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What’s happening this week in economics? Deloitte’s team of economists examines news and trends from around the world.
The International Monetary Fund (IMF) estimates that in 2019, the global economy would have grown at its slowest pace in 10 years. It also estimates that global growth will pick up slightly in 2020, but mainly because of a rebound in emerging markets such as Mexico, Brazil, India, and Indonesia.1 As for the four largest economies—the United States, the European Union (EU), China, Japan—the IMF expects a further deceleration in growth in 2020. The baseline IMF forecast assumes that the trade war will not worsen next year. Some analysts say this is not necessarily realistic given the recent experience, and that a further intensification of the trade war could push the global economy into recession territory. Although the United States and China recently agreed to a short-term truce, trade tension between the United States and the EU appears to be increasing.
The IMF forecast was released at the annual meeting of IMF and World Bank leaders in Washington. At that meeting, World Bank chief economist Pinelopi Goldberg noted that uncertainty related to the trade war is the main reason for economic weakness. She said, “Policy is supposed to remove instability. Instead, it is suppressing old certainties. No one knows what tomorrow will bring.”2 However, it is worth noting that the problems in the global economy mainly involve the industrial sector rather than services and are mainly manifest as weakness in trade and investment rather than in consumer spending. As such, there appears to be a sort of bifurcation taking place in Europe, the United States, Japan, and China. Adam Posen, the CEO of the Peterson Institute, said it is easy to say that “protectionist, backward trade policies will immediately mess you up, but we’ve been careful not to say that because it’s probably not true.” However, IMF chief economist Gita Gopinath said she is concerned that the problems in manufacturing will spill over into services. She noted recent data indicating weak orders for services in the United States, Germany, and Japan.
Finally, the IMF noted that historically, low policy interest rates have likely encouraged many investors to engage in extra risk taking. An IMF official said, “The search for yield among institutional investors—such as insurance companies, asset managers and pension funds—has led them to take on riskier and less liquid securities. These exposures may act as an amplifier of shocks.”3 The result has been a build-up of corporate debt that could pose a risk to the global economy should the slowdown accelerate. That is, slower growth could cause highly indebted enterprises to cut back on investment and possibly have difficulty in servicing debts. This, in turn, could hurt the balance sheets of institutional investors. The IMF says if a recession comes, about 40 percent of the US$19 trillion corporate debt will be at risk of default. If the market value of corporate debt declines, then investors will have to mark to market, thereby hurting balance sheets and potentially causing investors to avoid risk. The latter could cause some parts of financial markets to seize up. As such, it could be argued that a prolonged period of historically low borrowing costs has likely created conditions that represent a threat to financial stability.
The European Central Bank (ECB) held its last policy meeting under the tutelage of outgoing president Mario Draghi. He will soon be replaced by former IMF managing director Christine Lagarde. As expected, the ECB chose to leave policy unchanged. This followed a controversial easing of policy last month.4 More importantly, the ECB committed to maintaining an easy policy until inflation rises significantly. The bank said that interest rates will remain historically low “until it has seen the inflation outlook robustly converge to a level sufficiently close to, but below, 2 percent within its projection horizon, and such convergence has been consistently reflected in underlying inflation dynamics.” Meanwhile, Draghi once again expressed the view that monetary policy alone won’t revive economic growth, which has lately been dismal. He said that Europe needs more fiscal expansion and more liberalization of labor and product markets. In his press conference following the ECB policy announcement, Draghi defended the current negative policy interest rates, saying they are having a positive impact on the Eurozone economy. Some critics have complained that negative rates reduce the incentive for businesses to invest efficiently and might allow weak companies to remain in business when they should otherwise die. In addition, negative rates generate excessive risk taking and likely contribute to over-inflated asset prices.
The debate about negative rates took a new turn last week when Sweden’s central bank, the Riksbank, said it intends to end its nearly five-year-long experiment with negative rates and will soon raise the benchmark rate to zero.5 The Riksbank said that if negative rates are perceived as permanent, this will lead to a change in behavior by participants in the economy that could have negative consequences. For now, the Riksbank intends to keep the benchmark rate at zero for two years before raising it further. It also said should the economy weaken, it would be willing to cut rates again.
