Weekly global economic update
What’s happening this week in economics? Deloitte’s team of economists examines news and trends from around the world.
US Federal Reserve changes trajectory, markets react strongly
- The global zeitgeist appeared to have shifted recently, largely because of the actions and statements of the Federal Reserve. Not surprisingly, the Fed left interest rates unchanged. Perhaps more importantly, Fed Chair Powell signaled a likelihood that the Fed will start to cut rates in 2024. In response, bond yields fell sharply, with the yield on the Treasury’s 10-year bond falling below 4% for the first time since July, having peaked at 5% in mid-October. Equity prices surged, with major indices hitting historic peaks. The value of the US dollar fell against major currencies, even as bond yields in other countries plummeted.
The global financial market reaction reflected expectations of lower short-term interest rates on the part of the Fed. Yet expectations of Fed action likely influenced investor expectations of inflation and economic growth. The intention of the Fed suggests a likelihood that inflation will continue falling and that economic growth will decelerate.
Meanwhile, the members of the Federal Open Market Committee (FOMC) published the so-called “dot plot” that shows each members’ forecasts for short-term interest rates. The dot plot shows that the FOMC members expect the Federal Funds rate to drop by 75 basis points during 2024. Notably, futures markets are pricing in 150 basis points of cuts in 2024, with the first cut in rates expected in May. Many investors evidently think that the Fed will face an environment characterized by slow growth and declining inflation.
In his comments, Fed Chair Powell noted that, despite a tight labor market, “supply and demand conditions continue to come into a better balance,” with wage growth easing, labor supply rising, and job vacancies declining. He noted that the economy is slowing, with higher interest rates “weighing on business fixed investment.” He said that inflation is easing and that expectations of inflation are favorable. These comments provided the backdrop for his view that monetary easing can begin in 2024. With gradual easing, he said that the committee expects the Federal Funds rate to reach 2.9% by the end of 2026 (it is currently targeted in the range of 5.25 and 5.5%).
The Fed’s expected trajectory led to a sharp rise in the value of the Japanese yen. This will likely remove pressure on the Bank of Japan to tighten monetary policy. There had been concern about the steady decline in the value of the yen. In addition, the declining value of the dollar will remove pressure on the Chinese renminbi. China’s central bank has eased monetary policy gradually but has likely been concerned that the interest-rate gap with the United States will put undue downward pressure on the renminbi, thereby requiring intervention in currency markets to stabilize the renminbi. Now, with US interest rates set to be cut in 2024, the interest-rate gap will become less of an issue for Chinese policymakers.
If, in response to the Fed’s new trajectory, bond yields continue to fall and equity prices continue to rise, then 2024 could be a good year for investors. It could lead to a rebound in M&A transactions, a bottoming of business investment, and a renewal of housing market activity as mortgage interest rates decline (they are already down about 80 basis points from their peak). All this assumes no significant negative shocks to the global economy.
US inflation decelerates, but core inflation stalls
- Just prior to the Fed’s announcement of interest-rate policy, the US government released data on inflation in November. The data indicates a continuing and gradual decline in headline inflation, but a possibility that underlying inflation is getting stuck at a level higher than the Fed’s target. This raises questions about the potential impact of a Fed decision to start cutting rates in a few months.
Here are the inflation details: In November, consumer prices in the United States were up 3.1% from a year earlier, down from 3.2% in October, and the lowest since March 2021. Prices were up only 0.1% from the previous month. The continuing decline has been fueled by a sharp drop in energy prices (down 5.4% in November from a year earlier) and a sharp deceleration in food prices (up only 2.9% from a year earlier). Food price inflation had peaked in August 2022 at 11.3%.
When volatile food and energy prices are excluded, core prices were up 4% in November versus a year earlier, the same as in October and down only slightly from September. Core prices were up 0.3% from the previous month. The worry is that core inflation is stalling at a level consistent with wage increases. In other words, the tight labor market is sustaining underlying inflation. Until now, the evident view of the Federal Reserve was that monetary policy will need to remain tight until the labor market is sufficiently weakened to reduce wage pressure. Now, with rising expectations of a reversal of monetary tightening, there is uncertainty. On the other hand, the Fed appears to expect further weakening of the economy, a lagged effect of what they have already done. This could further reduce wage pressure.
