01 March 2023

Weekly global economic update

What’s happening this week in economics? Deloitte’s team of economists examines news and trends from around the world.

Ira Kalish

Ira Kalish

United States

Week of February 27, 2023

Many investors concerned by strong January consumer spending and high monthly inflation

  • Something interesting happened in January in the United States. We already learned that retail sales increased sharply while consumer prices rose far more than expected. The two were possibly related. Then recently we received more data that confirms what we already knew. The US government released its January data on disposable income, personal consumption expenditures, and a measure of inflation that is the one favored by the Federal Reserve. The data indicates that personal income grew rapidly, that consumers spent most of the increase, and that the previous deceleration in inflation slowed. The rise in income was likely related to the sharp increase in employment and the huge cost of living adjustment for recipients of Social Security. The slowdown in disinflation was likely related to strong consumer demand as well as a rebound in energy prices. Let’s look at the details.

The government reported that real (inflation-adjusted) disposable personal income (which is income after taxes) was up 1.4% from December to January, the biggest increase since March 2020 (when the first pandemic-related stimulus money was distributed). In nominal terms (not adjusted for inflation), wages were up an annual rate of US$107.4 billion after having risen US$43 billion in the previous month. This likely reflected the surge in job creation. In addition, Social Security payment were up at an annual rate of US$109.7 billion, up from a decrease of US$0.7 billion in the previous month. This surge was due to the one-time 8.7% cost-of-living adjustment. I know this was a big deal because my mother-in-law keeps talking about it.

Meanwhile, real consumer spending was up 1.1% from December to January. It increased less than real income because consumers chose to save more. Specifically, the personal savings rate increased from 4.5% in December to 4.7% in January. Moreover, the savings rate has steadily risen from a low of 2.7% in June.

As for types of spending, real spending on durable goods was up 5.2% from December to January. Real spending on nondurables was up 0.5% while real spending on services was up 0.6%. Real spending on durable goods is now 27% higher than three years ago, just prior to the pandemic. Real spending on services, on the other hand, is just 4% above the prepandemic level. In other words, the pandemic-related shift away from services and toward goods is not over. The surge in demand for durable goods had disrupted supply chains and contributed substantially to the early acceleration of inflation.

As for inflation, the report on income and expenditures includes data on the Federal Reserve’s favorite measure of inflation— that is, the personal consumption expenditure deflator, or PCE-deflator. It was up 5.4% in January versus a year earlier. That is down from a peak of 7% in June. It is the lowest annual rate since October 2021. Prices were up 0.6% from the previous month, an unexpectedly big increase. It was the biggest increase since June. Meanwhile, when volatile food and energy prices are excluded, core prices were up 4.7% from a year earlier, up from the 4.6% rate in December and down from the peak increase of 5.2% in September. Core prices were up 0.6% from the previous month.

It is that last number that shook markets recently. It suggests persistent underlying inflation and augurs further tightening by the Federal Reserve. Indeed, the president of the Cleveland Federal Reserve, Loretta Mester, said, “In my view, at this point with the labor market still strong, the costs of undershooting on policy or prematurely loosening policy still outweigh the costs of overshooting.” Recall that Fed Chair Powell recently said that the path toward lower inflation will “probably be bumpy.”

On the other hand, one month does not make a trend. It is possible that one-off factors drove the surprising increase in core inflation in January. We’ll have to wait for more data to draw conclusions. In response to the inflation news, US equity prices fell while bond yields increased.

In the United States, financial market conditions might be improving

  • Some observers are concerned about the consumer debt situation in the United States. It was reported that the share of automotive loans to households with low credit ratings that are nonperforming has increased significantly. Indeed, the Federal Reserve reports that the share of auto and credit card debt that is more than 30 days overdue has risen in recent quarters. However, it remains below the prepandemic level and far below the levels reached prior to the last major recession. The share that is over 90 days overdue continues to decline. Thus, it appears that, although there are some headwinds, the consumer debt situation in the United States is not especially onerous. The biggest increase in serious delinquency has been among consumers younger than 30. Still, even this remains below the prepandemic level.

Meanwhile, the surge in mortgage originations that took place during the pandemic is over. Following the surge in borrowing costs, the number of originations is back down to a level comparable to the prepandemic level. During the pandemic, roughly three-quarters of originations went to households with excellent credit, up from about one-quarter prior to the subprime crisis. Even now, roughly 60% of originations are going to households with excellent credit. Thus, there appears to be far less systemic risk in the mortgage market than what transpired in 2007–09.

Finally, the number of bankruptcies and foreclosures in the United States remains at an historically low level. The bottom line is that financial stress for US households, although up modestly, does not appear to be at a level normally associated with financial crisis or recession. Moreover, the decline in some measures of stress suggests that risks to the system might be declining. As such, Fed tightening has not had as negative an impact on consumer finance as is usually the case. 

  • When central banks tighten monetary policy and/or when economies falter, there is usually an increase in stress in corporate bond markets. This, in turn, contributes to a weakening of business investment and other transactions, thereby adding to economic weakness. 

The Federal Reserve Bank of New York maintains a corporate bond Market Distress Index (CMDI) meant to signal shifts in corporate bond market conditions. The index is based on “a wide range of indicators, including measures of primary market issuance and pricing, secondary market pricing and liquidity conditions, and the relative pricing between traded and nontraded bonds.” There are two indices: one for investment grade bonds; the other for high yield bonds. The latter index tends to be more volatile. 

Historically, the indices started to increase prior to recessions as the Fed started to tighten monetary policy, then declined when the Fed eased monetary policy. In addition, the indices increased even when there was no recession, such as in late 2015/early 2016 when the US economy decelerated sharply but did not go into recession. 

