Weekly global economic update

Week of January 29, 2024

• Red Sea shipping disruption could affect European economy
• Latest data suggests US economy headed for a soft landing
• China’s central bank eases monetary policy

• The situation in the Red Sea continues to disrupt global trade and a great deal of trade has been diverted and is now traveling around the Cape of Good Hope in South Africa. This has led to significantly higher shipping costs as well as delays and inefficiency in supply chains.

Diversion of ships, especially in the automotive industry, adds to the time it takes to deliver goods. This, in turn, is reducing the volume that can be shipped, especially because there is a tight supply of ships. Given strong demand for Asian vehicles in Europe, the result could be higher vehicle prices. European inflation could be modestly stoked by this crisis.  

The crisis in the Red Sea, according to Refinitiv data, is affecting oil trade, but so far not oil prices. Despite disruption, oil prices have been relatively stable, likely reflecting the continued excess supply in the market. Still, normally 12% of the world’s trade travels through the Red Sea and the Suez Canal. That includes 5% of crude oil, 10% of oil products, and 8% of liquid natural gas (LNG). Now, the number of oil tankers moving through the Red Sea is down by 50%.

Meanwhile, Russia and Saudi Arabia are experiencing the Red Sea crisis differently from one another. As per Refinitiv data, for Russia, the economy has managed to stay afloat despite Western sanctions because of the ability to sell oil to India and China, much of which goes through the Suez Canal. Until the current crisis, 75% of the oil traveling southbound through the Suez Canal was coming from Russia and headed toward Asia. Since the war in Ukraine began, China has purchased 63 billion euros of Russian oil while India has purchased 42 billion euros of oil. The crisis means that either Russian oil will take much longer to reach Asia, or it will be more expensive because of higher insurance costs. 

For Saudi Arabia, however, oil can be sent to India and China without going through the Suez Canal. This puts Saudi oil at an advantage. Since this crisis began, the volume of Russian oil headed to Asia has fallen while the volume of Saudi oil has risen. Although Saudi Arabia and Russia have cooperated in attempting to reduce global supply (in order to boost prices), the current situation makes them competitors and potentially creates tension between them. It could also cause more price competition, ultimately leading to downward pressure on the price of oil. Meanwhile, Iran (which supports the Houthi rebels) sells oil to China and does not require the use of the Suez Canal. Thus, the crisis is potentially beneficial to Iran. 

While the disruption of shipping in the Red Sea threatens to affect the economies of China and Europe, it is likely to be especially impactful for Egypt, which is home to the Suez Canal. Revenue from the canal represents 2% of Egyptian GDP and 15% of the country’s foreign exchange receipts. Moreover, before the Red Sea crisis began, the Ukraine war had led to an increase in Russian shipments of oil through the canal, thereby boosting Egyptian revenue. Thus, a 50% drop in canal traffic can have a severely negative impact on the Egyptian economy. 

Meanwhile, the Houthi rebels in Yemen that have attacked shipping in the Red Sea say that they will not attack Chinese or Russian ships, provided those ships have no links with Israel. In response, Chinese shipping companies are moving ships to the region, taking advantage of the opportunity to displace other shipping organizations. This is based on the assumption that they are not vulnerable to attack. Yet it is not clear that owners of cargo will feel comfortable shipping their goods through the Red Sea regardless of the flag flown by the ship. In fact, not all Chinese shippers are willing to go through the Red Sea. The largest Chinese shipper is diverting its ships around Africa. Some Chinese shippers going through the Red Sea are accompanied by the Chinese Navy. All are prominently displaying the Chinese flag, hopeful that the Houthi rebels will not mistake them for ships from other countries.  

Latest data suggests US economy headed for a soft landing

• In the long run, the rate at which economies grow depends on growth of employment and growth of the productivity of each worker. In most major industrial economies, labor force growth is relatively slow owing to the lagged effect of low birth rates. In the United States, unless there is a sudden acceleration in productivity, it is reasonable to expect modest GDP growth, around 1.5% per year in the years to come. Thus, it is stunning that, in 2023, real GDP grew 3.3%, according to the government’s latest data release. 

Moreover, recall that one year ago many pundits were predicting imminent US recession, expecting almost no GDP growth in 2023. They were clearly wrong. The US economy has demonstrated surprising resilience. Plus, growth continued at a strong pace in the fourth quarter of 2023, with real GDP rising at an annualized rate of 3.3% from the previous quarter. This was slower than the 4.9% growth in the third quarter. However, third-quarter growth was boosted by inventory accumulation. Thus, underlying growth was relatively steady from the third to the fourth quarter.

