Weekly global economic update
What’s happening this week in economics? Deloitte’s team of economists examines news and trends from around the world.
US inflation moderates, investors shift expectations about the Fed
- Inflation in the United States continued to decelerate in August. Consumer prices were up 2.5% from a year earlier, the lowest rate of inflation since February 2021. It was the fifth consecutive month in which annual inflation receded from the previous month. Prices were up 0.2% from the previous month. Also, the annualized three-month increase in the consumer price index (CPI) was 1.1%, indicating that inflation has decelerated significantly.
When volatile food and energy prices are excluded, core prices were up 3.2% in August versus a year earlier, the same as in July and the lowest rate since April 2021. Core prices were up 0.3% from the previous month, the biggest monthly increase since April. The annualized three-month increase in the core CPI was 2.1%, indicating that, in recent months, underlying inflation has reached the Fed’s target.
Let’s examine the details of the inflation report: First, there was a sharp drop in energy prices in August, which explains the gap between headline and core inflation. Gasoline prices were down 10.3% from a year earlier and down 0.6% from the previous month. Meanwhile, the price of food eaten at home was up only 0.9% from a year earlier. Food eaten away from home, however, was up 4%. The latter likely reflected the rising cost of labor at restaurants. The price of apparel was up only 0.3% from a year earlier. The prices of used cars were down 10.4% while the prices of new cars were down 1.2%. Airline fares were down 1.2%.
Looking at the broad categories of consumer spending, prices of durable goods were down 4.2% from a year earlier while prices of non-durables were unchanged. Non-durables excluding food were down 2.3%. Meanwhile, the prices of services were up 4.8% from a year earlier. The biggest component of services is shelter, with prices up 5.2%. Excluding shelter, service prices were up 4.3%. Thus, services remain the main source of inflationary pressure. That likely reflects the fact that services are labor-intensive while labor costs continue to rise.
The inflation report did nothing to change investor expectations that the Federal Reserve will start to cut interest rates later this month. The yield on the Treasury’s 10-year bond barely moved. However, that yield is down roughly 100 basis points since May, reflecting expectations of lower inflation and expectations of weaker economic growth. In addition, US equity prices initially dropped sharply before almost fully recovering.
Meanwhile, the futures market’s implied probability that the Fed will cut its benchmark interest rate by 50 basis points when it meets on September 18 dropped from 34% on Tuesday to 13% on Wednesday, the day the inflation report was released. In other words, the inflation report convinced investors that inflation remains a modest problem while the economy remains modestly strong. Notably, the market sees a 100% probability that the Fed will cut the interest rate.
However, recently, investors had dramatically increased their expectation that the US Federal Reserve will cut the benchmark Federal Funds rate by 50 basis points, with the implied probability rising to 47%. In other words, investors are now roughly split down the middle on what the Fed is likely to do.
The interesting thing is that, since Wednesday, there wasn’t any new information about the economy. Rather, the shift in sentiment likely reflected the impact of recent statements by Fed officials and former officials. For example, former New York Fed President William Dudley said that there is a strong case for a 50-basis-point cut. In addition, Donald Kohn, former vice chairman of the Fed, said that the Fed has “the opportunity to make up if they’ve waited too long.” Also, Loretta Mester, former President of the Cleveland Fed, said that “an argument can be made for a 50-basis-point [cut].”
Of course, how a 50-basis-point cut is communicated is important. There is a risk that investors would interpret such a dramatic move as signaling worry about the state of the economy. On the other hand, a 25-basis-point cut might lead investors to think that the Fed is still worried about inflation.
From the perspective of the Federal Reserve, the inflation report affirms that inflation has fallen sufficiently to start easing monetary policy. Yet the persistence of services inflation means that the Fed might choose to avoid an aggressive easing of policy, especially as the economy remains relatively strong. Although the job market has weakened somewhat, it is not in a state suggesting risk of imminent recession.
On the other hand, there are some warning signs emanating from the job market and elsewhere. First, private sector employment growth has slowed considerably, with a large amount of job growth now coming from health care and government. Second, a disproportionate share of jobs created have been part time rather than full time. Third, although consumer spending has held up well, spending has grown faster than income as households reduce saving and take on new debt. This situation augurs an easing in spending growth. Thus, the Fed has reason to be concerned that persistent tight monetary policy could damage the economy.
