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

United States

Federal Reserve leaves rates unchanged, hints at change

  • As expected, the Federal Reserve left the benchmark Federal Funds rate unchanged last week at between 5.25% and 5.5%. However, the Fed revised its predictions about future policy and future economic performance. Clearly, the Fed is not yet ready to start cutting rates. However, Chair Powell said that he was not concerned that inflation appeared to rebound in January and February, suggesting that it might have been due to difficulties in accounting for seasonal variation. He said he remains confident that inflation will continue to gradually decline, especially as the shelter component of the price index is widely expected to decelerate further. 

The members of the Federal Open Market Committee (FOMC), which sets policy, are surveyed regarding their expectations for the economy and for Fed actions. The median forecast for real GDP growth in 2024 increased from 1.4% when the committee met in December to 2.1% today. That is a big change and reflects the growing optimism about the resilience of the US economy. It also suggests more inflationary pressure. The median forecast for core PCE inflation in 2024 increased from 2.4% in December to 2.6% today. Finally, the members expect unemployment to remain relatively low, suggesting persistent wage pressure. This is important as the remaining inflation is mainly in labor-intensive services. 

As for policy, the median forecast for the Federal Funds rate at the end of 2024 was unchanged at 4.6%, indicating that the committee continues to expect three 25-basis point cuts this year, most likely during the second half of the year. However, the median forecast for the Federal Funds rate at the end of 2025 increased from 3.6% in December to 3.9% today. In other words, the members now expect a more gradual easing of monetary policy in 2025. That reflects expectations that the economy will remain strong and that, as a result, it will take longer to reduce inflationary pressures.  Interestingly, the forecasts of the most dovish members of the policy committee shifted toward more hawkishness. 

In addition, since the Fed started to tighten monetary policy, it has engaged in quantitative tightening. That is, it has sold assets, thereby reducing the size of the balance sheet. This has the effect of increasing bond yields and reducing liquidity. This policy was a reversal from quantitative easing during the pandemic when the Fed balance sheet surged to provide liquidity to a troubled market. Today, Chairman Powell said that the committee discussed the possibility of slowing the pace of asset sales, although no decision was made. When they do decide to shift the quantitative tightening policy, it will likely have a dampening effect on bond yields and, consequently, other long-term borrowing costs. 

In response to the Fed’s announcement, many investors exhibited modest optimism. Equity prices were up, bond yields were down, and the value of the dollar was down.

Japan adjusts monetary policy

  • It finally happened. For the first time in 17 years, the Bank of Japan (BOJ) increased interest rates. Japan was the last country to retain negative policy interest rates. Now there are none. For many months betting on the timing of the shift in BOJ policy became an industry in and of itself. Now, the BOJ is raising its benchmark interest rate from -0.1% to 0.1%. In addition, it is ending the policy of yield curve control. Under that policy, the BOJ bought and sold assets to target the yield curve.  Now, it will allow bond yields to move on their own. BOJ Governor Ueda said, “We are going to set monetary policy like other normal central banks. Policy rates are going to be determined based on the economic and price situations.” 

Under the new policy framework, the BOJ will gradually end purchases of commercial paper, corporate bonds, exchange traded funds, and real estate investment trusts.  However, it will continue purchasing government bonds at the same pace as previously but will not attempt to target the bond yield. In other words, the stance of monetary policy will remain “accommodative” but less so than previously. 

Going forward, Ueda said that the BOJ will retain the option of cutting rates again should the economy weaken significantly. On the other hand, it will be willing to raise rates further should inflation rise more than desired. 

Interestingly, following the BOJ announcement, the value of the yen fell. That might seem surprising given that a tightening of monetary policy is expected to lead to currency appreciation. However, currencies move not in response to actual events, but in response to the difference between expectations of events and the events themselves. In this case, investors already expected today’s BOJ action. Thus, given there was no surprise, the BOJ action had no impact on the exchange rate. 

Rather, the exchange rate moved for other reasons. In fact, the yen had already appreciated significantly in anticipation of today’s action. Thus, today’s currency movement could have been the result of the exchange rate having already overshot.  Also, today’s depreciation might reflect increasing expectations that the US Federal Reserve may delay interest rate normalization when it announces policy tomorrow.  Finally, if investors begin to expect the BOJ to tighten further, that will likely lead to an appreciation of the yen. That fact could inhibit the BOJ from further tightening. 

For many months, the BOJ was reluctant to act. It often noted that the sharp rise in Japanese inflation was related to supply constraints rather than excess demand. It expected inflation to return to a low level on its own as supply constraints eased. Inflation has certainly receded from its peak. Yet what likely led the BOJ to act now is that wages are accelerating, thereby setting the stage for inflation to remain elevated. Last week we learned that the wage increases negotiated by unions and major companies were the largest since 1991. Thus, the BOJ evidently feels comfortable with a slight tightening of monetary policy. 

Lastly, despite the dramatic nature of the announcement, the reality is that Japan’s interest rates remain far lower than in other major countries. Thus, Japan remains the outlier in monetary policy. Moreover, as noted by Governor Ueda, policy remains accommodative while it is tight in other major countries. Thus, the initial impact of today’s announcement might be modest at best. The important thing is that the policy has shifted, setting the stage for further adjustments that could be very impactful. 

  • One of the most profitable ways to invest money in recent years was the Japanese carry trade. With historically low (even negative) interest rates in Japan, and with downward pressure on the value of the yen, investors borrowed in yen, purchased other currencies (US dollars, Mexican pesos) and reaped a high return given elevated interest rates, then purchased yen and paid off their yen debts. In the past two years, this trade, when it involved Mexican pesos, was more profitable than putting money in the US equity market. Yet the success of this trade was predicated on currencies remaining relatively stable and there remaining a sizable interest rate gap between Japan and others. That is about to change. And this could be disruptive of global financial markets and trade flows.