Nevertheless, the details of the inflation numbers offer some good news. First, goods inflation remains dormant. Prices of durable goods were down 1.6% from a year earlier while prices of nondurable goods were up only 0.7%. Most inflation came from services, with prices up 5.2%. As previously, much of this was due to rising shelter prices (up 6.5% from a year earlier). When shelter is excluded, overall inflation was only 1.4% in November and core inflation was only 2.1%. Thus, shelter is the main issue. Moreover, it is expected that, due to stable home prices in the past year, the shelter component of the CPI will decelerate further in the months to come, thereby reducing overall and core inflation. In other words, the Fed might be correct that monetary policy can be eased while inflation comes down.
US retail sales perform better than expected
- Despite expectations that the consumer side of the US economy would decelerate sharply in the fourth quarter, retail sales data for November are not consistent with that story. Rather, the government reports that retail sales grew at a strong pace in November, boding well for continued strong economic growth in the fourth quarter.
Here are the details: In November, retail sales (not adjusted for inflation) were up 0.3% from the previous month. Yet, due to sharp price declines, sales at gasoline stations fell 2.9%. When gasoline stations are excluded, retail sales were up a strong 0.6% from October to November and were up 5.4% from a year earlier. Given that there is almost no inflation for goods, this means a strong increase in real (inflation-adjusted) spending.
As for categories of spending, sales at department stores fell 2.5% in November from the previous month. Some other categories saw negative or modest growth. These included electronics stores (down 1.1%), home improvement (down 0.4%), and grocery (up 0.1%). On the other hand, several categories experienced strong growth. These included nonstore retail (up 1%), furniture (up 0.9%), drugstores (up 0.9%), and restaurants (up 1.6%).
European Central Bank and Bank of England hold rates but signal no easing
- In the same week that the US Federal Reserve kept interest rates unchanged, the European Central Bank (ECB) and the Bank of England (BOE) did the same. In contrast, unlike the Fed, the two major central banks of Europe did not signal an intention to cut rates any time soon.
In the case of the ECB, President Lagarde said that, although rates are remaining unchanged for now, there is no discussion or debate taking place about cutting rates. Moreover, she said that she expects inflation to rebound in the months ahead. She noted that wages continue to rise faster than desired, thereby fueling persistent inflation. As such, a continued tight monetary policy will be needed to weaken the labor market and reduce wage pressure.
Despite Lagarde’s comments, futures prices indicate that investors expect the ECB to cut rates starting in April. They are pricing in cuts of 140 basis points in 2024, down from an expectation of 160-basis-point cuts a month ago. It looks like many investors are pessimistic about the Eurozone economic outlook and, consequently, expect the ECB to act in the face of declining economic activity and declining inflation. Currently, the ECB’s benchmark rate is 4%, up from –0.5% as recently as July 2022. If the ECB holds steady longer than the Fed, this implies further upward pressure on the value of the euro. That, in turn, would be disinflationary for Europe.
As for the BOE, its policy committee voted six to three to keep the benchmark interest rate at 5.25%. With headline and core inflation in the United Kingdom higher than in the Eurozone and the United States, the BOE is determined to keep monetary policy tight until inflation recedes further. The challenge for the United Kingdom is that the job market remains unusually tight, thereby fueling inflationary wage gains. The number of job vacancies remains higher than just prior to the pandemic. In the three months up to October, wages were 7.3% higher than a year earlier. This compares to 4% in the United States and 4.7% in the Eurozone.
Chinese deflation persists
- Deflation persists in China. In November, consumer prices were down 0.5% from a year earlier, the steepest decline since November 2020 at the height of the pandemic. In the last six months, prices have increased from a year earlier only once. The decline in prices was driven by a drop in both energy and food prices. When they are excluded, core prices were up 0.6% in November versus a year earlier. Still, this is very low.