European Central Bank cuts rate, again
- The European Central Bank (ECB) cut its benchmark interest rate by 25 basis points recently. This was the second rate cut this year. Investors expect further rate cuts in the months ahead, with one cut expected this year.
This action was based on ECB expectations that inflation will continue to decelerate. The ECB said that it expects inflation in 2024 to be 2.5% while inflation in 2025 is expected to be 2.2%. This is within the range of the ECB target of 2% inflation. Also, given that service inflation has been more persistent than previously expected, the ECB expects core inflation (which excludes the impact of energy and food prices) to be 2.9% this year and 2.3% in 2025. The ECB said that “the disinflation process should be supported by receding labor cost pressures and the past monetary policy tightening gradually feeding through to consumer prices.”
Christine Lagarde, President of the ECB, noted that “wages are still rising at an elevated pace. However, labor cost pressures are moderating, and profits are partially buffering the impact of higher wages on inflation.” This suggests a need for only moderate easing of monetary policy. On the other hand, she noted economic weakness, saying that “financing conditions remain restrictive, and economic activity is still subdued, reflecting weak private consumption and investment.” The ECB expects real GDP growth in the Eurozone to be 0.8% in 2024 rising to 1.3% in 2025. Lagarde said that “we expect the recovery to strengthen over time, as rising real incomes allow households to consume more. The gradually fading effects of restrictive monetary policy should support consumption and investment.”
Clearly the ECB is attempting to balance its concern about persistent service inflation and concern about economic weakness. Lagarde said that “we will keep policy rates sufficiently restrictive for as long as necessary.” She said that the ECB is not committing to a pre-determined interest rate path. Rather, future decisions will depend on evolving data.
Investor reaction to the ECB announcement was relatively muted, given that the ECB decision was largely anticipated. Going forward, investors expect a moderate pace of interest-rate reductions. If the ECB moves more slowly than the US Federal Reserve (which is what some observers expect), that likely would lead to a rise in the value of the euro against the US dollar.
Mario Draghi offers ideas on boosting European growth
- In the European Union, there is great concern that Europe is in danger of falling behind the United States and China. Growth in Europe has been modest at best. Moreover, the United States and China have collectively been at the leading edge of development of new technologies. Consequently, the EU appointed former ECB President and former Italian Prime Minister Mario Draghi to report on how to address this problem. He has returned from his analysis urging that Europe collectively boost investment by 800 billion euros per year on new technologies. In addition, he urged that the EU ease competition rules to enable more concentration in certain industries such as telecoms and centralize supervision of capital markets.
Draghi noted that each economy in Europe is now relatively small. He said that “never in the past has the scale of our countries appeared so small and inadequate relative to the size of the challenges. The reasons for a unified response have never been so compelling—and in our unity we will find the strength to reform.” He also said that “the private sector is unlikely to be able to finance the lion’s share of this investment without public sector support.” He said that “some joint funding for investment in key European public goods, such as breakthrough innovation, will be necessary.”
Also, Draghi’s report offered a cogent explanation as to why Europe is behind the United States in per capita income, and why this problem is likely to get worse absent new action. Draghi points out that, when using an exchange rate that reflects the true purchasing power of the currencies involved, per capita GDP in the EU is 34% lower than that of the United States. Of course, there are wide differences within Europe. The report says that 70% of the difference between the United States and EU is due to differences in labor productivity (output per hour worked), while 30% is due to differences in the number of hours worked (Europeans work fewer hours than Americans, on average).
Moreover, under current conditions, the difference in productivity is likely to either remain the same or grow. Productivity grows due to innovation in technology and business processes. The innovations are implemented due to business investment. Such investment is significantly higher as a share of GDP in the United States than in the EU, according to the Draghi report. Moreover, as a share of GDP, investment has declined in the EU. This largely explains why economic growth in the EU has been slower than in the United States. It also explains why Draghi proposes a big increase in investment.
But, according to Draghi, there is more to the story. He points out that venture capital investment is far higher in the United States than in the EU. Venture capital is used to fund startup companies, especially those that are at the leading edge of technological and process innovations. The existence of venture capital plays a big role in disrupting business models and driving significant change, thus boosting productivity. Draghi’s point is that, lacking this kind of activity, Europe could wind up stagnating and failing to implement productivity-enhancing innovations. Indeed, as the report points out, the United States accounts for 66% of unicorns (new businesses with valuations above US$1 billion) while the EU accounts for only 8%. China accounts for 26%.