The latest purchasing managers’ indices (PMI) for the Eurozone reveal that the regional economy remains stalled.6 The PMI is a forward-looking indicator meant to signal the direction of activity in the manufacturing or services sectors. A PMI is based on sub-indices such as output, new orders, export orders, employment, pricing, inventories, and sentiment. A reading above 50 indicates growing activity; the higher the number, the faster the growth. The latest PMIs from IHS Markit show continued extreme weakness for manufacturing and only modest growth for services. The manufacturing PMI for October was unchanged from September at 45.7, a level indicating a rapid decline in activity. The separate services PMI increased slightly to 51.8, a level indicating only modest growth. Together, Markit suggests that these PMIs are consistent with a GDP growth rate of only 0.1 percent. In other words, the Eurozone economy has stalled. Moreover, the weakness is largely due to Germany, where the manufacturing PMI for October was only 41.7. In France, on the other hand, it was 50.5.
There was conflicting news last week about the state of the US manufacturing sector. On one hand, there was a sharp drop in new orders for durable manufactured goods, including capital goods, in September. On the other, the flash purchasing manager’s index for manufacturing increased in October, although it remained at a relatively low level.
Specifically, the US government reported that new orders for durable goods declined 1.1 percent from August to September, down 0.8 percent from a year earlier.7 Excluding volatile transportation equipment, new orders were down 0.3 percent for the month. Excluding defense equipment, new orders were down 1.2 percent for the month. Notably, new orders for capital goods, excluding defense and aircraft, were down 0.5 percent. This bodes poorly for business investment. These figures are consistent with the pattern seen in several recent months. New orders for durable goods have been weak for much of 2019. It is likely that this reflects, in part, the negative impact of the trade wars.
Meanwhile, IHS Markit reported that the purchasing manager’s index (PMI) for US manufacturing increased slightly in October.8 The PMI for manufacturing increased from 51.1 in September to 51.5 in October, the second consecutive month of growth and the highest level in six months. Still, this is a level consistent with slow growth in activity. Moreover, it is well below the levels seen earlier this year. Clearly, the US manufacturing sector has decelerated substantially. However, the modest rebound reflects a surprising improvement in export orders. The separate PMI for services also increased but remained at a very low level of 51.0. IHS Markit commented that the two PMIs are consistent with economic growth of 1.5 percent. Additionally, it said that “the overall subdued picture reflects a spreading of economic weakness from manufacturing to services, but encouragingly we are now seeing some signs of manufacturing pulling out of its downturn, in part driven by a return to growth for exports.” It is not clear why exports are turning around, or whether this is the start of a trend. We will have to wait and see.
US trade negotiator Robert Lighthizer says that the United States and China are “close to finalizing some sections” of the first phase trade agreement that the two sides hope to complete. 9 This follows a deal earlier this month in which the United States agreed to postpone tariff increases that had been scheduled for October 15 in exchange for a Chinese commitment to boost purchases of US farm products. The two sides agreed to work for three to five weeks to complete a first-phase agreement that would address a small number of key issues and be a prelude for further talks and agreements. The issues said to be under consideration involve protection of intellectual property as well as commitments to avoid currency manipulation.
If the progress that Lighthizer spoke of continues, the hope is that the leaders of both the countries can sign an agreement when they meet in Santiago, Chile, next month for the Asia-Pacific Economic Cooperation (APEC) Summit. The deal agreed upon earlier this month did not address the fact that the United States remains committed to boosting tariffs on a significant volume of imports from China in December. The Chinese side is expected to pressurize the United States to agree that the first-phase agreement will address this issue as well. The United States is likely to require further concessions in exchange for this.
As for the US side, although it has previously indicated an aversion to small, incremental deals, it now appears amenable to doing this in order to avoid further harm to the US economy—especially a year before a presidential election. Polls indicate that a plurality of voters believe that tariffs are hurting the economy, something the administration is likely to consider in its trade deliberations. On the other hand, hardliners in the administration and Congress will likely balk at a small deal, complaining that it fails to achieve key goals. In any event, the first phase is not yet done, and it is hard to say how likely it is that it will be completed.
As debate rages about how fiscal policy might be more efficacious than monetary policy at a time of historically low interest rates, there is a clear divergence of fiscal policies between the United States and eurozone.