The weakness of prices in China reflects several factors. First, consumer demand has been weak, in part due to troubles in the property market. The sharp decline in property prices has caused a decline in household wealth, thereby fueling an increase in consumer saving. Second, despite an easing of monetary policy, credit market activity remains weak. Third, the weakened global economy has hurt Chinese exports. Finally, producer prices fell 3% in November versus a year earlier, reflecting both weak demand and excess supply.
For China, with a high level of household and corporate debt, deflation is worrisome. It can make it more difficult to service debts, thereby creating financial risk. With debts steady and incomes falling, deflation reduces household and corporate cashflow, thereby hurting economic activity. The question now is whether the central bank and/or the government will take more aggressive steps to reboot the economy.
Should we worry about the US budget deficit?
- In meetings with clients recently, I have frequently been asked about the potential economic impact of large US government budget deficits. Here is my answer.
Currently, the US budget deficit is expected to be about 5.8% of GDP in 2023, a high number given that the economy is growing while unemployment is low. The Congressional Budget Office (CBO) estimates that, under current law (no change in tax and spending policy), the deficit will gradually decline in the next few years, hitting 5% in 2027 and then start to increase in the years to follow. This assumes a modest rate of economic growth. However, current law includes the expiration of some parts of the 2018 tax law. If Congress extends these provisions, deficits are expected to be even bigger.
The expected rise in the deficit reflects higher costs of servicing the debt. In addition, it reflects the demographically driven rise in spending on entitlement programs for the elderly, especially Medicare. As a result of continued large deficits, the ratio of publicly held debt to GDP will likely rise above 115%, higher than the level reached at the end of World War Two.
Some observers are worried about the ability of the government to sell so much debt without experiencing a big increase in borrowing costs. Some also worry that the Federal Reserve may be compelled to monetize the debt, thereby creating ruinous inflation. We have seen these scenarios in other countries in the past (Venezuela, Zimbabwe, Argentina, Weimar Germany), but never in the United States. Two questions arise: First, is it reasonable to worry about this? Second, what can reasonably be done to lower deficits?
People worry about US deficits because they fear that it could become challenging to issue US$20 trillion in bonds in the next decade. They worry that US borrowing costs could surge, thereby stifling business investment and hurting economic growth. The experience of the UK earlier this year, when the government proposed big tax cuts amid large deficits, was a cautionary tale. It led to a surge in bond yields and a near seizing up of Britain’s bond market. It also led to a change of leadership in the government.
In contrast, a less alarmist view is that US Treasury bonds remain the world’s safest and most liquid asset. Moreover, the reserve status of the US dollar, which will not likely change soon, provides an advantage to the US Treasury that other governments lack. Plus, the experience of Japan, which has much more debt as a share of GDP than the United States but still low borrowing costs, suggests that there remains plenty of room for the United States to borrow. The bottom line is that we don’t know how much the US government can borrow before a crisis sets in. Already, amid upwardly revised predictions of future deficits, we have seen a decline in bond yields. Thus, expectations of future deficits have yet to alarm bond traders.
As to the question about how to cut deficits, this is more a political than an economic problem. Reducing future budget deficits can be done but should be done gradually so as not to damage economic growth. It could involve higher taxes, reduced spending, a higher retirement age for pensioners, or more immigration—or some combination thereof. Yet the political debate is highly restricted. Democrats call for higher taxes on upper income households. Republicans call for deep cuts in nondefense discretionary spending. Neither is a recipe for successful reduction of long-term deficits.
As for spending, nondefense discretionary spending is a small share of what the government does. The government also funds national defense, interest on the debt, and most important of all: entitlements. The latter are simply spending categories not directly allocated by Congress. Rather, spending is based on the number of people who are legally entitled to certain government benefits—largely related to health care. Entitlements have grown rapidly, and are expected to grow, because of the aging of the population. It addition, the likely decline in the working-age population, which funds entitlements, will make it more difficult to generate the funds needed to service entitlement programs. Failure to address entitlements makes it nearly impossible to cut future deficits.