We now know that the BOJ is raising interest rates. Moreover, it is widely expected that, sometime in the next few months, the US Federal Reserve will start to cut interest rates. Plus, the Bank of Mexico has already announced an interest rate reduction. Thus, the interest rate gap will narrow. Moreover, it is likely that, with a narrower interest rate gap, the value of the Japanese yen could eventually rise, thereby reducing, or even eliminating, the potential profitability of the carry trade. When the carry trade halts, that alone will put upward pressure on the value of the yen. Reduced Japanese investor demand for assets in the United States and Mexico could put upward pressure on bond yields in those two countries. Thus, there will likely be some financial market volatility. 

A dramatic surge in the value of the Japanese yen will, over time, influence trade flows. A higher valued yen will reduce the competitiveness of Japanese exports. The prime beneficiary of that could be China where there is already downward pressure on the value of the renminbi. A significant part of China’s economic strategy involves promoting exports of automobiles, capital goods, and clean energy technology. Not coincidentally, these are also areas of strength for Japan’s export-oriented companies.  Although China has tried to avoid currency depreciation, a rising yen would boost Chinese export competitiveness without the need for renminbi depreciation.

Mixed economic data from China

  • China released new monthly economic data and it was a mixed bag. While industrial production and fixed asset investment accelerated sharply, retail sales continued to decelerate and investment in property continued to fall.

Due to the shifting timing of the annual Lunar New Year holiday, the government publishes data for January and February combined. Here is the latest data: In January and February, industrial production was up 7.0% from a year earlier, better than the 6.8% growth in December and the fastest rise in output in almost two years. Manufacturing output was up 7.7%. By industry, there was especially strong growth for computers and communication (up 14.6%), chemicals (up 10.0%), and automobiles (up 9.8%). 

In addition, in the first two months of 2024, fixed asset investment was up 4.2% from a year earlier, the strongest increase since April 2023. The sharp rise in investment was driven by investment in electricity, gas, heat, and water (up 25.3%), mining (up 14.4%), and railway transportation (up 27.0%). Thus, infrastructure played a big role in boosting investment.

On the other hand, investment in property fell 9.0% from a year earlier, thereby dampening economic activity. In fact, property sales by floor area fell 20.5% in the first two months versus a year earlier. And funds raised by property developers fell 24.1%. This suggests continued weakness in property sector activity, boding poorly for more investment. The government has provided incentives to finish uncompleted residential projects and has cut borrowing costs for potential home buyers. Still, the market remains hugely unbalanced. When property is excluded from the data, fixed asset investment was up a more robust 8.9%.

The fact that a large share of investment growth is coming from infrastructure spending is potentially worrisome. That is because the government is now taking steps to reduce such investment, especially given that it has been funded by local government borrowing.  Moreover, local government debt is now estimated to be about US$9.8 trillion. Local governments often fund the servicing of such debt through property sales. Given the property market crisis in China, and the resulting decline in property values, local governments are increasingly squeezed. That is why the government in Beijing is now allowing local governments to issue special refinancing bonds that will be used to pay off existing debts. Yet this comes with restrictions on new borrowing. That, in turn, will likely result in reduced infrastructure investment going forward. 

Finally, Chinese retail sales were up 5.5% in January and February versus a year earlier, down from 7.4% in December and the slowest pace of growth since August 2023. Strong growth was seen for communications equipment (up 16.2%) and automobiles (up 8.7%). On the other hand, growth was modest or negative in other categories. For example, spending was up 1.9% for clothing and up 2.1% for building materials. Spending was down 0.7% for personal care products. Retail spending has been hurt, in part, by declining property prices which encouraged households to boost saving.

Mexico not yet attracting a surge in FDI

  • Is Mexico the next China? Given the rapid effort by global companies to diversify supply chains away from China, and given Mexico’s favorable attributes (low labor costs, low transport costs for goods heading to the United States, free trade with the United States, benign political relations with the US, immunity to disruption of the Panama Canal), there has been an expectation that Mexico will see a manufacturing boom as companies shift away from China. Yet so far, it hasn’t happened on a large scale. Of course, there has been investment in Mexico, including on the part of Chinese companies. But obstacles to a boom remain.

First, the good news. Mexico is now the largest exporter to the United States, displacing China as US trade with China falters in the face of government-imposed trade barriers and diminished US investment in China. At the same time, Mexican trade with China has increased. In part, this reflects Chinese companies sending parts to Mexico to be assembled into final goods for export to the United States. This has benefited Mexico, although US trade authorities are scrutinizing such goods to ensure they are consistent with domestic content rules embedded in the US Mexico Canada Agreement (USMCA). Also, Mexico has attempted to lure investment. For example, it is offering a sizable tax benefit to electric vehicles producers. Chinese EV makers are interested.

Yet one problem for Mexico is that rising investor demand for property, commodities, and people is driving up costs. In addition, the rising value of the peso has also increased the cost to foreign companies investing in Mexico. The US dollar has fallen about 17% against the peso since mid-2022. Another problem is that Mexico’s infrastructure is often not well suited to the needs of large foreign companies. Although manufacturing as a share of GDP increased sharply from 2020 to 2022, it fell slightly in 2023. This suggests that the manufacturing industry might be up against supply constraints. If so, that does not bode well for a potential surge in manufacturing investment. 

Finally, Mexico faces global competition. While it is attractive for nearshoring to the United States, there are other countries that have attracted considerable investment that might otherwise have gone to China. These especially include Vietnam and India.  Moreover, investors worry about the future political climate on both sides of the US-Mexico border. For example, former US President Trump has proposed a 100% tariff on Chinese vehicles made in Mexico. In addition, the outcome of the upcoming Mexican election will affect Mexican government policy regarding investment, trade, taxation, regulation, and many other factors that influence investment decisions. As such, it is likely that potential inbound investment is being postponed until there is better clarity regarding the business environment. 

  • Meanwhile, the central bank of Mexico cut its benchmark interest rate by 25-basis points to 11.0%. Mexico now joins the central banks of three other major Latin American countries in cutting rates. The central banks of Brazil, Chile, and Peru all started to cut rates several months ago. Notably, all four Latin American central banks had started to raise interest rates many months before the central banks of the United States, United Kingdom, and eurozone. Now they are taking the lead in cutting rates. 

