiring by manufacturers.
Meanwhile, a similarly large increase in manufacturing activity took place in the United Kingdom where the PMI hit 58.9 in March, a 10-year high. Britain’s strong performance reflected growth of output, new orders, and employment. Stress in the supply chain led to increased lead times. The improvement in performance was attributed to the easing of economic restrictions and the successful distribution of the vaccine. As in the Eurozone, supply chain issues were a problem. Markit noted that, in the case of the United Kingdom, post-Brexit issues continued to disrupt supply chains. Meanwhile, although export orders “bounced back,” Markit expects that weak exports and supply chain issues will constrain growth of manufacturing in the months to come.
Bond yields in the United States have risen significantly since the start of the year. Because they have started from a very low base, even small basis point increases in bond yields lead to big declines in bond prices. That reflects the fact that there is an inverse relationship between bond prices and yields. Hence, if the yield rises from 1.5% to 1.7%, there is a much bigger decline in bond prices than if the yield increases from 5.5% to 5.7%. In the first quarter of 2021, the price of the US 10-year bond fell by the largest amount since 1980.
What accounts for this? Essentially, investors now expect faster growth and higher inflation than they previously expected, owing to massive government stimulus and rapid rollout of the vaccine. The 10-year breakeven rate,4 which is a good proxy for inflation expectations for the next 10 years, has risen from roughly 1.8% at the start of this year to almost 2.4% now. Meanwhile the yield on the 10-year bond increased from roughly 1.0% to 1.7% in the same period. Thus, most of the increase in the bond yield can be attributed to an increase in expectations of inflation.
Why such a big increase in a short period of time? The principal reason is likely the passage of an unexpectedly large fiscal stimulus bill. At the start of the year, then President-elect Biden was talking about a large bill, but many observers expected his plan to be whittled down in negotiations. That didn’t happen. To the surprise of many, Biden got the bill he wanted. Moreover, since the start of the year, the rate of vaccination has been much higher than many observers had even hoped. That, in turn, has stimulated economic activity. Depending on how quickly the stimulus money is spent (and there is considerable debate about this), it is possible that it will cause the economy to overheat, thereby creating inflationary bottlenecks. The Federal Reserve even acknowledges that inflation will rise temporarily. Yet it also says that higher inflation will be due to temporary factors and will not be sustained. The central bank does not expect the kind of wage-price spiral that ordinarily creates longer-term inflation.
The big debate now concerns whether the Fed is right. Plus, Fed Chair Powell has said that, if needed, the Fed will reverse its easy monetary policy in order to contain inflation. Yet some critics wonder if Powell is being realistic. Once the inflation genie is out of the bottle, it is not necessarily so easy to contain it. Thus, investors expect that, over a 10-year period, inflation will be above the Fed’s 2.0% target. Interestingly, the 10-year bond yield has been relatively steady in the last two weeks. Perhaps investors have incorporated their new inflation expectations and no longer expect any further surprises. The market did not react much to the recent proposal by President Biden for a large infrastructure program, perhaps because that money is meant to be spent over a much longer period and because it is meant to be funded by a tax increase. So, is the bond market correction over? Or is this the start of the much-heralded end of the three-decade bull market in bonds? If I knew the answer, I’d probably own a private island in the Bahamas.
In March 2021, employment in the United States grew at the fastest pace since August 2020. How can we account for this surge in employment? Certainly, the further easing of economic restrictions contributed to a burst of job growth in the hospitality sector. In addition, there is the question of the government stimulus. In December, a relatively modest US$900 billion stimulus (compared to the US$1.9 trillion stimulus that came later) led to a surge in retail spending in January. Observing this and being aware that a much-bigger stimulus was coming in March, businesses likely accelerated hiring in order to take advantage of the expected increase in demand. The US$1.9 trillion stimulus was signed into law on March 11 and the data from the latest employment report was accumulated during the week of March 15. Thus, there was little time for the stimulus to have a direct impact on job growth. Rather, it was the anticipation of the burst of demand that had an impact. Moreover, it is likely that businesses anticipated positive effects from mass vaccination. In the April jobs report (to be released a month from now), we will likely see the impact as businesses digest a change in aggregate demand for the economy.
So, what exactly happened in March? There are two employment reports released by the US government—one based on a survey of establishments, the other based on a survey of households. Before looking at the March establishment report, it is useful to look back at the past year in order to put things in context. In March and April of last year, there was a catastrophic drop in employment as the virus surged and state governments shut down. Then, as governments reopened, job growth was exceptionally rapid in May through August with payroll rising an average of 2.7 million in each of those four months. However, another surge in the virus began in the early Autumn, leading to a change in consumer behavior. The result was much slower job growth in September through November with payroll rising an average of 553,000 in those three months and an actual decline in payroll employment in December of 306,000. Then, job growth recovered modestly, with payroll up 233,000 in January and 468,000 in February.
Last week, we learned that payroll was up 916,000 in March, the strongest growth since August and a considerable acceleration since February. There was strong growth in such industries as construction, manufacturing, and especially leisure and hospitality. The establishment report is very positive. Still, employment remains 8.5 million below the level from a year ago and even farther below the level that would have occurred had the pandemic not happened. There remains a long way to go, which suggests that we are not yet at the point where wage pressures will create serious inflation. However, the Biden administration is hoping that the stimulus will cause a further acceleration in job growth, pushing the economy toward full employment sometime in 2022. Moreover, rapid vaccination of the population sets the stage for a resumption of normal social interaction and economic activity, thereby creating further opportunities for rehiring.
The separate household survey revealed that participation in the job market increased faster than the growth of the working-age population. As such, the participation rate increased slightly. Employment grew even more rapidly, leading to a decline in the unemployment rate from 6.2% in February to 6.0% in March. There was an especially large decline in teenage unemployment. By education level, there was a massive decline in unemployment for the least educated and almost no change for the very educated.
The United States and Japan are concerned about the current global shortage of semiconductors and its impact on economic recovery. From a longer-term perspective, they are also concerned about geopolitical risk to semiconductor availability. For example, tensions between the United States and China create a risk regarding US access to semiconductors made in China. The increasing view that China might invade Taiwan puts access to Taiwanese semiconductors at risk. Thus, Japan and the United States are creating a joint task force to design alternative supply chains and reduce dependence on China and Taiwan. The two sides will consider the division of labor regarding research and development, production, and distribution. Moreover, they intend to create a less concentrated supply chain, one that is less reliant on one or two locations and, therefore, less vulnerable to disruption. The task force will be comprised of national security and economic planning personnel from both governments. This will include people from Japan’s Ministry of Economy, Trade, and Industry and the US Department of Commerce. There does not appear to be discussion about imposing trade restrictions. Rather, both sides evidently want to provide government subsidies for making changes. For example, the Biden administration will ask Congress for US$50 billion to subsidize growth of semiconductor production in the United States.
It is reasonable to wonder whether government planning of supply chains will lead to the most efficient outcome. Governments have a history of supporting inefficient businesses and providing subsidies to the politically best connected. The joint plan sounds uncomfortably like the kind of planned trade that was characteristic of centrally planned economies in the past. However, there is a storied history of US government incentives (mainly military) leading to the development and proliferation of new technologies. This included the worldwide web, global positioning satellites, facial recognition, and virtual reality, to name a few.