Regarding health care, costs have stopped rising as a share of GDP, possibly due to improvements in the productivity of health care delivery. If this trend continues, it could help to reduce future budget deficits, thereby reducing the political challenge of addressing the issue. Still, the recent dysfunctionality of the US Congress does not bode well for taking necessary steps to reduce future deficits.
US job market shows strength
- The job market in the United States remained strong in November according to the latest employment reports from the government. While job growth is slower than in the first half of this year, it accelerated in November from the previous month and is at a rate faster than the long-term ability of the economy to generate jobs. In a sense, the job market is returning to normal after a period of extraordinary postpandemic recovery. What might surprise many people is that, at least so far, the job market has not exhibited the characteristics of an economic downturn. For the past year, this was widely expected. It might still happen, but for now it is not evident in the data.
Here are the details: The US government releases two reports on the job market. One is based on a survey of establishments; the other is based on a survey of households. The establishment survey found that 199,000 new jobs were created in November, up from growth of 150,000 jobs in October.
Employment in manufacturing was up 28,000, largely reflecting the return of striking automotive workers. Indeed, automotive employment was up 30,000. In addition, employment in the motion picture industry was up 17,200, also reflecting the return of striking workers.
On the other hand, employment in the retailing industry fell 38,000 in November. This included a 19,000 drop for department stores. The government adjusts the data based on seasonal patterns. Normally in the past, retail employment surged in November due to the need for workers to serve holiday shoppers. Yet this year, it is likely that retailers did not boost employment substantially, partly due to the recent sharp rise in online shopping. This then leads to a drop in the seasonally adjusted level of employment.
Also, employment in health care and social assistance was up 93,200, accounting for almost half of employment growth. Plus, employment in leisure and hospitality was up 40,000. Finally, government employment was up 49,000, entirely due to state and local governments. Employment in government has finally returned to the prepandemic level.
In addition, the government reported that average hourly earnings of US workers were up 4% in November from a year earlier, the same as in October. This was the lowest level since early 2021. Thus, wage inflation is gradually easing as the labor market gradually weakens. Still, wage growth remains far faster than the Federal Reserve’s target of 2% inflation.
Finally, the separate survey of households indicated considerable strength in the job market. The report said that the working-age population grew 180,000 in November while the labor force grew 532,000. In addition, employment grew 747,000 while unemployment fell 215,000. The result was that the unemployment rate fell from 3.9% in October to 3.7% in November. The youth unemployment rate fell especially sharply.
Overall, this was a favorable report indicating continued modest economic growth. It indicates that the economy is neither overheating nor contracting. The data remains consistent with a soft-landing story.
US interest rate expectations and the labor market
- US Federal Reserve Chair Powell has said that it is “premature” to start talking about cutting policy interest rates. Yet investors evidently disagree. Current prices of interest rate future imply that the Fed will cut the benchmark interest rate by 125 basis points in 2024. That would put the Federal Funds rate between 4% and 4.25% by the end of 2024. It would likely entail five 25-basis-point cuts through the course of the year. That would leave the key interest rate well below the level implied by the latest dot plot issued by the members of the Federal Open Market Committee (FOMC) of the Federal Reserve. Thus, there is a divergence between expectations of investors about Fed policy and the leaders of the Fed itself.
Investor expectations about Fed policy have shifted not because of anything the Fed leadership has said. Rather, it reflects the belief that the Fed will change its stance in response to changing data. Specifically, inflation has fallen faster than previously anticipated while the economy is clearly decelerating. These factors point to less need for tight monetary policy. In addition, the investor expectation of a quicker easing of monetary policy is likely related to a perception of increased risk of recession. Investors likely believe that, if there is evidence that a recession has begun, the Fed will act quickly to ease policy.
- Regardless of what the Federal Reserve intends to do going forward, it is increasingly clear that what it has already done is having an impact on the labor market. That is, evidence points to a weakening of the US job market. Recently, the government released the Job Openings and Labor Turnover Survey, known as JOLTS. It showed that, in October, there was a decline in the job openings rate. This is the share of available jobs that go unfilled because employers are unable to find people to fill them.