The latest reading of the indices is interesting. They began to rise at the start of 2022, and then peaked around October 2022. At that time, the index for investment grade bonds was well below the last peak reached in 2020 and even far below the level reached in 2016. The index for high yield bonds, while below the peak in 2020, was roughly comparable to the level reached in 2016. Then, the indices started to decline in October. Currently, they are relatively, and surprisingly, low. The investment grade index is now comparable to levels seen during the period 2012 to 2015. The high yield index is slightly elevated but lower than during past downturns. 

What does this mean? It suggests that, since October, bond market conditions have improved even as the Fed continued to tighten. It implies that bond investors are becoming more sanguine about the outlook, seeing less likelihood of recession and greater likelihood that the economy will avoid recession. Can these indices be trusted? After all, some clients have told me that they face greater difficulty raising funds now than a year ago. Certainly, the still elevated level of the high yield index suggests that some companies still face a more restrictive environment for raising capital than a year ago. However, the fact that both indices have fallen since October is likely good news for the overall economy. The leaders of the Federal Reserve might interpret this to mean that their job is not yet done. That is, they could see this as evidence that further monetary tightening is needed to quell inflation.

Eurozone inflation decelerates

  • The European Union published its final estimate of January inflation in the EU and the Eurozone. In the Eurozone, consumer prices were up 8.6% in January versus a year earlier. This is down from a peak of 10.6% in October and the lowest rate of inflation since June 2022. Prices fell 0.2% from December to January. When volatile food and energy prices are excluded, core prices were up 5.3% in January. This was a record high. However, core prices were down 0.8% from the previous month.

Also, it was reported that, in the larger EU, consumer prices were up 10% from a year earlier and up 0.2% from the previous month. The higher inflation in the EU mainly reflected much higher inflation in Eastern Europe. In fact, the highest inflation in the EU, in order, was in Hungary, Latvia, Czechia, Estonia, Lithuania, Poland, Slovakia, Bulgaria, Romania, and Croatia. Of these, only Croatia is part of the Eurozone. The lowest rates of inflation, in order, were found in Luxembourg, Spain, Cyprus, Malta, and France.

Among the larger economies in the region, annual inflation was 9.2% in Germany, 7% in France, 10.7% in Italy, 5.9% in Spain, 8.4% in the Netherlands, and 7.4% in Belgium.

Especially notable about this report was that energy prices were up for the month while core prices were down. This suggests that underlying inflation is receding while inflation has clearly peaked. Still, the European Central Bank (ECB) has indicated that it intends to continue raising the benchmark rate, at least for a few more months. Given the surprising resilience of the European economy and the tightness of the labor market, the ECB is likely concerned that underlying inflationary pressures remain strong. That is, such resilience might make it difficult to push inflation down toward the target rate of 2%. Thus, further weakening of the regional economy might be needed.

Japanese inflation accelerates

  • Inflation in Japan continued to accelerate in January. Core prices (which in Japan means all goods and services less fresh food) were up 4.2% in January versus a year earlier, a 41-year high. When energy prices are excluded, so-called core-core prices were up 3.2% from a year earlier, the highest in roughly 30 years. This means that underlying inflation has taken off, significantly above the 2% target of the Bank of Japan (BOJ).

Recall that, for the past decade, the BOJ has pursued an unusually aggressive monetary policy of negative short-term interest rates and management of the yield curve, the intention being to end a long period of deflationary pressure. Only with the end of the pandemic was success achieved. Now there is a debate as to whether the aggressive policy should be retained in order to sustain economic growth or should be gradually ended in order to avoid even worse inflation. This debate comes at the same time that the leadership of the BOJ is changing. Long-serving BOJ Governor Kuroda is retiring, likely to be succeeded by Kazuo Ueda.

Ueda is seen as a pragmatic technocrat compared to Kuroda’s ideological stance. Still, in his confirmation hearings, Ueda said that it is “appropriate” to sustain the easy monetary policy, but that he hopes to mitigate the side effects of this policy. He said that Kuroda’s policy had been “unavoidable,” but that the easy monetary policy will eventually need to be ended. Still, he said that it is “too early to discuss specifics.” As such, it is difficult to discern Ueda’s intentions from these remarks.

Week of February 20, 2023

US inflation, Fed policy, and investor expectations

  • Inflation in the United States continued to decelerate in January, but less than many pundits had anticipated. As such, last week’s comments from the commentariat were relatively negative, focusing on the stickiness of inflation and the challenge for the Federal Reserve in suppressing inflation. Is this pessimism warranted? The reality is that, to the extent that the decline in inflation slowed, it was mainly due to an increase in energy prices after several months of decline.

Here are the numbers: In January, the consumer price index (CPI) was up 6.4% from a year earlier. This was down from 6.5% in December. It was the lowest rate of annual inflation since October 2021. What alarmed some investors is that prices were up 0.5% from the previous month, up from a 0.1% gain in the previous month. This was the highest monthly increase in three months. It was due to a 2% increase in energy prices from December to January. This follows a 3.1% decline in energy prices in the previous month. Following a sharp 7.2% decline in gasoline prices in December, gasoline increased by 1.9% in January. Energy prices tend to be volatile. However, the increase in January likely reflected improved sentiment about the global economy. 

Meanwhile, when volatile food and energy prices are excluded, core prices were up 5.6% in January versus a year earlier, the lowest since December 2021. Core prices were up 0.4% from December, the same rate of increase as in the previous month. Thus, underlying inflation is gradually improving.

Some categories of the CPI continued to exhibit strong increases. For example, food prices continue to rise rapidly, up 10.1% from a year earlier, but up a relatively modest 0.5% from the previous month. Airline fares were up a stunning 25.6% from a year earlier but were down 2.1% from the previous month. 