Draghi notes that Europe starts out with some very positive attributes. When it comes to scientific research, patents, and publications in scholarly journals, Europe is relatively strong compared to the United States. The problem appears to be in taking the next step. Draghi said that making that leap is inhibited by decentralization of public investment. While the US government (rather than states) funds a lot of R&D (including through the military), most public support for R&D in Europe is through national governments rather than the EU. Draghi suggests that this needs to change to drive big achievements. Making big leaps in today’s technological landscape requires massive scale.
One thing that has probably stifled technological innovation in Europe is the absence of a massive defense sector. In the United States, by contrast, huge expenditures on defense-related research have played a role in the development of semiconductors, the world wide web, mobile telephony, and satellite communication and navigation. This has enabled US-based companies to leapfrog their competitors in such technologies. Draghi’s evident hope is that similarly large government investments in Europe will play a similar role.
Implementing Draghi’s proposal will likely require a change in the mindset of EU leaders. It would require agreeing to a big increase in financial and fiscal integration, with the EU borrowing money on a large scale to fund investments in R&D. It would also require EU-wide deregulation.
Chinese inflation remains very low
- In August, consumer price inflation in China reached the highest level since February. The problem is that the highest level was only 0.6%. In part, the acceleration of Chinese inflation reflected a sharp rise in food prices, up 2.8% in August versus a year earlier. Food prices were boosted by extreme weather disrupting food production. When food is excluded, consumer prices were up a much more modest 0.2%. When food and energy prices are excluded, core prices were up 0.3%. Thus, China is just skirting deflation.
Meanwhile, China’s producer price index fell 1.8% in August versus a year earlier. This was the steepest drop since April. Moreover, producer prices have fallen on an annual basis in every month since October 2022. Producer prices were also down 0.7% from July to August, a very sharp monthly decline. The government reported that the decline in producer prices was especially affected by declining prices of steel-related goods, agriculture, and energy. The continuing decline in producer prices reflects several factors including declining commodity prices, weak domestic demand, and excess domestic capacity. Producer prices feed into consumer prices, which partly explains why consumer price inflation is close to a deflationary level.
Why is very low inflation a problem? There are several reasons. First, it is a signal that the economy is weak while production exceeds demand. Second, when prices are stable or falling, this means that real (inflation-adjusted) interest rates are relatively high, thereby having a negative impact on credit market activity. Third, when prices fall, it has a dampening effect on consumer spending as consumers delay purchases lest they miss a bargain. Fourth, declining prices hurt company margins and might inhibit investment. These are among the reasons most central banks target inflation of 2%. Their view is that a little inflation helps to grease the wheels of commerce. Moreover, inflation too close to zero risks a shift to deflation.
Will the inflation report lead to a shift in central bank or fiscal policy? It is hard to say. China has already eased monetary policy slightly and has committed to a modest fiscal stimulus. However, many voices have lately called for a more aggressive monetary policy and more fiscal stimulus. Among the voices is Yi Gang, a respected former head of China’s central bank.
However, there are factors inhibiting a significant shift in policy. First, a looser monetary policy risks downward pressure on the value of the renminbi. That, in turn, could hurt relations with trading partners. Plus, it would hurt the ability to service foreign currency debts. Second, more fiscal stimulus means boosting the amount of central government debt. Yet the central government is reportedly concerned about the high level of local government debt. Meanwhile, although monetary and fiscal stimulus might boost demand, it would not necessarily address excess supply. Dealing with that problem might require reducing subsidies and allowing loss-making companies to be shuttered.
Where are oil prices going?
- The price of crude oil is now at roughly the lowest level since early 2022, having fallen sharply since April of this year. The decline in prices reflects weakening global demand combined with strong supply. Moreover, the International Energy Agency (IEA) expects prices to continue falling. The head of the IEA, Fatih Birol, said that “given the current weak demand and lots of oil coming from the non-OPEC countries, mainly from America and others, we may well see downward pressure on the price.”
Meanwhile, the IEA released a report in which it noted that oil demand in the first half of this year was the lowest since the pandemic. The IEA said that the slowdown in demand was principally due to China. Birol said that “the main reason for the slower growth of the oil market is China. In the last 10 years, around 60% of global oil demand growth has come from China. Now the Chinese economy is slowing down.” Indeed, the IEA reported that Chinese oil consumption declined between March and July of this year.