The central bank targets inflation. In February, the consumer price index was up 4.4% from a year earlier, up from the previous month. Yet core inflation (excluding volatile food and energy prices), at 4.6%, was the lowest since June 2021. Thus, significant progress has been made. Moreover, real (inflation-adjusted) interest rates remain very high. 

The central bank might be concerned that the relatively tight monetary policy has hurt economic growth. In the fourth quarter of 2023, real GDP was up 2.5% from a year earlier, down from the previous quarter. Real GDP was up only 0.1% from the previous quarter. Moreover, unemployment is up sharply. Plus, the value of the peso has appreciated significantly in the past two years, thereby hurting export competitiveness while reducing inflationary pressure. Thus, the economy evidently faces headwinds, likely due to the tight monetary policy.  

US inflation ticks up, but no need for alarm

  • The recent headlines pointed to a slight uptick in US annual inflation, with the Wall Street Journal noting that it was “hotter than expected.” This was true. However, core inflation (which excludes the impact of volatile food and energy prices) was down slightly. What was most notable was that month-to-month inflation was relatively high. Although the headline writers were evidently alarmed, many investors were not. Bond yields increased only slightly. Moreover, US equity prices continued to rise, despite a sense that the Fed will wait longer before cutting rates. Investors evidently have confidence in the strength of the economy, partly reflected in inflation. But mostly, investors are enthusiastic about technology and the longer-term implications. Inflation is no longer the top story. 

Nevertheless, in this update, inflation remains our top story. Let’s look at the numbers: In February, the US consumer price index (CPI) was up 3.2% from a year earlier, up from the 3.1% gain in the previous month. Prices were up 0.4% from January, the biggest monthly increase since September. Meanwhile, when volatile food and energy prices are excluded, core prices were up 3.8%, down from 3.9% in the previous month and the lowest in almost three years. Core prices were up 0.4% from January, the same as in the previous month. This was the highest monthly increase since April 2023.  

The monthly price increases are of concern, suggesting that inflation is accelerating from the lows it reached in late 2023. If so, that will likely influence the decisions of the Federal Reserve. Meanwhile, inflation continues to be mainly a problem involving services. The government reported that prices of durable goods were down 1.6% from a year earlier and down 0.1% from the previous month. Prices of non-durable goods were up 1.1% from a year earlier and up 0.5% from the previous month. The latter included energy goods where prices were up sharply for the month. 

Yet the prices of services were up 5% from a year earlier and up 0.5% from the previous month. Services tend to be labor intensive. With a tight labor market characterized by low unemployment and a relatively high job openings rate, wages are rising, contributing to service inflation. Thus, the Fed has indicated an intention to keep monetary policy tight for longer to weaken the job market and suppress wage inflation. 

One important component of services is shelter (housing). Shelter prices were up 5.7% from a year earlier and up 0.4% from the previous month. It is likely that shelter inflation will ease in the months to come given house price trends. When shelter is excluded from the CPI, prices were up only on 1.8% from a year earlier. This is lower than the Fed’s 2% target. Thus, shelter is one of the problems. 

Finally, let’s examine a couple of other interesting categories: Prices of apparel were unchanged from a year earlier; prices of airline tickets were down 6.1% from a year earlier; prices of new cars were up 0.4%, while prices of used cars were down 1.8%; prices for motor vehicle insurance were up 20.6%, while prices of hospital services were up 6.1%. Meanwhile, prices of natural gas service were down 8.8%, while prices of food eaten at home were only up 1%. Thus, as usual, it was a mixed bag. 

Going forward, the Federal Reserve will watch labor market conditions closely, especially given that recent wage gains have clearly contributed to service inflation. There are two factors that could help to ease inflation: First, more immigration would boost labor supply, thereby dampening wage gains. This likely already happened in 2023. Second, increased labor productivity would allow companies to raise wages without raising prices. Thus, if productivity continues to rise rapidly, it could have a salutary impact on inflation. That, in turn, would influence the timing of a Fed reversal of policy.

Eurozone productivity drops, boding poorly for growth and inflation

  • For the first time since the global financial crisis in 2008–10, productivity in the Eurozone (output per hours worked) has been steadily declining. Specifically, in each of the most recent six quarters, productivity fell from a year earlier, with productivity down 1.2% in the fourth quarter of 2023 versus a year earlier. What is happening? First, productivity was extremely volatile during and immediately after the pandemic, making the data hard to interpret. Yet now that the economy is back to normal patterns, the productivity numbers are more meaningful. In the last two years, we have seen a relatively strong labor market with rising employment and rising hours worked, yet weak output, leading to declining productivity. 

Why is productivity important? There are two reasons. First, absent productivity growth, it is impossible to generate strong per capita economic growth (and rising living standards). Second, when productivity falls, it leads to an increase in unit labor costs (the labor cost of producing a unit of output). From the perspective of the European Central Bank (ECB), a lack of productivity growth makes it that much harder to reduce inflation at a time when wages are rising. Productivity gains would offset wage gains, enabling companies to pay higher wages without raising prices. The ECB intends to keep monetary policy tight until the labor market weakens. If productivity were rising, this would not be necessary.

What drives productivity? Generally, productivity is affected by innovation in technology or business processes. These can be affected by strong research and development spending, high-quality universities, improvements in the quality of human capital, better infrastructure, reduced obstacles to efficiency through better/less regulation, and more efficient capital markets. Plus, increased foreign competition creates an incentive to boost productivity to maintain competitiveness.

While Eurozone productivity has been falling, productivity in the United States has been rising sharply, contributing to the rising gap between US and Eurozone growth and per capita income. This fact puts downward pressure on the value of the euro. That, in turn, exacerbates inflation although it improves export competitiveness. 

What accounts for Europe’s lagging productivity versus the United States? There are several potential reasons. Among the reasons offered by some economists have been the following: US universities dominate lists of top research centers in the world; US financial markets are better at channeling funds to entrepreneurs; US labor and product markets are less regulated; and European companies have lagged in implementing digital transformation. 

On the other hand, some analysts say that the current decline in Eurozone productivity is due to labor hoarding by companies. That is, due to a tight labor market, European companies are holding onto labor they don’t need at a time when demand for their goods and services is weak.