The stickiest inflation was found in the shelter category, which accounts for more than one-third of the CPI. The shelter component reflects actual rents for rental properties. However, for owned properties, the government conducts a survey of owners and asks them what they would charge if they were renting out their property. This is meant to capture the inferred cost of owning a property, especially given that only a small share of properties is turned over in any given month. The result is that the shelter component only changes gradually, and lags changes in property values. Until mid-2022, residential property prices were rising rapidly. As such, the shelter component of the CPI continues to accelerate, up 7.9% in January from a year earlier and up 0.7% from the previous month. Yet in recent months, property prices have been falling. This will likely be captured in the shelter component in the second half of 2023. When that happens, the decline in inflation will accelerate. Meanwhile, when food and shelter are excluded, consumer prices were up 4.6% in January versus a year earlier. 

Some categories of the CPI are declining. For example, used car prices were down 11.6% in January versus a year earlier and were down 1.9% from the previous month. Prices of major appliances were down 3.9% from a year earlier and down 2.4% from the previous month. Computer prices were down 6.2% and smartphone prices were down 23.9% from a year earlier. In fact, prices of all durable goods were down 1.3% from a year earlier and up only 0.1% from the previous month. This is notable because, when inflation started to take off, it was mainly due to a surge in prices of durable goods. That reflected a sudden surge in demand for durables that suppliers were hard-pressed to satisfy. The result was disruption of supply chains, higher costs, and ultimately higher prices. Now that demand for durables is declining, prices are falling. 

So, what happens next? It is likely that inflation will continue to decelerate in the months to come unless there is a sudden surge in energy prices. That could happen if China’s economy rebounds more quickly than anticipated, but it is not very likely. Moreover, once the shelter component of the CPI starts to decelerate, likely in the second half of the year, then overall inflation will likely decelerate more rapidly. 

Perhaps the bigger question is what the Federal Reserve will do. Recall that, recently, Fed Chair Powell said that bringing down inflation is “probably going to be bumpy.” He said that there will likely be “a couple of more rate hikes” and that getting inflation down will “take a significant period of time.” Powell noted that goods prices are coming down and that housing costs will come down later this year. However, he pointed to the stickiness of service prices as the main problem at this time. Other Fed leaders have similarly expressed the view that more monetary tightening will be required to bring inflation toward the target level of 2%. 

Recent strong data on employment growth and retail sales, the latest inflation date, and comments by Chairman Powell about the future direction of monetary policy have led many investors to upwardly revise their long-term expectations of inflation. The employment numbers reported recently caused concern that the tightness of the job market might inhibit the ability of the Fed to sufficiently weaken inflationary pressure. In addition, Powell’s recent remarks suggest a bias toward more rather than less tightening, if only to ensure that demand weakens sufficiently to suppress inflation. 

The result is that breakeven rates have risen lately. Breakeven rates are a measure of bond investor expectations of inflation. They are calculated by taking the yield on a government bond and subtracting the yield on an inflation-protected bond. The latter are bonds in which the principal value moves in line with inflation. As such, the yield on the inflation-protected bond is an after-inflation, or real, yield. Thus, the difference between the headline yield and the inflation-protected yield is, effectively, the bond investor expectation of inflation. 

The breakeven rate for the five-year bond increased from 2.09% on January 18 to 2.5% late last week. This is the highest five-year breakeven since early December 2022. Breakeven rates had been mostly declining since October as the inflation rate continued to fall and the Fed continued to tighten. Yet now, many investors are slightly revising their expectations upward. The modest increase in the breakeven rate suggests that investors now expect the decline in inflation to be more gradual and that a return to the Fed’s target rate will take a bit longer.

US retail sales surprise in January. What does it mean?

  • When several US economic indicators declined in December (retail sales, consumer spending, industrial production), some analysts saw this as possibly the first sign that a recession had begun. After all, the National Bureau of Economic Research, which tracks the timing of recessions, examines such monthly economic data to gauge the state of the economy and determine when a downturn has begun. Yet talk of immediate or imminent recession likely ended last week when the US government reported that both retail sales and industrial production grew in January, with retail sales up very strongly. The big question is this: Did the strong January retail sales numbers reflect a strong economic rebound in which case the Federal Reserve will have to tighten more than expected to suppress inflation? Or did the strong retail sales numbers reflect a quirk in the seasonal pattern of retail sales? That would imply that the numbers did not indicate a strengthening of the economy. Let’s look at the data.

First, US retail sales were up 3% from December to January, far more than expected and the biggest monthly increase since March 2021. Sales were up 6.4% from a year earlier. These numbers are nominal. That is, they are not adjusted for inflation. Given that monthly inflation in January was 0.5%, the 3% monthly increase was a big real, or inflation-adjusted, gain. 

The big increase might have reflected a strong economy. After all, we already know that employment grew by more than 500,000 jobs in January. In addition, 70 million recipients of Social Security checks saw an 8.7% cost-of-living increase in January. 

On the other hand, the retail sales numbers are adjusted for seasonal variation. That is, there is normally a very large increase in spending in December because of the Christmas holidays. This is usually followed by a very sharp decline in spending in January, especially as many people return gifts at that time. However, it could be that the gain in spending in December was muted if people did more of their holiday shopping early. That would account for the decline in seasonally adjusted retail sales in December. And, if that was the case, then there would have been a smaller than usual decline in spending in January. That, in turn, would mean that, after adjusting for seasonality, sales increased in January by more than expected. Thus, the big increase in January might simply be due to this statistical issue.