First, the US government ran a budget deficit of US$986 billion in the fiscal year that ended last month. This was the biggest deficit in seven years—it was 4.6 percent of the GDP and was up 0.8 percentage points from the previous year.10 The rapid increase in the size of the deficit, unusual at a time of full employment, came about because of two factors. These were: the tax cut that the Congress passed at the end of 2017 and the sizable increases in government spending enacted by the Congress. Moreover, spending is set to increase even further during the current fiscal year, based on a budget agreement between the president and the Congress. Thus, the deficit will almost surely cross US$1 trillion in the current fiscal year. The percentage increase in spending last year was the largest since 2009, which was the height of the financial crisis. Normally, deficits decline during periods of economic growth and low unemployment, and vice versa. During periods of economic expansion, deficits usually only increase due to military spending gains associated with war. The current situation is an historical aberration.
What are the implications of this? On one hand, fiscal expansion tends to have a positive impact on economic activity, especially if it doesn’t lead to higher bond yields due to higher government borrowing. When the government borrows money that is sitting on the sidelines and spends it, economic activity increases. Thus, it’s reasonable to expect that economic activity this year and next will be higher than it otherwise would have been. On the other hand, big deficits will grow even bigger in the next decade due to demographic change. That is, higher pension and health care costs associated with a larger retired population will put increased pressure on the government. At some unknown point, large deficits could become unsustainable, leading to a combination of higher borrowing costs, higher inflation, and a substantial depreciation of the currency. These things will be more likely to take place if the US dollar were to lose its status as the dominant world trading currency. Under such circumstances, the US government might need to engage in draconian austerity. Finally, if, as some analysts expect, there is a recession next year, it will likely be more difficult for the Congress to provide necessary fiscal stimulus while deficits are already very large. If the Congress fails to provide fiscal stimulus, the result could be a deeper recession than would otherwise be the case.
Meanwhile, the recent weakness of the eurozone economy has led the European Central Bank (ECB) to ease monetary policy by lowering interest rates and resuming quantitative easing. Yet ECB president Mario Draghi said that monetary policy alone might not be sufficient to avert recession and that a more expansionary fiscal policy is likely needed. He is not alone. The IMF, several EU member states, as well as leading European business leaders have also called for fiscal stimulus, especially on the part of Germany, which continues to run budget surpluses and has negative borrowing costs. Even as this debate takes place, fiscal policy remains relatively conservative across eurozone. After hitting a high of 7 percent of GDP in 2010, the combined fiscal deficit of the eurozone countries gradually declined until the deficit was only 0.2 percent of GDP in early 2018.11 The latest data indicates that the combined deficit was 0.7 percent of GDP in the second quarter of 2019. This is largely because of Germany’s surplus. Indeed, the deficits (or surpluses) vary by country. In the second quarter of 2019, Germany had a surplus of 1.7 percent of GDP and the Netherlands had a surplus of 2.3 percent of GDP while France had a deficit of 3.4 percent of GDP. Meanwhile, with deficits historically low and economies continuing to grow at a modest pace, the debt/GDP ratio for eurozone has been declining. In the second quarter of 2019, the combined debt/GDP ratio for eurozone was 86.4 percent, down from 87.3 percent a year earlier, a decline of 0.9 percentage points of GDP. This figure varied by country. In the past year, the debt/GDP ratio fell 1.9 percentage points in Germany, 3.0 percentage points in the Netherlands, 4.4 percentage points in Ireland, and 1.2 percentage points in Belgium. On the other hand, the debt/GDP ratio increased in France, Italy, Spain, and Greece.
While the trade conflict between the United States and China has had a disruptive effect on other east Asian countries, one country that appears to have benefitted is Vietnam. According to reports, in the first nine months of 2019, Vietnam’s exports (denominated in US dollars) were up 8.4 percent from the same period a year earlier.12 Moreover, exports to the United States were up 33 percent.
Unlike what has happened globally, Vietnam’s exports have been growing faster than GDP and rising as a share of GDP. In fact, Vietnam has just joined a small group of countries for which exports represent more than 100 percent of GDP. Most other countries in this situation are small (such as Hong Kong, Singapore, and Luxembourg). Vietnam, on the other hand, has 96 million people. As the trade war continues, and as labor costs in China continue to rise, many companies that produce low value-added products using inexpensive labor have shifted their supply chains from China to Vietnam. Of course, there have been similar shifts to other countries in Southeast Asia, but Vietnam has received far more investments than any other country.