Italy surprises on the upside

  • For much of the past two decades, Italy was the weak link in the Eurozone, barely experiencing economic growth, while Germany was the star. Currently, it appears that the two countries have traded places. Germany’s economy has been weak while Italy has been performing well. In fact, Italy’s real GDP is up more sharply since the start of the pandemic than Germany, France, or the United Kingdom. Moreover, investors’ confidence in Italy’s economic management has led to a sharp decline in the spread between German and Italian government bond yields.  

Italy’s recent economic success partly reflects the impact of the so-called “super bonus,” a tax credit introduced in 2020 to encourage home improvement. It worked, causing capital formation in Italy to surge 30% since just prior to the pandemic—much faster than in other European countries. On the other hand, the fiscal effect of this subsidy was large and onerous. Thus, the government is gradually withdrawing the incentive, which is set to end by 2025. Over time, this will cause investment in property to diminish. 

Meanwhile, Italy’s current star status, and the evident confidence on the part of investors, partly reflect the surprising direction of the government of Prime Minister Giorgia Meloni. She leads a far-right political party. When she assumed office in October 2022, there was a widespread expectation that she would be unsupportive of the EU and of Ukraine and that she would follow a relatively statist economic policy, characterized by a lack of fiscal probity. 

Instead, the opposite happened. She has played a productive role within the EU, pushing for more support for Ukraine. She has developed a strong relationship with US President Joe Biden, demonstrating commitment to the Atlantic alliance. And she withdrew Italy from China’s Belt and Road Initiative, instead creating strategic partnerships with India and Japan. Most importantly, unlike other populist governments in Europe, she did not go on a spending binge. Rather, she has pursued fiscal probity, reversing the “super bonus” that had been implemented by a populist government. 

The most notable result of this set of policies is that the spread between the yields on German and Italian long-term bonds has fallen from over 200 basis points in October 2023 to 116 basis points now, the lowest since November 2021. Lower yields on Italian bonds mean that Italy faces fewer obstacles to servicing its relatively large sovereign debt. Italy’s finance minister said that he hopes to further reduce the spread as the government continues efforts to reduce the budget deficit. Plus, when the ECB finally starts to cut short-term interest rates, this will likely have a salutary effect on bond yields.

Red Sea crisis not too onerous

  • When Houthi rebels in Yemen started to attack commercial ships in the Red Sea in December, there was concern that this would seriously disrupt global shipping, increase costs, and fuel higher inflation in Europe—especially as the Red Sea is the principal venue for shipping goods from Asia to Europe. Yet it turns out that the Houthi attacks on ships in the Red Sea, while annoying, have not seriously disrupted global shipping or contributed to higher inflation.

It is true that much shipping has been diverted around the Cape of southern Africa, thereby creating delays and shortages as well as increasing the cost of shipping. The number of ships traversing the Red Sea is down about 61% from before the attacks began. Still, it is not nearly as bad as during the pandemic. At that time, the cost of shipping a container from East Asia to Northern Europe increased about 15-fold. In this case, the cost increased about fourfold. Plus, freight costs have begun to decline from their recent peak. 

Evidently, shippers are adjusting, possibly finding alternative sources and routes. Interestingly, although the number of ships going through the Red Sea fell sharply, the number of ships arriving in Northwest Europe each week has rebounded to close to the pre-attack level. That is, when the attacks began, the number of arrivals fell sharply but has since recovered considerably. 

The result is that an index of global supply chain pressure, published by the Federal Reserve Bank of New York, while up from the middle of 2023, is at a level comparable to the average during the pre-pandemic decade. That is, global supply chain pressure is normal. In the absence of severe supply chain disruption, it is unlikely that the Red Sea crisis will lead to a significant increase in inflation in Europe.

Chinese inflation rebounds, but deflationary risk remains

  • Inflation returned to China in February, with consumer prices rising 0.7% from a year earlier. This was the first time since August 2023 that prices have risen from a year earlier. It was also the highest annual inflation since March 2023. In addition, consumer prices were up 1% from the previous month, the biggest monthly increase since January 2021. Does this mean that the deflation scare is over? Not necessarily. It could be that strong demand during the Lunar New Year holiday caused a temporary boost to prices. Also, there was a sudden boost to pork prices, which play a big role in the consumer price index. It remains unclear whether this boost to inflation will be sustained in the months to come. 

Notably, producer prices continue to fall, and the decline is accelerating. In February, producer prices were down 2.7% from a year earlier after having fallen 2.5% in the previous month. Producer prices have fallen consistently for the past year and a half. Producer prices feed into consumer prices. Thus, continued producer price deflation could bode poorly for a sustained return to positive consumer price inflation. 

Deflationary pressure has stemmed from a combination of weak domestic demand and excess capacity. The government recently predicted that, in 2024, real GDP will grow 5%, more than many private sector economists are expecting. If the economy grows as strongly as the government expects, it is likely that inflation will rise. Indeed, the government predicts inflation of 3% in 2024. 

Yet China continues to face significant headwinds, including a troubled property market, stagnant domestic investment, a high personal savings rate, very weak inbound foreign investment, and external headwinds. The government is not planning a significant shift in fiscal or monetary policy that might offset the headwinds. Nor is it currently taking steps to ease excess supply. 

Meanwhile, although the yield on China’s 10-year bond increased slightly last week on news of positive inflation, the yield remains close to the lowest level this century. This reflects expectations of low or negative inflation and slow economic growth. The rising gap between Chinese and US bond yields creates a risk of further efforts by investors to take capital out of China, thereby putting downward pressure on the currency. Although a weaker renminbi would boost export competitiveness, it would also likely invite more protectionist measures from trading partners. Plus, a weaker currency would increase the cost of servicing foreign currency debts. 

China cuts back on infrastructure investment

  • In the past two decades, a large share of China’s economic growth stemmed from investment in residential property and investment in infrastructure. Both entailed a significant accumulation of debt that has alarmed the government. Consequently, two years ago the government took steps to limit residential property development, even allowing some property developers to default on debts. This has already had a major negative impact on economic growth. Now, it is reported that the government wants local governments to cut back on infrastructure spending given the massive and potentially unsustainable debts that local governments have already accumulated. 