Meanwhile, let’s look at the details. Almost every category of retail sales saw a significant increase in January. The only exceptions were grocery stores (up 0.1% for the month) and gasoline stations (unchanged). With people avoiding grocery stores, they evidently went out to eat. Sales at restaurants and bars were up 7.2% from the previous month and up a stunning 25.2% from a year earlier. Meanwhile, sales at department stores surged 17.5% from the previous month after having fallen 6.5% in December. This could be related to that seasonal quirk I described above. It could also reflect people using their holiday gift cards in January. And it could simply mean that demand for fashion goods surged in January. 

Also, spending at electronics stores, while up 3.5% from the previous month, were down 6.3% from a year earlier. This might be due to the sharp decline in prices of computers and smartphones in the past year. Finally, sales were up strongly at automotive dealers, rising 6.4% from the previous month.  

In response to the retail sales report, equity prices fell while bond yields rose on expectations that the Federal Reserve will have to tighten monetary policy more than previously expected. Evidently, many investors interpreted the retail sales numbers as indicating a strong economy. The irony is that the strong retail sales and employment numbers in January might increase the likelihood of a recession by compelling the Fed to keep monetary policy tighter than otherwise.

Upward revision of growth expectations for the British economy

Ian Stewart, chief economist of Deloitte UK, offers an upwardly revised forecast for British economic growth:

  • For the first time in more than a year we are raising our forecast for UK growth. A recession is still in the cards, but a shorter, milder recession than had seemed likely. Better news on energy supply, inflation, and the outlook for the economies of China, the United States, and the EU lie behind our upgrade.

We see the UK economy contracting by 0.8% this year, up from our previous forecast of a 1.4% decline in GDP. With Friday’s news that the UK GDP growth was flat in the fourth quarter of last year, following a contraction of 0.2% in the third quarter, the UK narrowly avoided a technical recession in the second half of 2022 (a recession is defined as two consecutive quarters of negative growth). That is unlikely to last and we see GDP contracting for the first three quarters of this year. 

The energy crisis has eased. Europe has sharply reduced its use of Russian gas and filled the gap with imports of liquified natural gas (LNG) from the United States and Qatar. Mild weather has helped reduce energy usage and gusty winds have lifted the power output from turbines to record levels. UK wholesale gas prices are running at about one-fifth of their summer peak and this is taking some of the pressure off consumers. The United Kingdom, and continental Europe, seems likely to avoid blackouts this summer.

UK inflation is running at 10.5% but has probably peaked and is likely to fall sharply over the next 18 months. Financial markets believe that the Bank of England has done the lion’s share of the monetary tightening that will be needed in this cycle. Markets are pricing in a peak in rates of around 4.5% compared with over 6% expected last September. The prospect of a lower peak in rates has led to a loosening of financial conditions, supporting risk assets, such as equities, and the outlook for growth.

While prospects for growth in the United States and the euro area this year remain poor, lower energy prices and inflation have reduced the risks of deep downturns. Prospects for China, the world’s second-largest economy, have improved with the ending of the country’s zero–COVID-19 policy. Sharp increases in the value of China’s currency and equities suggest that many investors see stronger Chinese growth ahead.

Things look slightly better than they did at the start of this year, but they remain challenging. The Bank of England acknowledges that the risks to inflation are “skewed significantly to the upside.” Commodity prices are falling, but underlying inflation pressures remain strong.

To bring inflation back down without causing a recession requires not just lower commodity prices, but weaker wage growth and a softening of domestic price pressures. Previously that has been achieved through higher unemployment and shrinking demand pushing the economy into recession.

But could it be different this time, with central banks achieving a soft landing combining sharply lower inflation and continued growth? Falling commodity prices help, but to get inflation back to its 2% target will require wage pressures and easing of home-grown inflation. The resilience of the economy more than a year into a tightening cycle underscores the momentum of activity. A period of shrinking domestic demand and rising unemployment still looks necessary to curb domestically generated inflation. Milder, and shorter it may be, but a recession is still likely on the cards for the United Kingdom.

The evolving energy situation in Europe and the United States

  • A weakening global economy is among the factors that contributed to a decline in energy prices in the past few months. This, in turn, has helped to alleviate inflationary pressure in multiple countries. It has also reduced the risk of deep recession, especially in Europe. 

Regarding Europe, the biggest issue in the past year has been the volatility of natural gas prices, fueled by Russia’s decision to weaponize gas and significantly reduce transmission of pipeline gas to Western Europe. Yet European countries have successfully boosted the supply of gas coming from Norway and Algeria as well as LNG coming from the United States and Qatar. In addition, demand has weakened, in part because of a mild winter and a weaker overall economy. The result has been a sharp decline in the price of natural gas. In fact, gas is now at the lowest price since mid-2021, well before the start of the war in Ukraine. The price has fallen roughly 85% since the peak reached last August. Still, the price of gas remains about four times higher than the prepandemic level. 

Going forward, Europe’s energy situation will likely be stable, partly owing to success in building up gas storage. Moreover, although gas supplies to industry have fallen sharply, manufacturing output has been relatively stable owing to successful efforts at efficiently using alternative sources of energy. Assuming that the weather in Europe does not suddenly worsen, it is likely that storage accumulation will continue in 2023, thereby setting the stage for stability during next winter. The big wild card is the war in Ukraine. If the war ends and Russia renews pipeline transmission, this would lead to a sharp decline in prices. However, I’m not aware of anyone who is predicting a quick end to this war. 

Meanwhile, the US price of natural gas continues to decline as well. The US price of gas is down roughly 75% from the peak in August. It is at the lowest level since September 2020 and is lower than in the prepandemic period. On the other hand, the export price of US LNG is up significantly from a year earlier, although the price started to decline late in 2022. The rise in US LNG prices reflects strengthened European demand for US gas. 