Vietnam benefits from low labor costs, a friendly atmosphere for inbound investment, and free trade agreements with several other countries including the United States. In terms of development, Vietnam is today where China was 20 years ago. The principal danger to Vietnam’s export led growth is the risk that the United States chooses to target it as part of its trade war. This is not out of the question. After all, there have been accusations that some Chinese companies are using Vietnam simply as a transshipment location in order to avoid US tariffs. The United States is said to be concerned about this and has discussed the possibility of imposing tariffs on Vietnam in retaliation. In addition, the US administration is likely concerned that Vietnam now has the fifth largest trade surplus with the United States. Meanwhile, other countries in the region have suffered a loss of trade due to their dependence on China-led supply chains.
For most of the period since May, the yield spread in the United States has been negative. That is, the yield on the 10-year Treasury bond has been below the yield on the three-month Treasury bill. This was a result of the tightening of monetary policy, which led to higher short-term rates while, at the same time, suppressing expectations of inflation, thereby leading to lower long-term rates. The inversion has reflected investor pessimism about inflation and growth, and this pessimism has likely been exacerbated by the trade war. An inversion is often seen as a good predictor of recession. In fact, almost every time there has been such an inversion in the post-war era, a recession soon followed. Moreover, every recession of the post-war era was preceded by an inversion of the yield spread.
In the past week, however, the yield spread turned slightly positive.26 How shall we interpret this? It is possible that last week’s announcement that the United States and China had reached a minor trade agreement boosted investor confidence, thereby leading to higher long-term yields. In addition, the Federal Reserve recently announced that it will resume purchases of government bonds on a monthly basis in order to provide sufficient liquidity to the market for short-term funds.27 This follows a seizing up of the market for repurchase contracts (repos). This loosening of monetary policy would normally be expected to boost longer-term yields.
Does all of this mean that recession risk is now over? Hardly. First, if the United States-China trade deal goes no further, or if it turns out to be a nonevent, it is likely that the yield spread will once again invert. Second, history tells us that when there is a sustained inversion of the yield spread (as has been the case), it is often followed by an end to that inversion just before a recession begins. For example, after inverting, the yield spread returned to positive territory several months before the recession of 2007-09 began. This was also true of each of the prior several recessions. Thus, even if the yield spread remains positive in the months ahead, the fact that it inverted for a sustained period is probably a good indicator that trouble could still arrive.
Of course, much will depend on what the Federal Reserve does. It is widely expected to cut the benchmark interest rate by 25 basis points by the end of this month. Beyond that, there is uncertainty given the clear divisions among leaders of the Federal Reserve. A sustained and repeated reduction in the benchmark rate could lead to a much higher yield spread. On the other hand, if the Fed pauses, it could result in an inversion. It is simply hard to say.
Not long ago, US President Trump dismissed the notion of a small trade deal with China, saying that he preferred a big comprehensive deal or no deal at all. Late last week, however, it was announced that a modest deal was reached.29 Investors responded with a surge in US, Chinese, and European equity prices as well as an increase in the value of the Chinese renminbi. Yet although both sides said that a deal was completed, many aspects remain unclear or unfinished.
Before discussing the parameters of the deal, it is helpful to note where things currently stand.30 As of now, the United States imposes a 25 percent tariff on about US$250 billion of imports from China and a 15 percent tariff on another US$110 of imports. In addition, the United States had previously indicated that on October 15, it will raise the 25 percent tariff to 30 percent. Additionally, it has announced it will impose a 15 percent tariff on another US$156 billion in imports on December 15. Together, it would bring almost all Chinese imports under a tariff umbrella.
Under the deal announced last week, the United States agreed to postpone the tariff increases set for October 15 in which the tariff on half of US imports from China would rise from 25 percent to 30 percent. In exchange, the two sides agreed to continue talks for several more weeks with the goal of completing a deal. The deal is meant to address such issues as protection of intellectual property, trade in financial services, and Chinese purchases of US agricultural products. As for the last item, China committed to boosting such purchases by US$40–50 billion. No specifics were provided regarding the other issues. In addition, US Treasury Secretary Mnuchin said that the United States might revisit its decision to label China a currency manipulator. President Trump said that this agreement, meant to be completed in three to five weeks, will be the first of three “phases.” He said that “phase two” will start immediately after the completion of “phase one.” Trump called the deal a “very substantial phase one deal.” Chinese Vice Premier Liu, with whom Trump met at the White House, called the discussions between the two sides “very good.” This deal, which is still not complete, does not address the US tariffs set to be implemented on December 15. Nor does it address the retaliatory tariffs already imposed by China. As such, it basically buys time for China by delaying tariffs that were set to go up this week. The only substantive action by China is its promise to boost purchases of farm goods. There is no certain clarity on the other structural issues.