Going forward, weak demand is expected to continue in China, where growth remains modest. In addition, the US economy is expected to decelerate next year versus this year. As for Europe, it’s economy is expected to accelerate, but only modestly. Meanwhile, the transition to clean energy continues, especially as China rapidly shifts to electric vehicles (EVs), thereby dampening demand for crude oil. The IEA said that, in China, “surging EV sales are reducing road fuel demand while the development of a vast national high-speed rail network is restricting growth in domestic air travel.”
Lower oil prices are already contributing to a sizable drop in the rate of inflation in many countries, including the United States, Eurozone, and Japan. Further declines in oil prices will help to sustain this trend. On the other hand, lower oil prices might boost demand for oil and oil-related products. Still, China’s rapid shift to EVs would likely dampen such an increase in demand.
Finally, one might argue that tensions in the Middle East have caused a risk premium to be added to the price of oil. That is, absent such tensions, it is possible that prices would be even lower than currently. The geopolitical situation in the Middle East is, therefore, a wild card that could influence the price of oil in either direction depending on events.
US job market softens, which may be good news
- Is the US job market becoming dangerously weak, or is it simply reverting to normalcy? The answer to this question has implications for the path of the US economy in the coming year. Here’s what’s happening.
First, the US government recently released its Job Openings and Labor Turnover Survey (JOLTS) for July. It found that the job openings rate (the share of available jobs that are unfilled) fell to 4.6% in July, the lowest level since December 2020. Moreover, it’s the same as the level seen in the months just prior to the pandemic. In other words, we are back to a pre-pandemic normal.
On the other hand, the job openings rate just prior to the pandemic was the highest it had been since data collection began in 2002. Thus, the job openings rate now remains historically high. Still, the sharp decline in the job openings rate over the past two years signals that the tightness of the job market has eased considerably (likely due to rising participation, high immigration, and possibly a weakening of demand for labor). This bodes well for further easing of wage pressure, thereby allowing inflation to decline to the target level of 2%. Indeed, the 10-year breakeven rate, which is a measure of bond investor expectations for inflation in the coming 10 years, was 2.07% as of recently.
As always, the job openings rate varies by industry. In July, the highest job openings rates were in health care (7.7%); accommodation and food service (6.9%); transportation, warehousing, and utilities (6.1%); and arts, recreation, and entertainment (5.8%). Our own professional services industry had a job openings rate of 5.5%. The lowest rates were in state and local schools (2.3%), manufacturing (4%), wholesale trade (4.1%), and construction (4.2%).
Another important indicator is job growth. Employment in the United States grew more slowly in August than investors had expected, but faster than the long-term ability of the economy to produce jobs. In addition, the unemployment rate fell. Investors reacted to the report by pushing down equity prices, bond yields, and oil prices. The value of the US dollar, however, increased against the euro and the British pound while it fell against the Japanese yen. The US government conducts two surveys to understand labor market conditions: One a survey of households, the other a survey of establishments. Let’s begin with the establishment survey.
In August, the US economy produced 142,000 new jobs, less than expected but still the fastest employment growth since May. Job growth in July was downwardly revised to 89,000. Job growth in the United States was concentrated in just four industries. If job growth in construction, health care and social assistance, leisure and hospitality, and local government are combined, it adds up to 146,000 new jobs, more than the total job growth for the United States.
Meanwhile, employment in manufacturing fell by 24,000. Half of that decline was due to declining employment in transportation equipment. In addition, employment fell by 11,000 in retailing. In most other industries, job growth was small. For example, in our own professional services industry employment increased by only 8,000. Thus, although the headline job growth number was relatively strong, the lack of broad-based employment growth was likely a concern to investors.
The establishment survey also provided data on wages. It found that average hourly earnings were up 3.8% in August versus a year earlier, the same as in June and slightly higher than in July. Wage growth has decelerated significantly since earlier in the year, likely reflecting the impact of declining inflation and an easing of the tightness in the job market.
Also, the separate household survey, which includes the impact of self-employment, found that employment grew slightly faster in August than the size of the labor force. The result was that the unemployment rate fell from 4.3% in July to 4.2% in August. In addition, the number of people unemployed because they lost jobs fell sharply in August. As such, the household survey suggested that, at the least, labor market conditions did not worsen in August.