Also, the government reported that the personal consumption expenditure deflator, which is the Federal Reserve’s favored measure of inflation, increased at an annual rate of 1.7% from the third to the fourth quarter. This was the slowest pace since the second quarter of 2020. In other words, inflation was within the Fed’s target in the fourth quarter. The Fed will take this information into account in its deliberations. 

Let’s look at the details: In the fourth quarter, real GDP increased at an annualized rate of 3.3% from the third quarter. This included a 2.8% increase in real consumer spending. That, in turn, included growth of 4.6% for durable goods, 3.4% for nondurable goods, and 2.4% for services. Consumer spending was boosted by moderate employment growth, rising real wages, and favorable financial conditions. That is, debt service payments as a share of income remain historically low. That enabled consumers to borrow significantly. Real disposable personal income grew at a rate of 2.5%. Consumer spending grew faster, thus indicating a drop in savings (which could include an increase in debt). 

In addition, nonresidential investment continued to grow in the fourth quarter, rising at an annual rate of 1.9%. This is notable given the tightness of monetary policy. Ordinarily, high interest rates stifle business investment. That has not been the case in this cycle. The US government divides investment into three categories: equipment (machinery, computers, telecoms, transport), intellectual property (software, R&D), and structures (office buildings, shopping centers, factories). Investment was up 1% for equipment, 2.1% for intellectual property, and 3.2% for structures. The modest growth of investment in equipment is important. This category saw a decline in three of the last five quarters, reflecting weak purchases of information technology. That, in turn, likely affected the willingness of businesses to purchase consulting services. 

Real exports grew 6.3%, with particularly strong growth of service exports. Imports were up a modest 1.9%. Finally, overall real government purchases were up at a rate of 3.3%. This included 0.9% for national defense, 4.6% for nondefense Federal expenditures, and 3.7% for state and local government. 

Going forward, the US economy appears poised to continue growing. The job market remains tight, generating increases in real wages, while employment continues to rise. Interest rates have peaked while risk spreads are relatively low. Moreover, there is now an expectation that the Federal Reserve will cut interest rates this year. That expectation has already contributed to a decline in bond yields and a rise in equity prices. That expectation might stimulate more business investment. A soft landing seems likely. However, the lagged effect of the tight monetary policy will likely retard growth to some degree. Thus, real GDP will probably rise more slowly in 2024 than in 2023. 

• Meanwhile, the December numbers from the US government on personal income, consumer spending, and inflation also paint a picture of an economy heading toward a soft landing. The numbers indicate continued growth of income and spending as well as continued deceleration of underlying inflation. 

Most notable were the inflation numbers. Specifically, the government released data on the personal consumption expenditure deflator (PCE-deflator), which the Federal Reserve favors over the more popular consumer price index (CPI). The government says that the difference between the indices involves weighting, scope, and the overall formula. It says that the “CPI sources data from consumers, while PCE sources from businesses. The scope effect is a result of the different types of expenditures CPI and PCE track. For example, CPI only tracks out-of-pocket consumer medical expenditures, but PCE also tracks expenditures made for consumers, thus including employer contributions.”

In any event, the latest PCE-deflator was up 2.6% in December versus a year earlier, the same as in November and the lowest since February 2021. The index was up 0.2% from the previous month. When volatile food and energy prices are excluded, the core index was up 2.9% from a year earlier, the lowest since March 2021. The core index was up 0.2% from the previous month. 

Breaking down the PCE-deflator into components, the index for durable goods fell 2.3% from a year earlier and fell 0.4% from the previous month. Moreover, the durable goods index has fallen consistently both on a monthly and an annual basis for the past seven months. Thus, it appears that the prices of durable goods are returning to their prepandemic pattern. Prior to the pandemic, prices of durable goods often declined due to sizable productivity gains in the production of durables, especially technology such as computers and mobile telephones. During the pandemic, durable goods prices soared due to supply chain disruption and a dramatic increase in demand. Now, things are going back to normal.

Meanwhile, prices of nondurable goods were up 1.3% in December from a year earlier and down 0.1% from the previous month. Finally, prices of services were up 3.9% from a year earlier and up 0.3% from the previous month. 

The very favorable inflation numbers once again raise the question as to when the Federal Reserve will start to cut interest rates. Not only was core 12-month inflation 2.9% in December, but core six-month inflation at an annual rate was 1.9%. In other words, in the past six months, underlying inflation has been below the Fed’s 2% target. And, with inflation declining, the real (inflation-adjusted) short-term interest rate is rising. That, in turn, could have a negative impact on economic activity. Given this, for how long must the Fed retain a tight monetary policy? That is the key question.