The issue of Huawei—that is of great concern to the Chinese government—was left uncertain as well.31 The United States has imposed sanctions on Huawei based on allegations that the company provides Chinese companies and government with a backchannel to spy on the United States. The US trade negotiator Robert Lighthizer said that this issue is being considered in a separate process. Members of the US Congress from both parties have urged the administration not to use the issue of Huawei as a bargaining chip in trade negotiations. If the administration does include Huawei in the next round, it will likely cause an eruption in Congress.
Finally, Trump said, “One of the great things about the China Deal is the fact that, for various reasons, we do not have to go through the very long and politically complex Congressional Approval Process. When the deal is fully negotiated, I sign it myself on behalf of our Country. Fast and Clean.” This means that it will not be a formal deal with enforcement mechanisms. Rather, it will essentially be a gentleman’s agreement. In this case, the only incentive for either side to abide by the terms is the threat of new tariffs.
Meanwhile, Trump said that he still thinks the Federal Reserve should cut interest rates despite the new trade deal.
The impact of the trade war between the United States and China is becoming increasingly evident from the trade flows reported by the US government. In the first eight months of 2019, US imports from China dropped sharply, while imports from Mexico and Vietnam increased considerably.32 This shift in trade patterns is likely to continue and possibly accelerate as companies redesign their supply chains in order to avoid tariffs. In the absence of a permanent settlement between the two countries, “global companies” will likely be increasingly eager to find a more permanent solution to the uncertainty now plaguing them. Looking at the data, US imports from China were down 12.5 percent in the first eight months of 2019 than in the same period in 2018—this was a decline of US$43.3 billion.33 Meanwhile, US imports from Mexico were up 5.5 percent, for an increase of US$12.4 billion. In addition, US imports from Vietnam were up a staggering 34 percent, for an increase of US$10.9 billion. The US government is concerned that the boost to imports from Vietnam actually represents increased transhipment of Chinese goods through Vietnam, rather than actual production in Vietnam, in order to avert US tariffs. The United States has raised the possibility of imposing tariffs on Vietnam if this practice continues. Still, it is likely that a sizable part of the increase in Vietnamese and Mexican exports to the United States was due to a shift of production from China to those countries. For a while, there was considerable talk of companies shifting production to Mexico to take advantage of free access to the US market, lower transport costs, and relatively low wages. However, when the United States threatened to impose onerous tariffs on Mexico due to concerns about migration earlier this year, many companies likely became more cautious about investing in Mexico.
Meanwhile, although total US imports from Europe increased significantly during this period, imports from Germany remained stagnant. This is likely related to the global slowdown in the automotive sector as well as fears of US tariffs on German automotive imports. With a trade dispute between the United States and Europe now brewing, it is possible that US imports from Europe will be hurt in the coming year.
The Belt and Road Initiative (BRI)—China’s signature project of recent years that involves lending money to emerging countries for the purpose of constructing infrastructure—exists in part because China has long generated large external surpluses. This means that China has excess capital to invest overseas. The government considers the BRI an opportunity to secure foreign resources, unload excess production of steel and cement, and expand China’s geopolitical footprint in key emerging markets.
Now, however, China’s surplus is dwindling, driven in part by changing demographics that have reduced the excess of saving over investment. One casualty of this shift appears to be the BRI. Specifically, the latest data indicate that BRI lending for new projects declined 13 percent from 2017 to 2018, and another 6.7 percent in the first eight months of 2019.34 Also, the number of new loans in excess of US$1 billion fell from 46 in 2016 to 28 in 2018, and then to only two in the first half of 2019. In addition to the decline in the availability of funds, it is reported that some state-run banks in China are becoming more cautious about such lending, evidently having been burned by bad loans. Additionally, some of the recipient countries have become more cautious about accepting such loans, also having been burned by the accumulation of unsustainable debt. Indeed, the BRI has been criticized for damaging the finances of recipient countries while providing a Chinese government subsidy for state-owned enterprises, especially those plagued by excess capacity.
In any case, the disappearance of China’s surplus, and the resulting loss of an abundance of funds, will require that the country be more careful in choosing BRI projects.