The latest report confirmed that the US job market is slowing. This contributed to the decline in equity prices and the slight drop in bond yields. However, as was true a month ago, investors could be overreacting. Rather than being headed for recession, the US economy appears to be reverting to a more normal and sustainable rate of growth. Recall that the US economy grew at an annualized rate of 3% in the second quarter. This cannot be sustained in a tight labor market without generating increased inflation.
Finally, the US government reported last week on the number of initial claims for unemployment insurance. The report said that there were 227,000 initial claims for unemployment insurance in the most recent week, down from 232,000 in the previous week. The four-week moving average was 230,000, down from 231, 750 in the previous week. The four-week moving average was the lowest since June of this year. In other words, the number of people initially claiming unemployment insurance remains relatively low, suggesting that businesses are not engaged in mass dismissals.
What can we infer from the three sets of data discussed above? First, the job market has weakened. Yet the data also suggests that the job market is now operating in a manner typical of the pre-pandemic era. That is, it is reverting to normal. So far, at least, the data from the job market is not signaling a deterioration sufficient to produce an economic downturn. Rather, it suggests a job market that may generate a normal level of economic growth, likely slower in the coming months than in the past year.
The fact that the economy is slowing is good news from an inflation perspective and allows the Federal Reserve to cut rates later this month with confidence. On the other hand, investors are evidently so worried that the economy might decelerate too quickly that they are now pricing in a likelihood that the Fed will cut rates by more than 100 basis points before the end of the year. Still, one might reasonably ask why the Fed should cut rates dramatically when the unemployment rate is falling while job growth is in excess of 100,000 per month.
The inversion of the US yield curve is ending. What does this mean?
- In the United States, the yield curve is no longer inverted. In the past, when inversion ended, a recession soon started. Will that happen this time? First, however, let’s define things. The yield curve to which I’m referring is the gap between the yields on the 10-year and two-year bonds. For the first time in 26 months, this gap is no longer negative. However, another commonly observed yield curve is the gap between the 10-year yield and the three-month yield. That gap remains inverted. Traditionally, an inverted yield curve has been a good predictor of recession. In most instances in which there was an inversion, a recession followed the end of inversion, although the timing varied.
Yet it is important to note that inversion does not cause recession. Rather, it can reflect factors that might cause a recession. For example, inversion often means that there has been a tightening of monetary policy, which involves an increase in short-term interest rates. That happens because the Federal Reserve attempts to quell inflation by restricting credit market conditions. The reversal of inversion comes when investors expect a Fed easing, thereby suppressing shorter-term rates. That is evidently what has happened lately. Moreover, each time there is news about job market weakening, investors appear to boost their implied probability of a rate cut.
Monetary policy acts with a lag. Thus, the negative impact on the economy might not begin until the policy begins to ease. The argument can be made that, in the current situation, the negative impact of monetary tightening is only now beginning, as evidenced by a weakening of the job market. Thus, even as the Fed soon begins to ease policy, the negative impact of months of high interest rates might continue to unfold. This could mean recession, or it might simply mean a slowdown in growth.
On the other hand, the economy has been remarkably resilient in the face of monetary tightening. There are a couple of reasons for this. First, the huge fiscal stimulus during the pandemic led to a surge in household savings. Spending that excess savings allowed consumer spending to continue growing for a long time. However, the excess savings is largely depleted. Now, households are cutting back on saving to sustain spending. In addition, fiscal stimulus continues, already having a positive impact on investment in manufacturing due to subsidies. Third, it could be that the private sector is less vulnerable to high interest rates than previously, due in part to strong household and business balance sheets.
If the Fed believes that the economy is at risk of imminent recession, it is likely to accelerate the process of interest-rate reductions. That explains why many investors now expect a 50-basis-point cut later this month. My own view is that recession will likely be avoided in the coming year, but that the economy may significantly decelerate from the gangbuster growth we have recently seen.
Office property woes
- In the United States, the delinquency rate on commercial property loans by banks has risen to the highest level since the fourth quarter of 2014. On the other hand, at 1.42%, the delinquency rate is far lower than the 8.75% rate seen at the end of 2010. Thus, delinquencies do not appear to be a problem. Still, some observers believe that the commercial property market in the United States is a ticking time bomb. Moreover, the delinquency rate on office property has now risen above 8% for the first time since 2013. Office property accounts for about 16% of commercial property debt.