The Fed’s justification for a tight policy has been the tightness of the job market. With wages rising at about 4% year over year, the Fed has been worried that it will be difficult to bring inflation down to 2%. However, the Fed has also noted that, if labor productivity increases, it would offset the impact of wage increases and allow inflation to decelerate. And that, in turn, would enable the Fed to cut rates sooner rather than later. In fact, a spike in productivity might be what is happening now. We will have to wait until the next productivity numbers are released before we can know. Meanwhile, as per Refinitiv data, the Fed has signaled an intention to cut interest rates in the second half of this year. Investors are now pricing in a rate cut in June.  

The government also released data on income and expenditures. Specifically, real (inflation-adjusted) disposable personal income (which is household income after taxes) was up 0.1% from the previous month. The personal savings rate declined from 4.1% in November to 3.7% in December. Consequently, spending increased faster than income. Real consumer spending was up 0.5% from the previous month. This included a 1.5% increase for durable goods, a 0.9% increase for nondurable goods, and a 0.3% increase for services. This indicates strong growth of consumer spending, albeit due to households reducing their savings. Thus, going forward, unless income growth accelerates, it seems likely that spending growth will decelerate.  

China’s central bank eases monetary policy

• China has seen a sharp decline in equity prices in the past two years. The market capitalization of Chinese equities has fallen by roughly US$6 trillion since 2021. And the cyclically adjusted price-earnings ratio (CAPE) for Chinese equities is only about one-third that of the United States. This is evidently of concern to the government. There are reports that the government is considering using funds from state-owned enterprises to purchase US$278 billion in equities. Plus, Refinitiv reported that regulators have asked hedge fund managers to restrict short selling in the equity futures market. In addition, it is reported that the government will tighten limits on capital outflows, thereby reducing the ability of equity sellers to place their money overseas. 

It is not clear, however, if these actions will be successful in boosting equity values. After all, if investors perceive the government action as indicative of economic trouble, then they might choose to sell. Although equity prices rose in response to the news that the government might purchase equities, past episodes of state purchasing have not been successful in significantly boosting valuations. Moreover, there might be better ways for the government to stabilize financial markets. In fact, recently, the People’s Bank of China (PBOC), the central bank, announced that the required reserve ratio (RRR) for commercial banks will be cut by 50 basis points, thereby unleashing US$140 billion in cash into the banking system. 

The cut to the RRR is the biggest in two years. In addition, the PBOC said that it will soon announce new policies regarding the market for commercial property loans. The PBOC is likely keen to stabilize the troubled property market. The cut in the RRR is a type of easing of monetary policy. It follows two 25-basis-point cuts in 2023. However, easing monetary policy might not be sufficient to stimulate a recovery in economic activity. Some analysts have suggested that China is in a “liquidity trap” in which potential borrowers are not responsive to lower interest rates because of a predilection to hold cash. That, in turn, might reflect a lack of confidence in the economic future. Some analysts suggest fiscal stimulus as an alternative. If targeted toward households, fiscal stimulus could boost domestic demand, thereby reversing deflation and easing excess capacity. 

Meanwhile, PBOC Governor Pan Gongsheng said that the goal of the policy adjustment is to “create a good monetary and financial environment for the economy.” The PBOC has been reluctant to aggressively ease monetary policy for fear that it will create downward pressure on the value of the currency. However, Pan noted that if, as expected, the US Federal Reserve starts to cut rates this year, then easing Chinese monetary policy will not have an onerous impact on the currency. The PBOC did not suggest cutting major interest rates. Doing so would likely have a positive impact on equity prices.

Week of January 22, 2024

• Investors re-evaluate expectations for monetary policy
• Deflation in China continues while the population shrinks
• In Japan, inflation decelerates while retail sales decline

Investors re-evaluate expectations for monetary policy

• In recent months, there was a growing expectation that central banks will soon start to loosen monetary policy, especially given that inflation has receded more quickly than anticipated. Yet in recent days, expectations have begun to shift. First, there is a view that, although inflation has come down sharply, it is getting stuck at a level that remains too high. This has to do, in part, with continued tightness in labor markets in the United States and Europe. Second, economies have shown greater resilience than expected, especially the United States, which bodes poorly for further reductions in inflation. Finally, central-bank leaders have gone out of their way to quell expectations of imminent monetary easing. For these reasons, many investors are starting to have second thoughts about the future direction of interest rates.

Regarding central bankers, Christine Lagarde, president of the European Central Bank (ECB), said recently that interest rates in the Eurozone will likely come down in the summer rather than the spring. Until lately, many investors expected rates to be cut in the spring. Lagarde said that such expectations are “not helping” to fight inflation, and that future interest rate decisions will depend, in part, on what happens in labor markets. Of particular concern is wage behavior and the possibility that big wage gains could help to sustain high inflation. Although she acknowledged that the ECB is likely done raising rates, she said that “we have to stay restrictive for as long as necessary.” In response to her comments, equity prices in Europe and the United States fell sharply. In addition, bond yields increased. 