Despite a decline in the prices of oil, natural gas, and coal, the price of electricity in the United States rose sharply in 2022. Electricity prices are regulated by state governments, which permitted significant price increases in 2022 owing to the early surge in energy prices. In addition, utilities are facing serious labor shortages, which add to costs. The added cost of electricity in the United States is creating a financial burden for households, especially those at the lower end of the income spectrum. If the price stabilizes in 2023, this could be helpful in reducing recessionary and inflationary pressure.

Week of February 13, 2023

Constraints on China’s long-term growth have global implications

  • There is debate about the future growth path of China, not just in the coming year, but in the longer term. This is important not only for China, but because of China’s large footprint in the global economy. If China grows more slowly than in the past, it could affect demand for the world’s goods and services and could influence commodity prices and carbon emissions. To determine the likely long-term growth path of China, it is useful to consider the factors that drive growth.

In the long term, economies grow either because there is an increase in the number of workers and/or the amount each worker produces (productivity). First, consider China’s supply of labor. The working-age population is currently in decline and will decline further in the coming decade. This is the lagged effect of a declining birth rate. Even if the birth rate were to suddenly increase, it would take another generation to have an impact on the working-age population. Thus, for China to grow in the coming decade, productivity must grow at a good pace.

Second, consider the productivity outlook for China. Productivity is driven by investment, which boosts the capital intensity of work and implements new innovations. In the long term, innovation is the key to productivity. Productivity growth is also driven by improvements in human capital, especially when workers are shifted from low-productivity to high-productivity processes.

In China, investment as a share of GDP has long been relatively high, helping to fuel strong growth. Yet in the past decade, the share of investment coming from the private sector has declined, while the share attributable to the state sector has increased. This has been due, in part, to the pattern of lending by state-run banks and to a broader government policy of support for the state sector. The return on private sector investment has been much higher than in the state sector. This implies that private sector investment is likely to have a bigger impact on productivity. As such, if the trend toward greater support for the state sector continues, it will likely have a negative impact on economic growth.

Meanwhile, in the past few decades, China benefitted considerably from massive migration of workers from farms to factories and then to offices. This internal migration boosted productivity by shifting workers to more productive processes. Such migration has slowed considerably. If it does not rebound in the coming decade, this will have a negative impact on growth.

Finally, growth in productivity and in productive capacity could be stymied in the coming years by restrictions on flows of high-end technology to China from the United States, Japan, and the Netherlands. These three countries are restricting the export to China of equipment needed to produce the highest-end semiconductors. The United States is concerned that such chips can be used to produce highly sophisticated weapons. For China, however, the restrictions can impede, or at least slow, the domestic development of key technologies such as new generations of smartphones and electric vehicles. It could stymie China’s ability to develop world-class brands in leading-edge products. That, in turn, could hurt its ability to move up the value chain and grow at a rapid pace.

To summarize, there appear to be several significant headwinds for China that could slow economic growth in the coming decade. These can be clustered into three buckets: demographics, government policy regarding the state versus private sectors, and external constraints on technology acquisition. The first and last are largely beyond the control of the government. The second, however, is something that the government can control. How the government will approach this issue is uncertain.

Meanwhile, the short-term outlook for China is improving now that COVID-19–related restrictions have been lifted. In addition, the government is providing support for the property sector, thereby offsetting the negative effects of the decline in property prices and activity. Growth in 2023 will likely be considerably stronger than in 2022.

Services PMIs show evidence of global economic resilience

  • The global economy continues to surprise investors and pundits by its relative strength. GDP growth numbers for the fourth quarter of 2022 were better than expected in the United States and Eurozone, inflation appears to be decelerating in both North America and Europe, job markets remain unusually tight, and China’s reopening has excited businesses with the prospect of renewed Chinese demand. 

Now there is added evidence that things are not so bad in the form of purchasing managers’ indices (PMIs) for the broad services sector. Services encompass the majority of economic activity in most countries. It includes retail and wholesale trade, telecoms, finance, professional services, transportation and warehousing, education, and health care. PMIs are forward-looking indicators meant to signal the direction of activity in services. They are based on subindices such as output, new orders, export orders, employment, pricing, pipelines, and sentiment. A reading above 50 signals increased activity. The higher the number the faster the growth—and vice versa.

The latest PMIs for January as a whole are better than for December. The global services PMI increased from 48.1 in December to 50.1 in January, indicating slight growth in activity for the first time since July 2022. This reflected improvement in the PMIs of the United States, Eurozone, China, and Japan. The PMIs of the Eurozone, China, India, and Japan all indicated growing activity. The US PMI was below 50 but improved from the previous month. 

Let’s look at the details. The biggest contributor to the significant improvement in the global PMI was China. The services PMI for China increased from 48 in December to 52.9 in January. This was principally due to the impact of reopening the economy and removing all COVID-19–related restrictions. IHS Markit noted that both supply and demand for services improved markedly in January. While it is clear that China’s economy is rebounding, there remains uncertainty about how fast the rebound will be.

Meanwhile, the PMI for the Eurozone moved into positive territory, rising from 49.8 in December to 50.8 in January. Within the Eurozone, the PMIs for Germany and France remained slightly below 50, although the German PMI hit a seven-month high at 49.9. The PMIs for Spain and Italy were above 51 and hit six- and seven-month highs, respectively. Thus, the Eurozone services sector was evidently growing as the new year began. Markit commented that this “suggests that the Eurozone could escape a recession.” If I had been asked six months ago about this, I would have said it was extremely unlikely that Europe would avoid recession. Now it is at least a possibility. Markit pointed to reduced price pressures, reduced supply constraints in the energy market, warmer weather, lower energy prices, and new government energy subsidies as factors contributing to a better environment for services. On the other hand, Markit noted that rising interest rates mean that the risk of recession has not disappeared.