However, if both property and infrastructure investment decline as a share of GDP, what will replace them? The answer ought to be consumer spending, which has been suppressed as a share of GDP. If consumer spending does not accelerate sufficiently to offset the drop in investment, the economy will grow slowly.

It is reported that the government in Beijing has ordered several major infrastructure projects in indebted provinces to be halted. In addition, it is reported that the State Council has ordered 10 provinces and two major cities to improve oversight of infrastructure projects. China’s finance minister said that “governments of all levels better get used to belt-tightening and start to understand that this is not a temporary need, but a long-term solution.” 

Meanwhile, China’s Premier Li said, “We will make concerted efforts to defuse local government debt risk while ensuring stable development.” This combination might be difficult to achieve if there are not separate efforts to boost consumer spending. The government has predicted real GDP growth in 2024 of 5%, a number higher than most private sector economists expect. Achieving this goal in the context of declining investment in property and infrastructure would be difficult under any circumstances. Although the government intends to issue special bonds to support local governments, this is not an increase from the previous year. As such, it does not represent a shift in fiscal policy. Moreover, these bonds will do nothing to boost the consumer side of the economy.

Finally, rather than focusing on boosting consumer demand, the Chinese government policy is to shift investment from property and infrastructure to high technology and clean energy. The country has had success in these areas, but it is not clear if they will be sufficient to drive the entire economy. Moreover, Western restrictions on the flow of technology to China and on imports from China challenge China’s success in moving up the value chain of technology. Constraints on China’s ability to export could exacerbate the problem of excess capacity. The latter, in turn, has contributed to deflationary pressure.

Generative AI, climate change, carbon emissions, and Chinese electric vehicles

  • The recent surge in equity prices in the United States was largely, but not entirely, related to enthusiasm about investment in generative AI. There is an expectation that such investment will grow rapidly in the coming few years, potentially having a positive impact on productivity. Yet there is another aspect of generative AI that has drawn less attention. It is the fact that AI uses lots of power, potentially causing a sizable increase in carbon emissions. 

First, it should be noted that generative AI has the potential to assist in minimizing carbon emissions among other benefits. It can detect pipeline leaks and contribute to the development of new materials and processes that are more energy efficient. Still, the use of billions of devices connected to the internet, and especially the use of data centers, leads to considerable consumption of electricity. This is not to mention the air-conditioning necessary to cool data centers. 

It is reported that connected devices will account for 3.5% of global carbon emissions in 2025, and possibly 14% of global emissions in 2040. The future increase would likely be due to generative AI as well as increased usage of devices in emerging countries. In addition, a study by scientists at Cornell University found that training large language models (LLMs), which must be done continuously, consumes a large amount of electricity, thereby pumping more carbon into the atmosphere. 

What can be done? First, the world will need to shift toward producing electricity using clean energy. This would include solar, wind, hydroelectric, nuclear, and hydrogen power. Second, producers of AI-related services will have to engage in efficient usage of energy. A recent study offered suggestions on how to accomplish this. Yet unless governments compel companies to follow these suggestions, it will not be clear whether efficiency is being undertaken. 

As a resident of California, I recall that, about a decade ago, we faced a temporary yet serious shortage of electricity. In part, it was due to a rapid increase in demand, almost entirely due to the rapid rollout of new servers and data centers in our state’s large technology industry. This was, I think, a warning about what could happen globally in the years to come. 

  • Meanwhile, despite all the efforts underway to reduce carbon emissions, the International Energy Agency (IEA) says global emissions hit a record level in 2023, up 1.1% from the previous year—down from 1.3% growth in the prior year. Moreover, the increase was entirely due to emerging countries. Emissions in advanced economies fell 4.5% from 2022 to 2023, hitting a 50-year low.  Emissions fell 9.0% in Europe and fell 4.1% in the United States. In advanced economies, renewables and nuclear accounted for 50% of electricity generation. 

On the other hand, emissions were up 5.2% in China and up 7.0% in India. China was, by far, the biggest emitter of carbon. The IEA says that 40% of the increase in global emissions last year was due to burning fossil fuels as a replacement for hydro power. Climate-induced droughts led to a decline in the ability to produce hydro power. Going forward, this could be a serious issue. 

The good news is that, in the last 10 years, global emissions only grew at an annual rate of 0.5%, the slowest since the 1930s. However, that was due, in part, to the disruptive impact of the pandemic which suppressed travel. Going forward, the IEA anticipates a big increase in the use of clean energy to produce electricity and a big increase in the use of electric vehicles (EVs). 

  • Regarding EVs, major governments around the world are awaiting a flood of EVs from China to arrive. Chinese EV producers have been dramatically ramping up capacity. Moreover, very inexpensive EVs are now available from Chinese producers. This has alarmed Western governments, many of which are considering restrictions on imports of Chinese EVs. 

In the United States, President Biden initiated an investigation into potential security threats from Chinese EVs. The issue is whether the data capture capacity of such vehicles can be used in a way that threatens US national security and/or privacy for US households and businesses. Biden said that “China is determined to dominate the future of the auto market, including by using unfair practices. China’s policies could flood our markets with its vehicles, posing risks to our national security. I’m not going to let that happen on my watch.”  Although national security is the stated reason for concern, his action comes following pressure from US-based automotive producers and the union representing their workers.      

However, there is concern that there could also be restrictions on Chinese parts and software that are used by US producers. Moreover, any restrictions will mean that US consumers will face higher prices for EVs than otherwise. Some Chinese EV producers are investing in production outside of China. It is not clear if US restrictions would apply to vehicles made, for example, in Mexico. Meanwhile, the European Union and the United Kingdom are both investigating Chinese EVs with an eye toward potential import restrictions.