It has been more than four years since the pandemic led to a mass movement of workers from offices to homes. And while many workers have returned to the office, many have not. This, in turn, has led many companies to reassess their office needs. Given that most companies lease office space with multi-year leases, it takes time for a change of sentiment to influence the market. That change is happening, with many companies either not renewing leases or negotiating much lower leasing costs.
Meanwhile, with much higher interest rates than two years ago, many office building owners are struggling to re-finance their mortgages. It has been reported that nearly one trillion dollars of commercial mortgage loans are coming due this year. In addition, valuations of office buildings have fallen sharply, leading to difficulty in selling properties. Many distressed sales are taking place, leaving owners facing cashflow challenges. For the small- and medium-sized US banks that account for about 70% of commercial mortgages, this situation is causing financial stress.
To address this situation, there is growing and bipartisan support in the US Congress to provide tax incentives to convert office space to housing. This is considered not only a way to address stress in the financial community, but also to address a shortage of housing in the United States. Still, most office buildings are not built in a way that is conducive to such conversions.
China gets advice
- Former central bank chiefs in both China and Japan have expressed concern about China’s deflationary pressure. Moreover, the former head of the Bank of Japan (BOJ) worried that China might be experiencing the problems that Japan faced in the 1990s and first decade of this century. Both leaders expressed concern that China is plagued by insufficient domestic demand and excess capacity. At a time when other major economies are struggling to bring inflation under 3%, China is struggling to keep inflation modestly positive.
The former Governor of the People’s Bank of China (PBOC), Yi Gang, said: “I think right now we should focus on fighting deflationary pressure. The immediate task is to turn the GDP deflator positive in the short term. I know there are doubts and some people don’t agree, but we must try our best.” Yi’s proposed solution to the problem of deflation involves more fiscal stimulus, a more aggressive easing of monetary policy, addressing the property market disequilibrium, and dealing with excessive local government debt.
Meanwhile, the former head of the BOJ, Haruhiko Kuroda, said that China’s combination of property market troubles, deflationary pressure, and demographic challenges are similar to what Japan experienced in the period from 1998 to 2012. Although Kuroda said that China’s deflation problem is not yet as severe as Japan’s earlier problem, it nonetheless requires action.
The statements by these two former central bankers will likely carry weight given the esteem in which they are held. Meanwhile, the problem of excess capacity in China is exacerbated by the difficulty in shutting down loss-making businesses, many of which are invested by local governments. These local governments are reluctant to close companies that provide plenty of jobs. In Japan in the 1990s and early 2000s, a similar problem emerged. Many “zombie” companies in Japan were partly owned by banks that would rather roll over bad loans than force companies to shut down. This type of situation exacerbates excess capacity and deflationary pressure.
Central bankers see a soft landing coming
- Recently, the world’s leading central bankers gathered for their annual meeting in Jackson Hole, Wyoming, an idyllic landscape for discussing such mundane topics as interest rates and inflation. What made the gathering notable was that it represented a pivot away from the pessimism of the last few years. No longer was fear expressed about imminent recession. Nor was there any discussion this time about troubling trade-offs between inflation and employment. Rather, the gathering exhibited general confidence that the major economies can experience a soft landing. Let’s look at what the leading central bankers had to say, beginning with Jay Powell of the US Federal Reserve.
Powell was surprisingly explicit that “the time has come for policy to adjust.” Investors were not surprised at the content of his comments, just by the fact that he said it. Thus, asset prices did not respond sharply, although bond yields fell while the value of the US dollar fell. Moreover, Powell noted that “the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks.”
Powell’s statement that interest-rate cuts are appropriate came after he reviewed the recent history of inflation in which he noted that the rise of inflation had largely to do with pandemic-related supply issues. He then asked the question: “How did inflation fall without a sharp rise in unemployment?” His answer was that “pandemic-related distortions to supply and demand, as well as severe shocks to energy and commodity markets, were important drivers of high inflation, and their reversal has been a key part of the story of its decline.” He added that “our restrictive monetary policy contributed to a moderation in aggregate demand.” Plus, he said that this moderation eased demand for labor while rising labor supply brought “the labor market to a state where it is no longer a source of inflationary pressures.” He concluded that expectations of inflation are well anchored, thereby allowing the Fed to cut rates.