Alone among major economies, the United Kingdom experienced a worsening of the services PMI in January. The PMI fell from 49.9 in December to 48.7 in January. This was the weakest service sector performance in two years. Markit said that “the UK economy risks falling into recession as labor shortages, industrial disputes, and higher interest rates take their toll on activity.” On the other hand, new orders stabilized while export orders picked up speed. The result was that the weakness was somewhat muted.

Similar to the United Kingdom, the US services PMI was below 50 in January, although it did improve from December. Specifically, the US PMI increased from 44.7 in December to 46.8 in January, a number indicating a significant decline in activity. Markit reported that hiring “ground to a halt.” Yet this conflicts with the US government’s amazingly strong employment report for January. Markit said that the weak PMI was “led by a slump in financial services activity, linked in turn to higher borrowing costs, with consumer-facing service providers also reporting especially tough business conditions amid the ongoing squeeze in spending due to the rising cost of living.” Also, Markit said that the weak service and manufacturing PMIs increase the risk that GDP will contract in the first quarter.

Finally, Asia’s two largest economies other than China had favorable service PMIs in January. Japan’s PMI increased from 51.1 in December to 52.3 in January. Meanwhile, India’s PMI fell from 58.5 in December to 57.2 in January, a number still indicating very rapid growth.  

US productivity rebounds, boding well for reduced inflation

  • In the United States, productivity (output per hour worked) fell 1.3% from 2021 to 2022, the fastest pace since 1974. This reflected strong employment growth combined with weak growth in output. However, in the fourth quarter of 2022, productivity grew at a healthy pace from the previous quarter. Moreover, wage growth decelerated. The result was that unit labor costs (the labor cost of producing an additional unit of output) grew at the slowest pace in seven quarters. That, in turn, is good news regarding inflation. When unit labor costs are rising rapidly, this fuels inflation—and vice versa. The growth in unit labor costs is calculated by dividing the rise in wages by the rise in productivity. 

More specifically, from the third to the fourth quarter of 2022, hourly compensation increased at an annual rate of 4.1% and productivity increased at a rate of 3%. Thus, unit labor costs increased at a modest rate of 1.1%. As recently as the first quarter of 2022, unit labor costs were rising at a rate of more than 8%. As for the 3% growth in productivity, this stemmed from a 3.5% increase in output and a 0.5% increase in hours worked.  

US oil consumption declines, with global implications

  • In the United States, even as the economy has seemingly fully recovered from the pandemic, consumption of oil is down sharply from the prepandemic level. This means that there is a structural shift taking place, unrelated to the growth or size of the economy. There are three principal shifts taking place. First, people are driving less given the shift toward remote work and online shopping. By one measure, the number of miles driven in 2022 was 10% lower than in the prepandemic period. In urban areas, the decline was even greater. 

Second, there has been a sharp increase in the demand for electric vehicles. Third, there has been an improvement in the energy efficiency of gasoline-powered vehicles. The result is that, in 2022, oil consumption in the United States was 6% lower than in the year prior to the pandemic. In fact, excluding the sharp drop in 2020 at the start of the pandemic, oil consumption in 2022 was at the lowest level in 10 years. 

Meanwhile, the US government expects oil consumption to continue declining in 2023 and 2024. Given that the US accounts for about 9% of global consumption of oil, the decline in US consumption will likely have a negative impact on oil prices. Moreover, it is likely that the US trend is being replicated in other advanced economies.

What are the implications of this trend? First, it indicates that the long-expected decline in oil consumption is happening. It means that, in a few years, there could be a significant decline in oil prices and oil revenue for oil-exporting countries. Second, this potentially leads to significant geopolitical shifts. Some oil exporters could experience economic and political dislocation. This might include Russia, Iran, Nigeria, and Venezuela. Other more affluent oil exporters such as Saudi Arabia and other Gulf nations will be compelled to accelerate the shift toward economic diversification and greater reliance on earnings from sovereign wealth funds.

Japan’s central bank changes leadership. What are the implications?

  • To the surprise of many analysts, it is now reported that the Japanese government will appoint Kazuo Ueda as the next governor of the Bank of Japan (BOJ). Ueda is an academic economist and former member of the BOJ’s policy board.

The current BOJ regime has pursued a decade-long policy of easy monetary policy meant to boost inflation in an economy that suffered from slow growth and deflationary pressure. Even now, with inflation accelerating, the policy has not been changed. However, there is debate about the optimal policy for the coming year. One could argue that the aggressive monetary policy, if retained, risks fueling much higher inflation and tends to distort investment decisions by suppressing capital costs. On the other hand, one might worry that a reversal of the policy risks creating the conditions for a new recession given the fragility of the economy.

Last week, Ueda said that “the Bank of Japan’s current policy is appropriate” and that “monetary easing must continue.” However, many people believe that the BOJ will soon have to adjust policy given that the bank is currently the only purchaser of government bonds. There is a sense that this situation is not sustainable in the long run. Moreover, given that the selection of Ueda was different than what many analysts expected, there is now a sense that a policy change could be coming. Indeed, it had been widely expected that the post would go to the current deputy governor of the BOJ, Masayoshi Amamiya. He was expected to be relatively dovish on monetary policy. Now, with Ueda coming in, it is not entirely clear what will happen. As such, the yen increased in value on news of Ueda’s imminent appointment.

Week of February 6, 2023

US job market surprises as Fed eases the pace of tightening

  • The US government reported on the state of the labor market in January. Many observers had expected a continued deceleration in employment growth. The ADP estimate of private sector job growth earlier in the week was especially poor. It made sense to expect weakness because we’ve lately seen declining consumer spending, weakening business investment, decelerating wage gains, announcements of big layoffs at several important companies, and our own Deloitte surveys indicating pessimism on the part of CEOs and CFOs. 