In recent decades, China’s economic growth has been impressive, driving hundreds of millions of people from poverty into the middle class. This growth, which has taken China from being a poor nation to the world’s second-largest economy, has been one of the most significant events in world history. Nonetheless, according to a recent report from the World Bank, Innovative China,35 in the absence of significant reforms, this growth could decelerate sharply in the next decade. The World Bank notes that the growth of recent decades was driven by a range of factors that are likely to disappear. These include a growing working-age population, rapid migration of people from rural to urban areas, low wages that attracted foreign investment into export-intensive manufacturing, and expanding global trade liberalization. Each of these factors has begun to decelerate or reverse: the working-age population is declining, migration is slowing, wages have risen, and trade liberalization has stalled. Thus, going forward, China will have to rely on other factors in order to maintain significant economic growth.
While no one expects China to continue growing at the lofty rates achieved in the last three decades, the World Bank report says that if China fails to reform, growth could slow to an annual rate of 1.7 percent in the 2030s. The reforms needed would be meant to stimulate productivity growth at a time when the labor force is not growing at all. After all, economic growth mainly stems from either increasing the number of workers or increasing the output of each worker—also called productivity. Productivity growth, in turn, requires constant innovation. Yet in the past decade, productivity growth in China has decelerated. The reforms that the World Bank suggests focus on liberalization of labor, product, financial, and land markets. The Bank says that, with adequate reforms, growth could average 4.1 percent in the 2030s—not breakneck, but still strong. Specifically, the World Bank says that labor market reform should involve ending the household registration system, thereby allowing greater labor mobility. It says that there ought to be “fair competition” between state-run and private industry. This is different from a previous World Bank report that called for the privatization of state-run companies.
The latest report evidently takes into account the fact that the current government is keen on retaining a state-run sector. The World Bank says that such “fair” competition must involve equal access to capital. It notes that private companies in China are twice as likely to be turned down for bank loans as state-run companies. The report also calls for greater openness of China’s economy to private and foreign investment, thereby creating greater competition and encouraging improvements in productivity. It says that this will be especially important for the large and growing services sector, thereby enabling China to make the transition away from a manufacturing dominated economy. Finally, the World Bank says that a key to driving productivity improvements will be protection of intellectual property. Notably, this is something the US government has demanded as part of its trade dispute with China. Ironically, if China does agree to US demands on this issue, it would help to boost Chinese economic growth.
The US government’s latest Job Openings and Labor Turnover Survey (commonly called JOLTS) indicates that the tightness in the job market might be abating.36 In August, the job openings rate (the share of available jobs that are not filled) fell to 4.4 percent, the lowest level since March 2018 and down from the 4.7 percent rate seen a year earlier. The number of job openings, at 7.0 million, was below the 7.3 million seen a year earlier. Also, the number of people hired in August was down from a year earlier. By industry, the job openings rate was highest for professional and business services at 5.4 percent, but was down from the 6.0 percent rate seen a year earlier. Other industries with high job openings rates were health care, accommodation and food service, and retail trade. Industries with low job openings rates were nondurable manufacturing, wholesale trade, and education.
In September, consumer prices in the United States were unchanged from August, and were up 1.7 percent from a year earlier.37 When volatile food and energy prices are excluded, core prices were up 0.1 percent from August to September and up 2.4 percent from a year earlier. The latter figure matches a high reached in early 2018 and has not been exceeded in more than 12 years. As such, it appears that underlying inflation is accelerating, although it remains low compared to the longer-term historical level. It is only marginally higher than the Federal Reserve’s target of 2.0 percent inflation. Moreover, the monthly change in core prices was quite low. The gap between headline inflation and core inflation reflects the sharp decline in energy prices. The price of gasoline was down 8.2 percent in September versus a year earlier. The categories that saw strong increases in prices were medical care (up 4.4 percent), shelter (up 3.5 percent), used cars (up 2.6 percent compared to almost no change in the prices of new cars), and restaurant meals (up 3.2 percent compared to meals eaten at home up only 0.6 percent).
The inflation report offers support for both Fed hawks and doves. On the one hand, the slow increase in core prices from a month earlier supports the view that underlying inflation remains dormant. Indeed, producer prices fell in September. Consequently, one could argue in favor of a further easing of monetary policy. On the other hand, the acceleration in year-over-year inflation, combined with historically low unemployment, suggests that the trend is in the direction of higher inflation. This is not entirely surprising given the tightness of the labor market. Thus, one could argue against further easing of monetary policy. Where the Fed will fall on this debate remains to be seen. Fed Chairman Powell said this week, “Inflation is somewhat below our symmetric 2.0 percent objective but has been gradually firming over the past few months.”38 Powell said that, while many economic indicators remain favorable, the US economy faces significant headwinds, both from trade conflict and slowing overseas growth.