US job market offers mixed picture as Fed deliberates on policy

  • In the United States, employment continued to grow rapidly in February. Although data for job growth in December and January was revised down, the new data still indicates that, in the past three months, job growth in the United States was unusually strong—especially at this stage in the business cycle. Moreover, employment continues to grow faster than the long-term ability of the labor market to generate new jobs. This means that the job market remains tight. Indeed, wages continue to rise from a year earlier at a brisk pace.  On the other hand, the monthly increase in wages was the lowest in two years. Plus, the unemployment rate ticked up slightly, hitting the highest level in two years. Thus, the jobs report offers a somewhat mixed picture—which is exactly what the Federal Reserve likely wants to see. Consequently, bond yields fell slightly today. Let’s look at the details:

The US government releases a monthly employment report based on two surveys: a survey of establishments; and a survey of households. First, let’s look at the establishment survey. It found that, in February, 275,000 new jobs were created, more than investors had anticipated. On the other hand, the job increases in the previous two months were downwardly revised by a combined total of 167,000 jobs. Still, at 290,000 for December and 229,000 for January, job growth was relatively strong. 

There was especially strong growth in healthcare and social assistance, leisure and hospitality, local government, and construction. There was moderate growth for retail trade as well as transportation and warehousing. In our own industry of professional services, job growth was very modest. Manufacturing employment fell. 

In addition, the establishment survey provides data on average hourly earnings. In February, average earnings were up 4.3% from a year earlier, down from 4.5% in January but the same rate of increase as in December and November. More importantly, average hourly earnings were up only 0.1% from January to February, the slowest monthly gain in two years. This suggests the possibility that wage pressure is abating. The separate survey of households showed that the unemployment rate increased from 3.7% in January to 3.9% in February, the highest in two years. 

What accounts for the moderation in wages and the rise in unemployment. First, participation in the labor force by prime working age people (25 to 54) continues to rise, even though overall participation was flat in February. Second, immigration likely contributed to the rise in the labor force, thereby dampening wage pressure. 

The wage and unemployment numbers were taken as evidence that the labor market is starting to weaken, despite strong job growth. This is important for the Federal Reserve.  In Congressional testimony this week, Fed Chair Powell said “we’re waiting to become more confident that inflation is moving sustainably to 2%. And when we do get that confidence, and we’re not far from it, it will be appropriate to dial back the level of restriction so that we don’t drive the economy into recession.” The key words were “not far from it.” He uttered these words even before today’s jobs report. Thus, there is a widespread expectation that the Fed will cut rates by June. The futures markets have an implied probability of a rate cut in June of more than 50%.

China’s leaders expect strong growth despite headwinds

  • Some China watchers now believe that China’s economy will likely grow in the neighborhood of 3% to 4% per year in the coming years, a dramatic shift from the recent past.  Yet at the annual National People’s Congress (NPC) in Beijing last week, Premier Li Qiang said that he expects growth of 5% this year. This did not reflect a planned change in fiscal policy. Rather, Li said that he expects the budget deficit in the coming year to be the same as last year. Thus, no change in fiscal policy is foreseen. Moreover, his optimistic forecast did not reflect a view that China’s challenges have receded. Instead, Li acknowledged that “the foundation for the continuous recovery and improvement of our country’s economy is still not solid, with insufficient demand, overcapacity in some industries, weak societal expectations and many lingering risks.”

Thus, what is the basis for expecting relatively strong growth? The answer is that the government appears to believe that the economy has bottomed and that things are expected to improve soon. Li’s forecast assumes that inflation will be 3% in 2024, significantly up from the deflation now taking place. Li’s presentation at the NPC included plans to stabilize the troubled property market, boost the birth rate through better maternity policies, and issue about one trillion renminbi (US$141 billion) worth of special government bonds meant to “build up security capacity in key areas.”

The issuance of special bonds, the same amount as last year, is separate from the central government’s budget. Although the special bonds were seen by some observers as a signal of intent to address economic problems, the lack of change in the volume of such bonds means no change in the government’s fiscal stance and, therefore, no stimulative effect.  Thus, there was no dramatic shift in policy that could be the basis for a shift in expectations about the economy’s performance. 

The government also announced a slight increase from last year in the issuance of special purpose bonds by local governments. This is meant to help local governments gradually resolve the problem of large debts that were meant to be financed by the sale of land. Yet property market problems have significantly reduced the ability of local governments to generate revenue through the sale of land. This is not likely to change soon. In addition, the government said that central government transfers to local governments will rise a modest 4.1% this year from a year earlier. 

While the 5.0% target might not seem very high given that the economy is reported to have grown 5.2% in 2023, it is worth noting that last year’s growth was boosted by the impact of a low base in 2022 (a year of very slow growth due to covid lockdowns).  Thus, matching last year’s growth in 2024 would require a significant change in economic performance.

Finally, despite the government’s evident optimism, there remain significant headwinds that will likely make strong growth difficult to achieve. First, although consumer spending apparently accelerated modestly during the recent Lunar New Year holiday, household savings remains high. Plus, the loss of wealth due to declining property values is likely to sustain high savings, if only so that households can recoup lost wealth. Thus, it is hard to see what will cause a significant boost to household spending. 

Second, the sharp decline in inbound foreign direct investment (FDI) will not likely be reversed this year, especially given current relations with the US and other Western countries. That means less impetus for private sector investment. Plus, shifting supply chain investment could gradually erode China’s export prowess. Yet the government’s statements have promoted FDI. For example, Premier Li said that “we will strengthen services for foreign investors and make China a favored destination for foreign investment.  We will make it easier for foreign nationals to work, study and travel in China.” Even if these words are followed by action, it is not clear if it will cause a shift in global company intentions. After all, there is already a considerable shift on the part of global companies toward assuring supply chain resilience through diversification away from China.

Third, a weak global economy combined with potential increases in trade restrictions bode poorly for an acceleration in export growth. The government is promoting key industries (electric vehicles, information technology) as export champions. Yet it seems likely that the United States and European Union will impose new restrictions on imports of these products from China. 

Finally, China remains plagued by excess capacity in industry, especially in the state-run sector. Without significant effort to boost demand, and unless the state sector is reorganized to address excess capacity, there is likely to remain disinflationary pressure.  That, in turn will likely have a dampening effect on investment and household spending.