Instead, what we got was an almost unbelievably strong jobs report with more than 500,000 jobs created in January (the most since July) and a decline in the unemployment rate to 3.4%. This came after five consecutive months of decelerating job growth. Is this the start of a rebound or simply a statistical outlier? It is too early to say. In any event, here are the details.

The US government issues one employment report that includes two surveys: one is a survey of establishments; the other is a survey of households. The establishment survey reports that 517,000 new jobs were created in January with gains across a range of industries. Recall that, in the period between August and December, job growth ranged from 260,000 to 352,000—an extraordinary and unexpected number. This means that economic growth in the first quarter of this year is off to a strong start.

By industry, there were strong job gains in both construction and manufacturing. The lion’s share of construction jobs was in nonresidential, although residential construction saw an increase. Within the broad services sector, there were strong gains in retail (up 30,100), transportation and warehousing (up 22,900), professional and business services (up 82,000), private education services (up 25,800), health care services (up 79,200), leisure and hospitality (up 128,000 including 98,600 for restaurants and bars), and government (up 74,000). The latter included 39,000 for state governments and 30,000 for local governments. Even when job growth was much stronger early in the postpandemic period, job growth was mostly concentrated in leisure and hospitality. This report signals a more widespread creation of jobs.

The establishment survey also reported on wages. With strong job growth in a tight labor market, one would expect accelerating wages. Instead, the opposite happened. In January, average hourly earnings increased only 4.4% from a year earlier, the slowest rate of wage increases since August 2021. Earnings were up a modest 0.3% from the previous month. Thus, as inflation is receding, so are wage gains. This means that the labor market is not contributing to inflation. It also means that workers are experiencing a loss of real purchasing power. Meanwhile, there continued to be relatively strong wage gains in the leisure and hospitality sector, with average earnings up 7% from a year earlier. 

The separate survey of households found a modest increase in the participation rate in January. It also found that the number of employed grew faster than the number of labor market participants. The result was a decline in the unemployment rate from 3.5% in December to 3.4% in January. These numbers also reflect a strong labor market. 

The general zeitgeist had been that the Federal Reserve needs to see a weakening of the labor market before it is willing to slow or reverse the pace of monetary tightening. This reflects the belief that the job market remains sufficiently robust and that it might prevent inflation from easing to the 2% target. Thus, the most recent report was interpreted to mean that the Fed is likely to tighten more than previously expected. As such, equity prices fell while bond yields increased on expectations of further rate hikes amid underlying inflationary pressure. The dollar strengthened. 

However, some investors worry about a tight labor market because it could exacerbate inflation. And yet even with accelerating employment, wages are decelerating. It makes little sense. This part of the equation appears to be irrelevant to investors, at least for now. Often, investors react to news based on what they think other investors will do. That might explain their failure to consider the surprising wage environment. 

  • Meanwhile, the US government reported new data indicating a rebound in job vacancies while, at the same time, a broad measure of employment costs decelerated. This is similar to the jobs report that indicates a tight labor market but weakening wages. These conflicting signals set the stage for the decision by the Federal Reserve to boost the Federal Funds rate by 25 basis points (bps). This was expected and investors were not surprised. Still, it represents a shift in monetary policy after several months of rapid tightening. It indicates that the process of tightening is slowing down, setting the stage for an eventual pause, likely before the middle of this year. The Fed did indicate that further rate hikes are coming. The new guidance is for the Fed Funds rate to be between 4.5% and 4.75%. 

The data on job vacancies suggests a slight increase in the tightness of the job market. After several months of declining vacancies, the job vacancy rate increased to the highest level in five months, suggesting the possibility that the job market is not yet weakening in the way that the Federal Reserve would like to see. The employment cost index, meanwhile, saw a further easing of wage and benefit inflation, suggesting that the labor market, despite tightness, is still not contributing to inflation and that wage behavior is moving in the direction sought by the Fed.

Europe’s economy grows, inflation steadies, and central banks tighten

  • It is a rare thing to state the following: the Eurozone economy grew faster than the United States and China last year. However, it is true. Eurozone real GDP grew 3.5% in 2022 versus the year earlier. This compares to US growth of 2.1% and Chinese growth of 3%. The last time this happened was in 1974. More importantly, the European Union (EU) recently reported that, in the fourth quarter of 2022, Eurozone real GDP grew 0.1% from the previous quarter (or at an annualized rate of 0.5%) and was up 1.9% from a year earlier. Given that the energy shock emanating from Russia was expected to create dire circumstances for Europe, the EU report is quite notable.

Of the 20 member countries in the Eurozone, 14 had positive growth from the third to the fourth quarter while six experienced a decline in real GDP. Those six included Germany (down 0.2%) and Italy (down 0.1%). The others were Czechia, Lithuania, Austria, and Sweden. 

The fact that the Eurozone temporarily averted recession is likely due to several factors. These include a mild winter, which reduced the impact of the energy shock. Indeed, gas prices in Europe are down substantially, which helped to ease the loss of consumer purchasing power. In addition, several governments in Europe have provided subsidies to consumers and businesses to offset the impact of high energy prices. This is the equivalent of a fiscal stimulus and helped to offset the impact of a tighter monetary policy. Going forward, however, the European Central Bank (ECB) is still expected to tighten monetary policy further. As this happens, interest-sensitive sectors of the economy are expected to suffer negative consequences, potentially pushing the region into recession. 