To put things in context, the job openings rate hit 4.4% in February 2020, just prior to the pandemic. It initially fell to 3.5% when the economy cratered early in the pandemic. With a strong recovery and a shortage of labor, the openings rate then leapt to a record high of 7.4% in March 2022. However, with the Federal Reserve tightening monetary policy, the job market weakened. The openings rate gradually fell, hitting 5.3% in October. This was the lowest rate since February 2021.
Despite the sharp decline in the job openings rate in the past year, it remains historically high. In fact, excluding the period immediately following the pandemic, the current job openings rate is the highest on record. Thus, even though the job market has weakened due to Fed tightening, it remains historically tight. From the perspective of the Fed, a continued tight monetary policy will be needed to further weaken the job market and thereby reduce wage pressure. Only then can inflation be brought to the target level of 2%.
Meanwhile, it is interesting to see what is happening to the job markets of various sectors of the economy. In October, the highest job openings rate was in our own professional and business services sector at 7.1%, down from 7.7% a year earlier, but up from 6.7% in September. Other industries with high job openings rates are accommodation and food services (6.8%), health care (6.4%), and transportation/warehousing/utilities (6.1%). Industries with low job openings rates include wholesale trade (3.3%), retail trade (3.4%), and finance/insurance (3.9%).
The self-correcting nature of the bond market
- The economy has self-correcting mechanisms that help to stabilize activity. That is, when the economy weakens, investors expect lower credit demand, leading to lower borrowing costs. This, in turn, boosts credit demand. That is what is happening now. In the United States and Europe, bond yields have declined sharply lately, in part a reflection of expectations of weak demand. In addition, the decline in bond yields reflects changing expectations of inflation and of central bank policy toward inflation, both related to weaker demand.
First, the yield on the US government’s 10-year bond has fallen from a recent peak of 5% on October 19 to 4.18% as of this writing. The yield on Germany’s 10-year bond fell from a high of 2.96% on September 28 to 2.24% as of this writing. In both cases, this partly reflects a decline in inflation and a decline in expectations of inflation.
In the United States, the breakeven rate for the 10-year bond, which measures bond investor expectations of average inflation over the next 10 years, fell from a high of 2.49% on October 19 to 2.17% as of this writing. Thus, the decline in inflation expectations contributed 32-basis-point to the 82-basis-point decline in the 10-year bond yield.
The drop in expectations of inflation were likely influenced by declining oil prices. Indeed, the price of West Texas Intermediate (WTI) crude oil fell from US$93.67 on September 27 to US$70.95 as of this writing. Lower oil prices imply lower inflation. Plus, lower oil prices reflect weakening demand in the economy, which bodes well for lower inflation. And, importantly, lower expectations of inflation imply that the Federal Reserve will loosen monetary policy sooner rather than later. That is, investors expect lower short-term rates. Long-term rates are, in theory, a reflection of expectations of future short-term rates. Thus, expectations of monetary easing imply lower bond yields.
On balance, all this is good. That is, the economy is engaging in a self-correction mechanism whereby a weaker economy is leading to lower borrowing costs, thereby potentially helping to avert a sharp decline in activity and setting the stage for recovery.
Interest rate expectations in the Eurozone
- Pessimism about Eurozone growth prospects has convinced many investors that the European Central Bank (ECB) will cut interest rates sooner than the ECB leadership is letting on. We know this from looking at pricing in the futures market. Traders are betting that the first interest rate cut will come by March 2024. In addition, they are pricing in 150-basis-point cuts by the end of 2024. The benchmark rate is now 4%. This suggests a rate of 2.5% by early 2025.
What explains the expectations of traders? First, inflation has come down rapidly and is now lower than in the United States. Moreover, with energy prices on a downward trajectory, there is reason to expect even lower inflation in the months to come. Second, indicators of real economic activity in Europe have demonstrated weakness. Finally, the most hawkish member of the ECB, Isabel Shnabel of Germany, recently said that further rate hikes are unlikely given how rapidly inflation has declined.