The Fed has a dual mandate from the US Congress to minimize inflation and maximize employment. Until recently, it was largely focused on inflation, especially at a time when the labor market was very tight and likely contributing to inflation. Now, things have changed, with job growth having eased in recent months. Powell said that the Fed does not “seek or welcome further cooling in labor market conditions.” While he appeared confident that the economy will experience a soft landing, he said that the Fed has “ample room to respond to any risks we may face, including the risk of unwelcome further weakening in labor market conditions.”
Meanwhile, the European Central Bank (ECB) sent its chief economist, Philip Lane, to the gathering in Jackson Hole. Lane expressed some hesitation about further rate cuts. He said that “the return to target is not yet secure. The monetary stance will have to remain in restrictive territory for as long as needed to shepherd the disinflation process towards a timely return to the target.”
Recall that the ECB became the first large central bank to cut rates back in June. Moreover, investors are pricing in a likelihood of two more rate cuts this year. Still, services inflation in the Eurozone has been persistent while the labor market has remained relatively tight. Hence the hesitation. On the other hand, Lane said that “a rate path that is too high for too long would deliver chronically below-target inflation over the medium term and would be inefficient in terms of minimizing the side effects on output and employment.” Thus, he appeared to suggest that rate cuts are coming.
Finally, Bank of England (BOE) Governor Andrew Bailey said that he is “cautiously optimistic” about inflation. The BOE has already cut rates one time and investors are pricing in further rate cuts. The United Kingdom has made significant progress on inflation while the economy continues to grow. Bailey said, however, that it is “too early to declare victory” over inflation. Notably, Bailey appeared to embrace a soft-landing scenario, saying that “the economic costs of bringing down persistent inflation—costs in terms of lower output and higher unemployment—could be less than in the past.”
Overall, the Jackson Hole meeting exuded a sanguine attitude toward the major economies. However, one participant offered a note of caution. The president of the Federal Reserve Bank of Chicago, Austan Goolsbee, said that monetary policy tends to act with a long and variable lag. This raises “the question of how long are the lags in monetary policy, and the longer you think the lag is, the more concerned we should be about whether the Fed could make a rapid pivot.” In other words, we might not yet have experienced the negative consequences of the recent tightening of monetary policy. Moreover, it is unclear if the negative effects can be offset by a quick easing of policy. Time will tell.
Is US monetary policy tight or not?
- Recently, it has been said that the US Federal Reserve needs to cut interest rates because monetary policy has become tighter in the past year. That is because, with declining inflation, real (inflation-adjusted) interest rates have risen, thereby having a more negative impact on economic activity. It could be argued that, absent an imminent easing of monetary policy, the Fed risks allowing recessionary conditions to develop. And indeed, the Fed has been explicit in its intention to start cutting rates in September.
But there is another point of view. Adam Posen, president of the Peterson Institute and a former member of BOE’s policy committee, says that Fed policy is not tight. His reasoning is that financial market conditions remain relatively favorable. Thus, he says, the tightness or looseness of monetary policy should not be judged by the level of interest rates. Rather, it should be judged by the impact on financial market conditions. Moreover, he notes that the evident resilience of the US economy, due in part to productivity gains and strong immigration, also demonstrates that monetary policy has been relatively easy rather than tight. A tight policy would have led to a sharp deceleration in output.
Still, Posen does not argue that the Fed should leave interest rates in place. He supports a cut, especially given that inflation is down considerably and that the labor market is clearly weakening. However, he thinks that, ultimately, interest rates will land significantly higher than previously.
As for financial market conditions, there are several favorable indicators. Risk spreads remain historically low, equity valuations are historically high, and a Federal Reserve Index of Corporate Bond Market distress is historically low. In addition, consumer finances are in good shape. Although levels of debt, debt service payments, and delinquencies have risen, they remain relatively low by historical standards. Plus, the creditworthiness of most household borrowers is far better than before the global financial crisis. Thus, Fed policy has not had the effect of weakening credit market conditions or suppressing asset prices.
US household data is consistent with expectations for a rate cut
- In July, real (inflation-adjusted) disposable income grew modestly while real consumer spending grew rapidly. That divergence cannot go on indefinitely, but for now it is leading to strong economic performance. Meanwhile, the Federal Reserve’s favorite measure of inflation remained steady in July. Let’s look at the details.
The US government reported that, in July, real disposable personal income (household income after inflation and taxes) was up a modest 0.1% from the previous month. This reflected continued growth of employment and rising real wages. Meanwhile, real consumer expenditures were up 0.4% from June to July. This difference was possible because the personal savings rate continued to decline, falling from 3.1% in June to 2.9% in July. Recall that the savings rate had been as high as 4% in January, falling steadily ever since. It should be noted that the savings rate falls when the debt/income ratio rises.