The decline in real GDP in Germany is important. It reflects the disproportionate impact of the energy shock on Germany’s industry-intensive economy. Although gas prices have fallen, they remain elevated. This had a negative impact on output in heavy industry such as chemicals. In addition, despite government support, the energy shock evidently led to a decline in real consumer spending. Moreover, Germany’s weak performance in the fourth quarter was part of a longer-term trend. Real GDP remains only 0.2% larger than just prior to the pandemic, a much worse performance than in the rest of Europe. On the other hand, the fourth quarter performance was not as bad as might have been absent the mild winter weather.  

  • Inflation in the Eurozone continued to decelerate in January, entirely due to an easing of energy prices. Consumer prices were up 8.5% in January versus a year earlier. The rate of inflation has steadily declined since peaking in October at 10.6%. Prices were actually down 0.4% from December to January. The decline in energy prices played the principal role in reducing inflation. Energy prices were up 17.2% in January versus a year earlier, with energy inflation having peaked in October at 41.5%. Energy prices were down 0.9% from December to January. Food price inflation, meanwhile, continued to accelerate, hitting 14.1% in January.

When volatile food and energy prices are excluded, core prices were up 5.2% in January versus a year earlier, the same as in December, which was the highest on record. Core prices fell 0.8% from December to January, suggesting that core inflation has peaked. 

Annual inflation varied by country. Inflation was very high in the three Baltic countries, ranging from 18.4% to 21.6%. The EU did not report inflation for Germany. In the other big Eurozone economies, inflation was 10.9% in Italy, 7% in France, and 5.8% in Spain, which was the lowest inflation rate in the Eurozone.  

With respect to Spain, inflation rebounded in January, surprising and worrying investors. Consumer prices, measured on a harmonized basis for the Eurozone, were up 5.8% in January versus a year earlier, higher than the 5.5% in December. It was the first acceleration in inflation since July of 2022. Prices were down 0.5% from the previous month, due to continued declines in energy prices. That, in turn, likely reflected the impact of a mild winter. Yet, when volatile food and energy prices are excluded, core inflation continued to accelerate, hitting a record level of 7.5% (it was 7% in December). Thus, underlying inflation is getting worse. 

The inflation report for Spain was a big surprise given that Spain has seen a steady and sharp decline in inflation in recent months, putting Spanish inflation well below that of several other Eurozone economies. The sudden rebound could be seen as a red flag, especially given the continued acceleration of core inflation. It was likely easy for businesses to pass on cost increases to their customers given the relative strength of the economy, which grew 0.2%in the fourth quarter.

Despite the decline in headline inflation in the Eurozone, the ECB is expected to raise its benchmark interest rate by 50 bps at its upcoming meeting this month. The ECB is likely paying closer attention to core inflation, which has not yet decelerated but has likely peaked. The ECB is probably concerned that the Eurozone economy continues to exhibit strength as evidenced by positive purchasing managers’ indices, growing GDP in the fourth quarter, and a relatively robust job market. These factors make it difficult to suppress underlying inflation. 

  • Last week, monetary policy in Europe became much tighter, with both the ECB and the Bank of England (BOE) raising their benchmark interest rates by 50 bps. Recall that, earlier this week, the US Federal Reserve raised its benchmark rate by 25 bps. Thus, after a period in which monetary tightening in the United States was faster than in Europe, the opposite is now true. The interest rate gap between the United States and its European counterparts is declining. It was likely the expectation that this was coming that led to the drop in the value of the US dollar in recent months.

The principal reason that the European central banks are doing this is that inflation in Europe remains far higher than in the United States and does not show signs of abating. Although headline inflation in the Eurozone has fallen due to a drop in energy prices, core inflation has not started to decline. Moreover, it is likely that, in the coming months, the ECB and possibly the BOE will continue to tighten more than the US Federal Reserve. Indeed, the benchmark rates in the United Kingdom and Eurozone are currently significantly below that of the United States.

Regarding the action of the ECB, President Christine Lagarde was adamant that monetary policy is not close to reversing. She noted that the situation in Europe is different from that of the United States in several ways. First, Europe has had fiscal stimulus in the form of energy subsidies while the United States is in the midst of a fiscal contraction. She urged that European stimulus end soon. Second, she noted that, although wages in the United States are decelerating, that is not happening in Europe. Thus, there is greater risk in Europe that the tight labor market will contribute to inflation. Finally, with the opening of China and the possibility of a surge in commodity prices, she feels that this will influence prices in Europe more than in the United States. Yet despite Lagarde’s hawkish comments, many investors appear to be more sanguine about the outlook for Europe.

Meanwhile, the BOE is in an interesting situation. Its latest forecast is that inflation will fall below the 2% target by the end of the year. Yet that is due to the assumption that monetary tightening will stifle economic activity sufficiently to suppress inflation. As such, the BOE has chosen to continue on a path of severe tightening, knowing that this means very weak economic prospects. On the other hand, with the benchmark rate now at a 15 year high of 4%, the BOE hinted that it might now pause. Moreover, the BOE’s forecast of economic growth is not as bad as previously. Still, the policy committee said that “if there were to be evidence of more persistent inflationary pressure, then further tightening in monetary policy would be required.” 

Finally, investors reacted very positively to the news emanating from both central banks. Equity prices increased and bond yields fell sharply across Europe. They likely expect a rapid decline in inflation and a less onerous economic downturn than previously anticipated.

Cover image by: Sofia Sergi

Deloitte Global Economist Network

The Deloitte Global Economist Network is a diverse group of economists that produce relevant, interesting and thought-provoking content for external and internal audiences. The Network’s industry and economics expertise allows us to bring sophisticated analysis to complex industry-based questions. Publications range from in-depth reports and thought leadership examining critical issues to executive briefs aimed at keeping Deloitte’s top management and partners abreast of topical issues.

Ira Kalish

Ira Kalish

Chief Global Economist, Deloitte Touche Tohmatsu


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