At Davos, the governor of the Bank of France, who serves on the ECB policy committee, said that “it’s too soon to declare victory. The job is not yet done.” Also, the head of Finland’s central bank, a member of the policy committee, said that “it’s better to wait a bit longer than do a premature exit from this restrictive level, and then perhaps having to do a reversal.” The head of Germany’s central bank suggested that markets are “over-optimistic.” He added that it was better to wait until the summer to decide whether to cut rates.

Adding to the conversation, Gita Gopinath, deputy managing director of the International Monetary Fund, said that inflation will likely recede less rapidly in 2024 than it did in 2023. She said that, as a result, central bankers ought not cut rates too quickly. She specifically added that “the job is not done. Once you cut rates, it solidifies expectations of further rate cuts and you could end up with much larger loosening, which can be counterproductive.” She concluded that, based on the data, rates are likely to be cut in the second half of this year, not the first half. 

• A year ago in the United States, many pundits expected that a new era of permanently high inflation was upon us. Instead, inflation fell quite quickly. The result is that, today, many pundits expect inflation to decline further, hitting the 2% target fairly soon. They also expect that, as a result, the Federal Reserve will likely cut rates sooner than their leaders are indicating. On the other hand, the Fed itself is attempting to calm investor enthusiasm, suggesting that the final mile of inflation reduction could be difficult. Thus, a debate is under way. 

Rafael Bostic, president of the Federal Reserve Bank of Atlanta and a member of the Fed’s policy committee, said that he expects much slower progress in reducing inflation going forward. He added that “it would be a bad outcome if we started to ease, and inflation started to rise up and down like a see-saw. That would undermine people’s confidence in where the economy is going.” 

Essentially, the decline in the headline inflation rate from 9.1% in mid-2022 to 3.4% in December 2023 was relatively easy. It was largely due to a shift in consumer spending away from goods, an easing of supply chain disruption, and a sharp decline in energy prices. Moving beyond the current level, however, might be difficult given the continued tightness of the job market and the consequent rise in wages.

There are other reasons to be concerned about the path of inflation. First, headline inflation accelerated in December. Although core inflation (which excludes energy and food prices) continued to fall in December, it fell less than analysts had expected. Second, the economy appears to remain strong, with continued growth of employment and consumer spending. Plus, measures of consumer and business confidence are rising. These factors don’t seem to offer confidence that inflation will fall. Finally, events in the Middle East, including the disruption of shipping in the Red Sea, suggest the possibility of new inflationary pressure. A potential wider war would boost oil prices, generating higher inflation. Plus, the disruption of shipping has already caused a rise in shipping costs, which will ultimately be passed onto consumers. 

Despite reasons for pessimism about inflation, and despite comments by Fed leaders suggesting a preference for waiting longer to cut rates, investors still appear confident that rates will come down quickly. Surveys show that a substantial majority of investors polled expect significant rate cuts in 2024. Is this the “irrational exuberance” about which Alan Greenspan once commented? Or is this based on an expectation that inflation will decline quickly while the economy weakens, thereby creating the conditions for the Fed to start loosening monetary policy sooner rather than later? Time will tell. 

• Meanwhile, it is increasingly evident that high existing interest rates are taking a toll. Moody’s, the bond rating agency, said that defaults on corporate bonds are increasing sharply. Specifically, Moody’s reported that, in December, there were 20 large corporate defaults, up from just four in November. The 12-month trailing default rate in December was 4.8%, the highest since May 2021 when the pandemic was hurting many service-related businesses. Moody’s said that the rise in defaults is due to higher borrowing costs and tighter lending conditions. It warned that expectations of declining interest rates could lead to dangerous complacency on the part of borrowers.   

Moody’s noted that more than half the defaults in December were in the United States with an additional eight in Europe. It said that the sectors worst hit were business services and health care. In 2024, it expects these two sectors as well as high tech companies to be at most risk of default. Separately, S&P expects consumer industries and media and entertainment companies to be at risk. Interestingly, however, risk spreads remain historically low—especially the spread between yields on junk bonds and government bonds. Evidently, many investors remain confident that things will improve. 

Deflation in China continues while the population shrinks

• With the exception of the COVID-19–related slowdowns in 2020 and 2022, China’s economic growth in 2023 was the slowest since 1990. Real GDP grew 5.2% from 2022 to 2023. This number was boosted by the base effect of very weak growth in 2022, which was due to pandemic-related lockdowns. Meanwhile, the government reported that, in the fourth quarter of 2023, real GDP was up 5.2% from a year earlier and was up 1% from the previous quarter. 