Still, the government emphasized investments in new technologies as key to sustaining growth. It indicated an intention to boost investment in electric vehicles, pharma, hydrogen power, biomanufacturing, commercial spaceflight, and quantum technology. In part, this is meant to promote self-reliance at a time of difficult economic relations with other countries.  China can certainly rely on a vast domestic market to ramp up scale. However, significant restrictions on exporting these products, as well as restrictions on access to foreign technology, could weaken these industries and reduce their impact on growth.

ECB keeps rate high but signals expectation of lower inflation

The European Central Bank (ECB) left its benchmark interest rate unchanged at an historically high level of 4.0%. However, the ECB also downwardly revised its forecast for inflation this year, thereby signaling a likelihood that rates will be lowered sometime in the coming months. Christine Lagarde, President of the ECB, said “we are making good progress towards our inflation target and we are more confident as a result. But we are not sufficiently confident. We clearly need more evidence and more data. We will know a little more in April, but we will know a lot more in June.”

In Europe, as in the United States, the biggest obstacle to reducing inflation to the 2.0% target is the labor market. In both Europe and the United States, service price inflation remains elevated. Moreover, services tend to be labor intensive. Thus, the ECB and other central banks are carefully watching labor market conditions. Lagarde said that she would “zero in on and be laser-focused on, to see if there is confirmation of what we are beginning to see, which is moderation on the wage front and an absorption of those higher wage costs by the profit margins.” If wage inflation eases, the ECB would likely be amenable to cutting interest rates sooner rather than later.

Lagarde indicated that the ECB is not yet ready to act but is getting closer. She said “I wish everything was closer to our target, but we are not there yet. I am not saying that we will wait until we see everything at 2.0%.” On the other hand, the Bank for International Settlements (BIS), which is the central banks’ banker, said that the persistence of service price inflation could lead major central banks to keep rates higher for longer. 

In response to the ECB announcement, bond yields fell modestly. Investors were evidently not surprised by the action and words. For the ECB, the current situation involves a delicate balancing act. The Eurozone economy is weak, with Germany having been in recession and with growth in other major countries very modest. The longer monetary policy remains tight, the more likely that it will further weaken the economy. Meanwhile, inflation has been declining but is not yet where the ECB wants it to be.

Eurozone core inflation decelerates but problems remain

  • In the major advanced economies, there have lately been some common trends when it comes to inflation. Headline inflation fell sharply for a while, mostly due to the easing of supply constraints, but seemed to get stuck in the last few months. Core inflation (excluding food and energy prices) has continued to decelerate but remains above the central banks’ 2% target. Goods inflation has all but disappeared while inflation for services remains too high. The problem is that services are labor-intensive and labor markets remain unusually tight, with wages rising faster than prices. These trends are seen in the United States, Eurozone, and the United Kingdom. In each, there is much discussion about when central banks will start to cut interest rates. The persistence of services inflation has led many investors to believe that central banks will wait a bit longer than previously expected to start interest-rate normalization.

Last week, the European Union (EU) released the latest inflation data for the 20-member Eurozone, and the trends remain consistent with the story told above. Specifically, in February, consumer prices in the Eurozone were up 2.6% from a year earlier and up 0.6% from the previous month. In the last five months, annual headline inflation has ranged from 2.4% to 2.9%, seemingly stuck after a period of steady decline.

Meanwhile, core inflation (excluding food and energy) continues to decline. In February, core prices were up 2.8% from a year earlier, the lowest rate since March 2022. This means that underlying inflation is moving in the right direction. However, core prices were up 0.7% in February from a month earlier, suggesting trouble. The trouble, of course, is in services. First, prices of non-energy industrial goods were up only 1.6% from a year earlier and up 0.3% from the previous month. On the other hand, prices of services were up 3.9% from a year earlier and up 0.8% from the previous month. 

Thus, the main obstacle to bringing inflation down to the 2% target is labor-intensive services. Indeed, the unemployment rate in the Eurozone is now at a record low of 6.4% while real (inflation-adjusted) wages were rising at a rapid pace as recently as the third quarter of 2023. Given this, it is likely that the European Central Bank (ECB) will wait longer before cutting interest rates. 

By country, annual headline inflation in February was 2.7% in Germany, 3.1% in France, 0.9% in Italy, 2.9% in Spain, 2.7% in the Netherlands, and 3.6% in Belgium. 

US consumer spending slides while inflation in services is too high

  • American consumers cut back on spending in January, at least according to the government’s latest report on consumer spending. Recall that, a few weeks ago, data on retail sales also indicated a drop in spending in January. It is worth noting that the monthly data are adjusted for seasonal variation. Moreover, there is currently debate within the government as to whether the seasonal adjustments made by the government remain appropriate following the pandemic. That is, the pandemic led to changes in consumer behavior that might not be fully reflected in the government’s adjustment for seasonal factors. If so, the January data could be downwardly skewed. Or the data could reflect a decline in spending. After all, real (inflation-adjusted) disposable income did not grow in January.

In any event, here is the data: In January, real (inflation-adjusted) disposable income (income after taxes) was unchanged from the previous month. Real consumer spending fell 0.1% from December to January. The personal savings rate increased from 3.7% in December to 3.8% in January. The real decline in spending included a 2.1% drop in spending on durable goods, a 0.5% drop in spending on non-durable goods, and a 0.4% increase in spending on services. 

Perhaps the most important part of the government’s latest data release was the data on inflation. That is, the Federal Reserve’s favorite measure of inflation is the personal consumption expenditure deflator, or PCE-deflator. The news on this was mixed. On the one hand, the year-over-year increase in prices continues to decelerate. On the other hand, monthly price gains accelerated, especially for services–which are labor-intensive. In other words, the tightness of the labor market, and the consequent rise in labor costs, is contributing to sustained high inflation for services. This, in turn, is preventing inflation from decelerating toward the 2% target. For the Federal Reserve, this implies a need to sustain a tight monetary policy to weaken the labor market and thereby ease wage pressure.

Let’s look at the numbers: In January, the PCE-deflator was up 2.4% from a year earlier, down from 2.6% in December and the lowest annual inflation rate since February 2021. However, the index was up 0.3% from the previous month, the biggest monthly gain since September. When volatile food and energy prices are excluded, core prices were up 2.8% in January versus a year earlier, the lowest rate since March 2021. Yet core prices were up 0.4% from the previous month, the biggest increase since February 2023. 