Investors are more aggressive in their expectations for the ECB than is the case in the United States. There, investors are expecting the first rate cut to come in May. They also expect 125-basis-point cuts in 2024. The relative pessimism about Europe likely reflects an expectation that Europe is more likely to experience recession than the United States.
If, by the second half of 2024, Europe and the United States are experiencing steady rate cuts, this will likely boost the willingness of businesses to invest and to engage in transactions. It could set the stage for a relatively robust recovery in 2025. Still, the principal leaders of the ECB and the Fed have not spoken in a way that justifies current expectations.
Week of December 4, 2023
Capital flows out of China
- China has strict capital controls, which makes it challenging for people to transfer wealth outside the country. Such controls are meant to enable the central bank to stabilize the value of the currency without having to resort to massive currency market intervention. Yet, controls inhibit China’s ability to make its currency a global vehicle for trade and asset holding. Still, capital controls haven’t stopped people from moving large amounts of money out of China. It is reported that wealthy Chinese have moved hundreds of billions of dollars out of China. They have purchased foreign apartments, equities, and insurance properties. They have become the principal buyers of expensive apartments in Tokyo. London and New York are also popular destinations.
Why is this happening? And what is the economic impact? There are several possible reasons for this. First, US interest rates have risen sharply, boosting the attractiveness of dollar-denominated bonds and other instruments. Second, the principal form of wealth in China is residential property, and property prices have declined. Moreover, there is uncertainty about the future direction of property prices given the troubled nature of the market. Thus, foreign property has become more popular. Third, there is likely concern about the future direction of economic policy, especially given the government’s shift toward support for the state sector at the expense of the private sector. Finally, people might be worried about the troubled relationship China has with the West and its impact on China’s future prosperity.
The movement of money, estimated at roughly US$50 billion per month recently, likely puts downward pressure on the value of the renminbi, thereby requiring the central bank to purchase renminbi to stabilize the exchange rate. In so doing, the central bank is withdrawing liquidity from the financial system. It is essentially a tightening of monetary policy. This is not welcome at a time of low inflation and slow economic growth. While most experts say that the current flow of money is manageable, the risk is that an acceleration in outflows could destabilize the currency and the financial system, similar to what has happened in the past in unstable emerging markets.
Meanwhile, it is not only affluent Chinese who are causing an outflow. Global companies are also contributing to the flow. Specifically, there has been a sharp slowdown in inbound foreign direct investment (FDI) into China. In addition, outflows of FDI have increased, especially as foreign companies repatriate their local earnings. The result is that, for the first time in decades, there is a net outflow of FDI. This, too, puts downward pressure on the value of the currency. In addition, it deprives China of investments that bring new technologies and expertise into the country. In the longer term, less inbound FDI will mean less sophisticated investment and less trade between China and the rest of the world. Foreign investment often provides the basis for trade.
The slowdown in FDI inflows and the accelerated outflows are likely due to several factors. First, troubled relations between China and some of the Western governments have caused some global companies to be more cautious about investing in China. Second, as Nicholas Lardy of the Peterson Institute has written, “Beijing’s closure of foreign consultancy and due diligence firms that are critical to foreign firms’ evaluation of potential new investments and its increasingly stringent regulatory environment, including a new national security law and restrictions on cross-border data flows, have led foreign firms to reduce their direct investment or even to disinvest from their existing direct investments.” Meanwhile, the government has indicated a desire to encourage more inbound investment.
China encourages private sector investment
- Given that private sector investment in China has slowed down, the People’s Bank of China (PBOC), which is the country’s central bank, is encouraging commercial banks to boost lending to the private sector. Specifically, the PBOC and other regulators asked banks to set annual lending targets. In addition, the regulators established 25 measures meant to boost lending to the private sector.
The biggest source of trouble in private sector investment is the property sector. Investment into technology continues to grow. Thus, the PBOC said that banks should “reasonably meet the financial needs of private real estate enterprises.” It is reported that the Chinese government is establishing a list of property developers that will be eligible for government support.
Still, there is a larger problem beyond property. It is the perception that the government favors state enterprises at the expense of private sector players. It is not clear if more willingness to lend to private sector companies will offset the worries that private sector companies have about the potential return on investments, especially at a time of relatively weak economic growth and troubled global relations.