The weakness of growth in 2023 was due to several factors. These included the lingering effect of the crisis in the residential property market, weak private sector investment, modest consumer spending growth due to large accumulation of household savings, and declining exports due to a weak global economy. On the other hand, strong government support for key industries led to a sharp acceleration in industrial production. In fact, economic growth in the fourth quarter was the second fastest since the second quarter of 2021. 

Still, there remain significant headwinds, suggesting that growth in 2024 will likely be slower than in 2023. These include continuing problems in the residential property market, weak external and internal demand, only modest government stimulus, a declining working-age population, and evidence of increased migration from urban to rural areas. The result of this is deflation, which likely create new economic challenges. Deflation boosts the real value of debts, making it more difficult to service. Plus, deflation boosts the real cost of borrowing, thereby stifling credit market activity. The solution to deflation is more monetary stimulus. Yet the central bank appears hesitant to do this lest it cause a sharp decline in the value of the currency. 

Meanwhile, in addition to the release of GDP numbers, the Chinese government released other important indicators. In December, retail sales grew 7.4% from a year earlier, down from 10.1% in November and the slowest growth since September. Retail sales of automobiles was especially weak, up only 4% in December versus a year earlier compared to growth of 14.7% in November. Some categories saw a decline in sales. These included personal care (down 5.9%), home appliances (down 0.1%), and building materials (down 7.5%). The latter two categories were likely influenced by weak demand for housing. On the other hand, sales of clothing were up 26%. For all of 2023, retail sales were up 7.2% from the previous year. 

The government also reported that fixed asset investment was up only 3% from 2022 to 2023. Aside from the sharp decline at the start of the pandemic, this was the slowest growth of investment since records began in the 1990s. The principal culprit was the sharp decline in property investment, down 9.6%. Overall investment by the private sector was down 0.4%, offset by stronger growth of investment in the state sector. 

Overall, household and government consumption contributed 4.3 percentage points to GDP growth, while investment contributed 1.5 percentage points. These were offset by net exports, which contributed –0.6 percentage points. The latter was due to a 4.6% decline in exports and a 5.5% decline in imports. 

On the positive side, industrial production accelerated in December, rising 6.8% from a year earlier. This was the fastest growth since early 2022. Rising industrial production was driven by manufacturing, up 7.1% from a year earlier. By industry, there were strong increases in output for nonferrous metals (up 12.9%), chemicals (up 11%), computers and communications (up 9.6%), and automobiles (up 20%). For all of 2023, industrial production was up a more modest 4.6% from 2022. One can infer that the strength of industrial production was related to state-sector investment, especially in sectors that the government is promoting, such as automobiles.

• One of the obstacles to strong economic growth in China is a declining population. The government reports that, in 2023, China’s population declined for the second consecutive year. The population fell by an estimated two million. In part, this was due to a 5.6% decline in live births, which hit 9.02 million in 2023, the lowest number since records began in 1949. Meanwhile, the death rate hit a half-century high, largely due to the lagged impact of the pandemic. 

For much of China’s reform era, strong economic growth was fueled, in part, by a so-called demographic dividend in which the working-age population grew rapidly. In recent years, that trend has reversed. Although the government eliminated the one-child policy a decade ago, birth rates continue to decline as many couples delay childbirth and choose to have just one child. 

The best way to offset a declining working-age population is to boost productivity growth. The government is investing heavily in robots and automation, with the hope that this will enable economic growth to stabilize at a satisfactory level. In fact, in 2022, China was responsible for half of the robot installations in the world. It ranked fifth in robot intensity after South Korea, Singapore, Germany, and Japan. Yet persistent productivity growth requires constant innovation, something that might be limited if the private sector is not investing heavily.

In Japan, inflation decelerates while retail sales decline

• In 2023, inflation in Japan accelerated to the highest level since 1982. This led to expectations that the Bank of Japan (BOJ) would tighten monetary policy after a prolonged period of very low interest rates. It did not happen. Instead, inflation has been decelerating in the past half year and continued to decelerate in December. Meanwhile, the BOJ held steady. The government has three major measures of inflation: headline inflation, core inflation (excluding fresh foods), and core-core inflation (excluding food and energy). All three decelerated in December, indicating that progress in reducing inflation happened without the BOJ shifting policy. 

The BOJ long held that inflation was due to tight supply, rather than excess demand and, consequently, a tightening of monetary policy would not be effective in reducing inflation. Instead, the BOJ expected that supply disruption would end, thereby enabling a reduction in inflation. It appears that this is what happened. 