As for the details, prices of durable goods were down 2.4% from a year earlier and up 0.2% from the previous month. Prices of non-durables were up 0.5% from a year earlier while down 0.4% from the previous month. Now, here comes the problem: Prices of services were up 3.9% from a year earlier and up 0.6% from the previous month. The latter was the biggest monthly gain since March 2022. The strength of service inflation partly reflected continued rises in home prices. In addition, it also reflected increased demand for some services including hotels, personal care, and financial services. 

Going forward there remains a widespread view that the Federal Reserve will start to cut interest rates early in the second half of this calendar year. Yet that is already a shift from earlier expectations that the Fed would begin to normalize interest rates in March or April. The persistence of service inflation is likely one of the Fed’s biggest headaches.

Japan: Inflation decelerates, industrial output falls, and demographics worsen

  • Inflation in Japan continues to decelerate, likely reducing pressure on the Bank of Japan (BOJ) to tighten monetary policy. In January, consumer prices were up 2.2% from a year earlier, down from 2.6% in December and the lowest inflation rate since March 2022. Prices were unchanged from the previous month. Moreover, in the last three months, prices only rose 0.1%. Recall that annual inflation had peaked above 4% in early 2023.

Meanwhile, when volatile food and energy prices are excluded, so-called core-core prices were up 3.5% in January from a year earlier, down from 3.7% in December and the lowest rate in 11 months. Core-core inflation had peaked in August at 4.3%. There was considerable volatility by category, with the price of hotel bookings up 26.9% in January versus a year earlier (due to strong tourist demand). On the other hand, energy prices were down 12.1% with electricity prices down 21%. 

Going forward, there are favorable signs for a reduction in inflation. First, domestic demand remains weak, which contributed to real GDP falling in the most recent two quarters. Plus, real wages are falling as nominal wages fail to keep pace with inflation. Indeed, real wages fell 2.1% in January versus a year earlier, the 21st consecutive decline. This is different than in other advanced economies where real-wage increases are a headache for central bankers. Indeed, in North America and Europe, central banks are retaining tight monetary policies due to fears that tight labor markets will fuel continued inflation. 

This is not the case in Japan. Instead, the BOJ has maintained a very easy monetary policy throughout the recent spate of inflation, confident that the inflation was a temporary side effect of supply disruption and would ultimately recede. The BOJ is not concerned that labor markets will sustain high inflation as is the case elsewhere. Still, the BOJ has come under pressure to end the easy monetary policy. Although it has hinted at a change in policy, it has not yet taken action. 

  • In Japan, there was a sharp decline in industrial production in January, disproportionately due to a dramatic downturn in motor vehicle production. Specifically, industrial production fell 7.5% from December to January, led by a 17.8% drop in motor vehicle output. There was also a 12.6% decline in output of business machinery. In fact, production fell in 14 of 15 major industries. Moreover, the sharp drop in manufacturing output suggests that real GDP might decline in the first quarter of 2024. This would be the third consecutive quarter of falling real GDP.

The drop in automotive production was partly due to temporary suspension of production at some automotive factories due to non-economic factors. In addition, there was a 21.4% decline in lithium-ion battery output, largely due to global EV production adjustments. Still, the decline in multiple industries suggests a problem, likely due to a combination of weak domestic demand and weakening export demand. 

  • In the years to come, one of the key issues that will affect economic outcomes in many countries is demographics. In these pages I have written about demographic trends in China, the United States, and Europe. The common trend is a low birth rate combined with an aging population. All other things being equal, this implies slower economic growth and greater difficulty in servicing the pension and health care needs of the elderly. 

Nowhere is this a greater issue than in Japan. In 2023, there were a record low number of births at 758,631, down 5.1% from the previous year. In addition, the number of marriages fell 5.9% to 489,281, the first time in 90 years that this number fell below 500,000. Part of the problem is that the number of young people has been declining for some time, thereby reducing the number of births even if the birth rate doesn’t change. 

A senior Japanese government official said that “the declining birthrate is in a critical situation. The next six years or so until 2030, when the number of young people will rapidly decline, will be the last chance to reverse the trend.” He said that the government intends to take “unprecedented steps” to address this issue. This will include enhanced childcare. Prime Minister Kishida has said that this is the “gravest crisis” the country faces. Finally, the government has estimated that, barring a significant change, the population will decline 30% by 2070 with 40% of the population being over 65.

Russia’s economy is surprisingly resilient despite sanctions

  • Despite sanctions imposed by Western companies when the conflict in Ukraine began, the Russian economy has performed surprisingly well. In 2022, the year the conflict began, sanctions took a toll, leading to a 1.2% decline in real GDP. Yet in the past year, Russia has succeeded in boosting trade with non-Western countries, especially China and India. Plus, capital controls helped to stabilize the currency, leading to a sharp decline inflation. The result was that real GDP grew 3.6% in 2023. 

As 2024 begins, the economy is doing well. Industrial production was up 4.6% in January versus a year earlier, led by manufacturing. Strong defense spending, roughly 10% of GDP, contributed to this. Real (inflation-adjusted) wages were up 8.5% in January while retail sales were up 9.1%.

Part of Russia’s ability to boost production stems from access to parts from China, India, and even Western countries. Sanctions have not been airtight, so there are reports that Russia has been able to obtain inputs that were meant to be restricted.

Why is this important to us? After all, neither Deloitte nor many of our clients are active in Russia. The answer is that the sanctions were meant to cripple the Russian economy and reduce its ability to fight the conflict in Ukraine. Evidently, this has not been the case. That is not to say that Russia hasn’t suffered. Russian consumers no longer have access to many Western products and services. Plus, the conflict itself has destroyed a large part of Russia’s military arsenal. Yet it is clear that Russia’s economy is sufficiently strong that the country can continue fighting. Moreover, if the United States fails to support Ukraine, Russia will likely win the conflict. And, if that happens, it will have a big impact on the global economy.


Ira Kalish

United States


Cover image by: Sofia Sergi