China encourages retention of global supply chains
- There has been plenty written about changing global supply chains, with some global companies reducing exposure to China, inbound investment into China decelerating, and Southeast Asia becoming an increasing focal point for supply chain investment. Premier Li Qiang said that China wants to attract global companies and wants them to invest in supply chains in China.
Specifically, Li said that “we are willing to build closer production and industrial supply chain partnerships with all countries.” In addition, he warned against protectionism and said that China wants an international business environment characterized by adherence to the rule of law. Li’s comments were made at the opening of the China International Supply Chain Expo in Beijing. It is meant to highlight the opportunity available to global companies. In fact, of 550 exhibitors, 130 are foreign-based companies.
It is evident that several conflicting trends are taking place. On the one hand, China wants foreign investors and growing trade. On the other hand, the government wants greater control over data and wants to influence the direction of the market economy. On the one hand, global companies want to benefit from China’s huge market as well as its manufacturing prowess and strong technology base. On the other hand, some Western governments want to restrict China’s access to technology and capital. How these divergent trends will evolve is hard to say. In the interim, the uncertainty is making many investors nervous and could explain the exodus of some foreign capital from China.
Eurozone inflation continues to recede
- The European Union (EU) published inflation data for the entire 20-member Eurozone recently. It brought especially good news and raises questions about the future policy direction of the European Central Bank (ECB).
Here are the details: Consumer prices in the Eurozone were up 2.4% in November versus a year earlier, the lowest rate of inflation since July 2021. Recall that inflation had peaked in 2022 at 10.6%. Prices fell 0.5% from the previous month. Inflation was substantially suppressed by a sharp decline in energy prices, which fell 11.5% from a year earlier and fell 2.2% from the previous month. When volatile food and energy prices are excluded, core prices were up 3.6% from a year earlier but down 0.6% from the previous month. The annual rate of core inflation was the lowest since April 2022.
Prices of nonenergy industrial goods were up 2.9% while prices of services were up 4%. As such, although inflation has fallen sharply, underlying inflation remains significantly higher than the ECB’s 2% target.
By country, there were disparities. Annual inflation was 2.3% in Germany, 3.8% in France, 0.7% in Italy, 3.2% in Spain, 1.4% in the Netherlands, –0.7% in Belgium, 2.3% in Ireland, 3% in Greece, 2.3% in Portugal, and 0.8% in Finland. Notably, in 16 of the 20 Eurozone countries, consumer prices fell from October to November, mainly due to the sharp decline in energy prices.
Regarding Germany, the largest economy in the Eurozone, consumer prices were up only 2.3% in November versus a year earlier. This was the lowest rate since June 2021 and down sharply from 6.4% as recently as August. German inflation had peaked at 11.6% in October 2022. Consumer prices were down 0.7% from the previous month.
German inflation was down in all major categories, suggesting that underlying inflation is becoming less onerous. Core inflation (excluding the impact of volatile food and energy prices) was 3.8% in November, down from 4.3% in October. Energy prices were down 4.5% while food prices were up 5.5%. Service prices were up only 3.4% in November from a year earlier, down from 3.9% in the previous month.
German bond yields fell sharply on the inflation news, with the yield on the 10-year bond hitting 2.43%, the lowest since July 2023. Many investors interpreted the inflation data as signaling a greater likelihood that the ECB will hold rates steady and cut them sooner rather than later.
The favorable inflation data led investors to push down the value of the euro on expectations that the ECB could cut rates sooner than previously expected and sooner than the US Federal Reserve. On the other hand, ECB President Christine Lagarde said earlier this week that now is “not the time to start declaring victory.” She expressed concern about rapid increases in wages that are not yet being offset by accelerating productivity. This suggests that getting underlying inflation from 4% to 2% could be challenging and may require a weaker labor market. Indeed, the OECD recently predicted that the ECB will not start cutting interest rates until 2025.