Here are the numbers: In December, consumer prices were up 2.6% from a year earlier, down from 2.8% in November and the lowest inflation rates since July 2022. Core prices were up 2.3% from a year earlier, down from 2.5% in November and the lowest level since June 2022. Finally, core-core prices were up 3.7% in December from a year earlier, down from 3.8% in November and down from a peak of 4.3% in August. The December reading was the lowest rate of core-core inflation since early 2021.

Unlike in the United States and Europe, where real wages are rising, Japan faces continued reductions in real wages. That is, wages are rising slower than inflation. This means that the job market is not contributing to inflation. Thus, unlike the central banks in the United States and Europe, the BOJ needn’t implement a tight monetary policy to fight the effects of a tight labor market. On the other hand, the Japanese government is keen to boost wages in order to stimulate consumer spending. Weak consumer spending growth, combined with weak exports, is likely discouraging businesses from investing. The result is slow economic growth.

Week of January 15, 2024

• US inflation accelerates, but core inflation declines
• Eurozone retail sales stagnate but job market remains tight
• China continues to contend with deflation and falling exports
• Electric vehicles fuel Chinese exports

• The US Federal Reserve intends to ease monetary policy sometime this year. Yet the timing will depend, in part, on how quickly inflation recedes. Thus, the latest report that headline inflation accelerated in December might cause the Fed to postpone monetary policy easing. On the other hand, core inflation continued to decelerate, suggesting that the underlying trend is favorable. Let’s look at the data.

In December, the US consumer price index was up 3.4% from a year earlier. This was higher than the 3.1% clocked in November and was the highest annual rate of headline inflation in three months. In addition, prices were up 0.3% from the previous month, the highest monthly rise in three months. However, when volatile food and energy prices are excluded, a different picture emerges. Core prices were up 3.9% in December from a year earlier, down from 4% in the previous month. Moreover, this was the lowest rate of core inflation since May 2021. Core prices were up 0.3% from the previous month.

The biggest source of inflation was shelter, with prices up 6.2%. Shelter accounts for about 35% of the consumer price index. If shelter is excluded, prices were up a very modest 1.9% in December versus a year earlier. Moreover, there is reason to expect that shelter price inflation will likely abate in the coming year. The shelter component of the CPI is influenced by house prices with a lag. In the past year, house prices in the United States have been relatively stagnant. In the months to come, this will feed into the shelter component of the CPI, potentially helping to bring down inflation.

Meanwhile, prices of durable goods continued to decline, falling 1.2% in December versus a year earlier. Prices of nondurable goods were up 1.8%, but largely due to rising food prices (which were up 2.7%). When food is excluded, prices of nondurables were up only 0.8%. Finally, prices of services were up 5%, led by shelter. When shelter is excluded, service prices were up a more modest 3.4%. 

Producing services tend to be more labor-intensive than producing goods, which might explain the higher inflation, especially given that wages continue to rise rapidly. Indeed, this is the main concern on the part of the Fed. It worries that, with wages rising more than 4% on an annual basis, reducing inflation to the 2% target could be difficult. That is why the Fed intends to keep interest rates high for several more months. The goal is to further weaken the labor market, thereby reducing wage pressure. Indeed, the labor market has weakened, with the job-openings rate having fallen significantly. Still, it remains historically high while job growth continues to be strong. Thus, the economy has been somewhat immune to the actions of the Fed.

Although the report on consumer price inflation might have caused some alarm, suggesting the possibility that the Fed will postpone monetary policy easing, it was offset by news that producer prices fell in December. This is important as producer prices feed into consumer prices. Thus, a decline in producer prices augurs further reduction in consumer price inflation. Let’s look at the numbers.

In December, final prices of producer goods and services fell 0.1% from the previous month. This was the third consecutive month of decline. Producer prices of goods were down 0.4% while producer prices of services were unchanged from the previous month. Excluding the impact of volatile food and energy prices, core producer prices of goods and services were up 0.2% from the previous month. Core prices of goods were unchanged while core prices of services were up 0.4%. Finally, from a year earlier, producer prices were up 1% while core producer prices were up 2.5%. This report likely reaffirms expectations that the Federal Reserve will ease monetary policy later this year.

Regarding the US labor market, the government reported that, last week, there were 202,000 initial claims for unemployment insurance, down modestly from the previous week. This relatively low number indicates that the job market remains tight.

Eurozone retail sales stagnate but job market remains tight

• In the Eurozone, the volume of retail trade (which is adjusted for inflation) continued to stagnate in November. The volume of retail sales is now the lowest since the first half of 2021. Moreover, it has been relatively flat since late 2022. This weakness stems from the fact that, until recently, real (inflation-adjusted) wages were falling, high interest rates have been stifling credit market activity, and consumers have been cautious in the face of recession risk. Let’s look at the numbers.