As for the details of consumer expenditures, real spending on durable goods was up 1.7% from June to July, spending on non-durables was up 0.2%, and spending on services was up 0.2%. The considerable strength of spending on durables is notable, especially at a time when activity in the housing market remains stagnant. Housing often fuels purchases of home-related durable goods.
The report also included data on the personal consumption expenditure deflator (PCE-deflator), which the Federal Reserve favors over the better-known consumer price index (CPI) as a measure of inflation. The PCE-deflator was up 2.5% in July versus a year earlier, the same as in June, but also the same as in January and February. Thus, headline inflation appears to have stabilize slightly above the Fed’s 2% target. When volatile food and energy prices are excluded, the core PCE-deflator was up 2.6% in July versus a year earlier, the same as in May and June. However, core inflation decelerated from earlier in the year, having been 2.9% in January.
The data indicates that the prices of durable goods fell 2.5% in July versus a year earlier, prices of non-durables were up 1.3%, and prices for services were up 3.7%. Regarding services, prices have decelerated from April when they were up 4%. Still, services inflation remains too high, driven by a tight labor market. This has been the principal concern of the Fed. However, the labor market has clearly eased in recent months. Consequently, the Fed has signaled a strong intention to start cutting interest rates in September. The latest data do nothing to change that expectation. Indeed, equity prices and bond yields moved very little in response.
Eurozone inflation data is consistent with a September rate cut
- Inflation in the 20-member Eurozone was very low in August, boding well for the ECB to renew rate cuts in September. Specifically, the CPI was up only 2.2% in August versus a year earlier, down from 2.6% in the previous month and the lowest rate since July 2021. Prices were up 0.2% from the previous month. The low level was due, in part, to a sharp decline in energy prices.
When volatile food and energy prices are excluded core prices were up 2.8% in August versus a year earlier, down from 2.9% in July. However, core inflation has been steady throughout this year. Notably, service inflation increased to 4.2% in August, the highest since last October. That is likely the most worrisome aspect of the latest inflation report. On the other hand, the surge in services inflation could have been a temporary reaction to the Olympic games in France.
By country, annual inflation was 2% in Germany, 2.2% in France, 1.3% in Italy, 2.4% in Spain, 3.3% in the Netherlands, and 4.5% in Belgium. Financial market reaction to today’s report was relatively muted. Investors were evidently not surprised.
Now that there is a high anticipation that the US Federal Reserve will start cutting interest rates in September, and with many investors expecting the Fed to implement a 50-basis-point rate cut, the environment is now more favorable for the ECB to engage in a second rate cut (the first took place in June).
Usage of Chinese renminbi is rising
- China wants to reduce dependence on the use of US dollars in trade. Doing so would reduce currency risk and would increase the influence of China in dealing with its trading partners. Now it is reported that usage of the Chinese renminbi in China’s bilateral trade has grown significantly. The Chinese government reported that, in July, the renminbi accounted for 53% of China’s inbound and outbound transactions, up from 40% three years ago.
Partly, the increase reflects the surge in Chinese trade with Russia. Russians are restricted from using US dollars due to sanctions imposed following Ukraine-Russia war. Russia is eager to engage in renminbi-based transactions as it helps to offset the negative impact of Western sanctions.
In addition, the rise of renminbi transactions reflects an increase in the number of currency swap agreements that China has with several other countries. These include Saudi Arabia, Argentina, Mongolia, and Brazil, among others. In the case of Saudi Arabia, China has become the biggest purchaser of oil and prefers to transact in renminbi. Saudi Arabia has a trade surplus with China, which means that the kingdom is accumulating renminbi, which are not easy to invest outside of China. Thus, the Saudis are likely selling renminbi in exchange for dollars and euros.
Moreover, China has intervened in currency markets to stabilize the exchange rate between the US dollar and the renminbi. This helps to encourage others to transact in renminbi as it enables them to sell their renminbi in exchange for dollars at a reliable rate. If China were to remove existing capital controls, then it would become less risky for others to invest renminbi in China, thereby making renminbi transactions more attractive. Yet there is no indication that this will happen anytime soon.
Despite the rise in renminbi usage, the renminbi still only accounts for less than 5% of global transactions.