In the United States, consumers continue to spend while inflation recedes
- In October, consumer spending in the United States decelerated but continued to grow. After having grown rapidly in the third quarter, a moderate deceleration is welcome. From the perspective of the US Federal Reserve, the optimal situation is for the US economy to grow more slowly while inflation comes down. That appears to be happening. Indeed, the Fed’s favorite measure of inflation also decelerated in October, including core inflation. Let’s look at the details.
Last week, the US government reported that, in October, real (inflation-adjusted) disposable personal income (which excludes taxes) increased 0.3% from September. In addition, real personal consumption expenditures increased 0.2% during the same period. The personal savings rate increased slightly from 3.7% in September to 3.8% in October.
Real spending on durable goods fell 0.3%, nondurables increased 0.3%, and spending on services increased 0.2%. These numbers suggest moderate growth of consumer spending.
Also, the government reported on the Fed’s favorite measure of inflation: the personal consumption expenditures deflator, or PCE-deflator. It was up 3% in October from a year earlier and unchanged from the previous month. When volatile food and energy prices are excluded, core prices were up 3.5% from a year earlier, the lowest since April 2021. Prices of durable goods were down 2.2% while prices of nondurables were up 1.6%. Prices of services were up 4.4%.
Overall, today’s report offered welcome news. The consumer sector slowed but continued to grow, underlying inflation declined, and real income continued to rise—albeit more slowly. This data probably increases the likelihood that the Federal Reserve will continue to hold rates rather than raise them. If inflation continues to fall and the economy softens, then the Fed will likely be in a position to ease monetary policy sometime in 2024.
Bond yields signal view that central banks are done raising rates
- In the United States, bond yields continue to decline. The yield on the Treasury’s 10-year bond fell below 4.3% recently, the lowest level since mid-September and down sharply from the peak of 5% reached in mid-October. The decline since then reflects increasing confidence on the part of many investors that the Federal Reserve is finished raising interest rates and may cut them sooner than previously anticipated. Indeed, one of the most hawkish governors of the Federal Reserve, Christopher Waller, said that “I am increasingly confident that policy is currently well positioned to slow the economy and get inflation back to [the Fed’s target of] 2 per cent. If we see disinflation continuing for several more months—I don’t know how long that might be, three months, four months, five months—you could then start lowering the policy rate just because inflation’s lower.”
Waller’s confidence that the economy will slow down came on the same day that the government upwardly revised its estimate of third-quarter GDP growth. Previously, the government reported that real GDP grew at an annualized rate of 4.9% in the third quarter. Now it reports that growth was 5.2%. Yet many investors evidently believe that this will not be repeated and that the economy will slow down. October data on retail sales and job growth confirms a likely slowdown.
Meanwhile, the drop in bond yields has caused a drop in the value of the US dollar (a rise in the value of other major currencies). Specifically, as of this writing, the euro is just under US$1.10, the highest level since mid-August. The euro had bottomed at US$1.046 in early October and has been rising ever since. For the United States, a rising currency is disinflationary. For Europe and Japan, a declining currency will ultimately boost export competitiveness, although it could also boost inflation. For US companies doing business globally, a declining dollar will boost dollar-denominated earnings.
Also, the OECD recently released its latest economic prognostications. It expects global economic growth, including that of the United States, to decelerate in 2024 and that inflation will continue to decline. It expects the US Federal Reserve to cut interest rates in the second half of 2024, although it expects the ECB and the Bank of England to hold rates until 2025. It expects the Bank of Canada to start cutting rates at the same time as the United States. It urged central banks not to loosen policy too soon.
Finally, given that many investors are increasingly confident that the US Federal Reserve, the ECB, and other major central banks will not raise interest rates any further, they are starting to pile into riskier assets as evidenced by rising equity prices. In fact, in November, global equities rose faster than in any month since November 2020 when prices rose on news of a breakthrough in developing a COVID-19 vaccine.
Equity prices tend to be anticipatory. That is, they are based on expectations about future profits and future borrowing costs. The rise in equities reflects a view that interest rates will come down soon. It also reflects a view that, although the global economy might weaken further in 2024, that will be the turning point before the ultimate recovery. As such, investors likely see profit growth coming soon.