In November, retail sales volume in the 20-member Eurozone were down 0.3% from October and were down 1.1% from a year earlier. Mail order and internet spending were down 1.1% from October to November. The only category to experience an increase was automotive fuels. Spending on food fell marginally. 

By country, the monthly change in retail-sales volume was –2.5% in Germany, 0.4% in France, 1.5% in Spain, 0.1% in the Netherlands, 0.8% in Belgium, and 3% in Portugal. In other words, the decline in Eurozone spending was almost entirely due to Germany, which is in recession.  

What happens going forward? First, real wages are now rising in Europe as inflation has abated substantially while the labor market remains tight. This bodes well for increased retail-sales volume. Second, it is likely that the European Central Bank (ECB) is finished raising interest rates and may start to cut rates sometime later this year. When that happens, credit conditions will likely ease, thereby fueling interest-sensitive consumer purchases. Consequently, although retail sales volume is likely to remain stagnant in the first half of 2024, there is reason to expect a modest rebound in the second half. 

• Meanwhile, the job market in the Eurozone remains relatively tight. The European Union (EU) reports that, in November, the unemployment rate in the 20-member Eurozone fell to a record low of 6.4%. In the larger 27 member EU, the unemployment rate fell to 5.9%. The rate has remained relatively steady since the start of 2022, hovering at historically low levels despite economic weakness. In part, this reflects a persistent shortage of labor. 

By country, the unemployment rate in November was 3.1% in Germany (unchanged for the past three months despite a recession), 7.3% in France (unchanged for three months), 7.5% in Italy, 11.9% in Spain, 3.5% in the Netherlands, 5.6% in Belgium, 9.4% in Greece, 4.8% in Ireland, 6.6% in Portugal, 4.9% in Austria, and 7.4% in Finland. The lowest unemployment rate in the EU is in Czechia at 2.5%. 

The continuing strength of the labor market in Europe, especially in Germany (which has been in recession), is unusual and notable. It raises questions about the future direction of monetary policy by the ECB. The tightness of the labor market is driving increases in real wages. This, in turn, is a potential obstacle to the ECB goal of bringing underlying inflation down to the 2% target. The latest data showed that core inflation was 3.4% in December. If wages are rising more than 5%, this makes it difficult to achieve core inflation of 2%. This explains why ECB leaders have expressed determination to keep interest rates high for longer.

China continues to contend with deflation and falling exports

• In China, deflation persisted in December. Consumer prices were down 0.3% from a year earlier, the third consecutive month of declining prices. That has not happened since 2009. In the last six months, prices were up only once from a year earlier. The principal reason was food, with prices down 3.7% from a year earlier. Nonfood prices were up a very modest 0.5% from a year earlier. When volatile food and energy prices are excluded, core prices were up 0.6% from a year earlier, the same as in October and November. For all of 2023, consumer prices were up 0.2% from 2022. Thus, it was a year with virtually no inflation. Meanwhile, prices were up 0.1% from November to December. However, on a month-to-month basis, prices rose in only five of the last 12 months. 

China is clearly an outlier among major economies. In North America and Europe, core inflation is currently running close to 4%, although it has been declining. In Japan, which long had low or no inflation, core inflation is running close to 3%. In large emerging economies, inflation is even higher. In India, for example, inflation exceeds 6%. Moreover, some of these economies, like China, suffer from slow economic growth. Yet China alone is experiencing deflation.

Why is this important? First, deflation is an indication that there is either weak demand or excess supply in the economy. The fact that producer prices have consistently fallen since October 2022 is evidence that there is excess supply. Indeed, producer prices were down 2.7% in December versus a year earlier. Weak consumer spending and private sector investment are evidence of weak demand. Thus, it is most likely both factors that have contributed to deflation. 

Second, declining prices have an impact on economic activity. They lead to higher real (inflation-adjusted) borrowing costs, thereby hurting credit market activity. They increase the real value of debts, making them more difficult to service. The result could be increased defaults and bankruptcies. This was a problem that Japan faced in the 1990s. In addition, declining prices discourage consumers from spending, less they miss out on a bargain. Declining prices also discourage business investment for fear that the return on investments will decline. Thus, on balance, deflation is a bad thing. Plus, it could be a bad thing for the rest of the world if China attempts to offload excess goods on the rest of the world at low prices. This is what the EU has suggested that China is doing.

What can be done? If the cause of deflation is weak demand, then the solution is to boost demand through monetary and/or fiscal stimulus. Indeed, the Chinese authorities have eased borrowing conditions and boosted public investment. Still, they are reluctant to go all-in. Excessive monetary stimulus risks depressing the value of the currency. Excessive fiscal stimulus would lead to added government debt at a time when local governments face fiscal problems. 

If, on the other hand, deflation is due to excess capacity, then the solution is to reduce government interventions that lead to excess capacity. That might include reducing subsidies for state-owned enterprises or stopping government directions to state banks to roll over bad loans. However, such policies risk boosting unemployment and creating social disruption. Moreover, the government is evidently keen to promote key industries that are meant to boost China’s competitiveness in the global economy. In other words, there are no good choices. Yet doing nothing risks leaving China in a deflationary environment. 

• Meanwhile, China’s economic weakness was further revealed today with data on exports. Specifically, the government reported that, when evaluated in US dollars, exports declined 4.6% from 2022 to 2023. This was the first year since 2016 in which exports fell. The decline was largely attributed to a drop in exports of key commodities, including rare earth minerals as well as aluminum. In contrast, exports were up 2.3% in December versus a year earlier, mainly due to increased global demand for Chinese automobiles and parts, which was up 27%. The number of vehicles exported were up 58% from 2022 to 2023. 

In addition, imports fell 5.5%, largely due to declining purchases of commodities such as petroleum as well as reduced imports of steel and integrated circuits. Declining imports reflect both weak domestic demand as well as weak demand for inputs used to produce exports. 

Notably, Chinese exports to the United States fell 13.1% from 2022 to 2023, the largest decline since records began in 1995. Exports to the United States fell 6.9% in December versus a year earlier. In addition, China’s share of US imports fell to the lowest level since 2004. China is set to lose its status as the largest exporter to the United States to Mexico. The drop in trade with the United States reflects two major factors. First, trade restrictions such as tariffs and bans on trade in certain products, as well as restrictions on cross-border investment, have taken a toll. Second, many global companies, fearful of geopolitical risks, have reduced exposure to China, leading to a shift in supply chains to other countries—especially in Southeast Asia. This, in turn, has caused a change in trade patterns. Interestingly, with more US imports coming from Mexico and Southeast Asia, Chinese exports of inputs to those countries is increasing. 

China’s exports to other countries fell as well. In December, exports were down 7.3% to Japan, down 3.1% to South Korea, down 1.9% to the EU, down 6.1% to Southeast Asia, down 12.4% to Australia, and down 3% to Taiwan. On the other hand, exports were up 47% to Russia and more than 20% to Brazil.  

Electric vehicles fuel Chinese exports

• As indicated above, while China’s exports weakened, exports of automobiles provided strength. China’s automotive sector is one of the strong points for an economy that is otherwise performing only modestly. It is expected that China will be the world’s largest exporter of automobiles in 2024. It might already have been the largest in 2023. Most of its car exports are heading to other emerging nations, especially in Southeast Asia. It is also expected that electric vehicles (EVs) will account for about 30% of China’s car exports. 

With respect to EVs, it is reported that a shortage of ships capable of transporting automobiles has stifled Chinese exports of EVs and has increased the cost of transporting EVs. When many automotive factories shut down during the pandemic, some older auto transport ships were scrapped. With the pandemic over and demand on a path to recovery, there has been investment in new capacity, but much of it has not yet been completed. Hence, the number of ships in operation remains about 10% below the prepandemic level. Yet global demand exceeds the prepandemic level.

Meanwhile the domestic EV market in China is heating up. In 2023, it is estimated that there were 8.9 million EVs delivered within China, a 37% increase from the previous year. EVs accounted for 17% of the Chinese automotive market in 2022, a figure expected to rise to 33% by 2030. In addition, EVs sold in China accounted for 60% of the total EVs sold globally. Plus, Chinese EV producers hold 84% of the Chinese market, with plans to boost their global footprint.

Week of January 8, 2024

• US job market remains strong
• Federal Reserve sees progress on inflation but remains cautious
• US consumers become more optimistic
• Eurozone inflation rebounds yet core inflation decelerates
• Excess savings in Europe could boost consumer spending in 2024
• Chinese rural-urban migration might be reversing

US job market remains strong

• A surprisingly strong jobs report for December initially led to a rise in bond yields as many investors revised their expectations regarding the timing of a Fed rate cut. Yet later in the day on which the government released the jobs data, bond yields fell when the ISM released its purchasing manager’s index (PMI) for services which indicated surprising weakness. Thus, investors appear confused about the direction of the economy. What is undeniable, however, is that for much of 2023, the US job market repeatedly performed better than expected. Expectations were modest due to the tightening of monetary policy by the Federal Reserve. Yet the job market appeared relatively immune to monetary tightening, consistently generating more jobs than anticipated. Let’s look at the details:
  

The US government releases two reports on employment: one based on a survey of establishments; the other based on a survey of households. The establishment survey found that 216,000 jobs were created in December, up from 173,000 in November and the biggest jobs gain in three months. For all of 2023, 2.7 million jobs were created with employment rising by 1.7%.