Meanwhile, with headline inflation low, real (inflation-adjusted) wages continue to rise modestly, but more slowly than in recent months. In September, nominal average hourly earnings of all workers were up 2.9 percent from a year earlier, a slight deceleration from recent months.39 After taking account of inflation, real earnings were up 1.2 percent, also a deceleration from before. Thus, despite continued tightening of the labor market, real wages are not responding. This might reflect the fact that labor force participation is rising as formerly discouraged workers return to the labor market in search of work. The rise in the supply of labor might be suppressing wage gains. If so, this means that the tight labor market is not yet generating the kind of inflationary pressure that would normally be expected.
Since 2004, the United States and the European Union (EU) have been fighting a battle at the World Trade Organization (WTO).40 The United States accused the European Union of providing export subsidies to Airbus, and the European Union accused the US government of implicitly providing subsidies to Boeing through its purchase of defense equipment from Boeing. The WTO ruled several years ago that both sides are correct. It said that the European Union has provided subsidies worth US$23 billion and the United States has provided subsidies worth US$22 billion. Last week, the WTO ruled that, as compensation, the United States can impose tariffs on the European Union worth US$7.5 billion. It will provide a ruling on the tariffs that the European Union can impose at a later date.
The US administration says it will impose 25 percent tariffs on Spanish olive oil, French cheese, Scotch whiskey, mussels, and cashmere sweaters among other items.41 While largely focused on items purchased by relatively affluent consumers, these tariffs will enable domestic producers of cheese and whiskey to raise their prices, thus having a broader impact. Indeed, a trade association of US dairy farmers said that it “strongly endorses” these tariffs.42 One of the biggest dairy producing states is Wisconsin, which President Trump carried narrowly in 2016 and which was critical to his close victory. The WTO decision to allow the United States to impose tariffs on the European Union for violating rules on aerospace subsidies is, therefore, creating an opportunity for the United States to use tariffs for strategic political goals. However, given that the tariffs on the European Union will raise prices of key consumer products, the net impact will be to effectively reduce US consumer spending power. This comes at a time when the US economy is already facing headwinds from the larger US-China trade war. Also, although much of the press commentary has focused on the tariffs on food items, the United States is also set to impose a 10 percent tariff on Airbus planes. While this might help Boeing to achieve more orders, it should be noted that about 40 percent of the content of an Airbus aircraft are US-made components.43 Thus, the tariff is likely to have a negative impact on the US economy.
EU Trade Commissioner Cecilia Malmstrom has urged the United States not to implement tariffs and, rather, sit down and work out a negotiated settlement. She said that “the mutual imposition of countermeasures would only inflict damage on businesses and citizens on both sides of the Atlantic, and harm global trade and the broader aviation industry at a sensitive time.”44 However, Malmstrom said that the United States has refused to consider its proposals for a settlement. She said that “the European Union has, as recently as this July, shared concrete proposals with the United States for a new regime on aircraft subsidies, and a way forward on existing compliance obligations on both sides. So far, the United States has not reacted.” France’s Economics Minister Bruno Le Maire, noting that the United States has rejected the European Union’s attempts at negotiating a settlement of the aerospace dispute, said that “if the American administration rejects the hand that has been held out by France and the European Union, we are preparing ourselves to react with sanctions.” Leaders of the European Union expressed disappointment that the United States has chosen to impose tariffs on EU imports in response to the WTO ruling which permits the United States to do so.45 EU leaders indicated that the European Union will impose tariffs on the United States once the WTO, as expected, rules on the cost of US subsidies for Boeing. However, EU leaders hope that, rather than a new trade war, negotiations can take place to defuse the situation and settle the issue of subsidies. A spokesman for German Chancellor Merkel said: “Our aim is to achieve an agreement with the United States on both of our subsidies in the aerospace industry.”
Some EU leaders have expressed concern that, if the European Union imposes new tariffs on US imports, the US government might respond by imposing tariffs on imports of European vehicles—something it has previously threatened to do. In fact, the United States proposed such tariffs in May, but delayed a decision until this November. As such, it is likely that the European Union will not impose new tariffs before the November deadline on automotive tariffs. In any event, there is a fear of a wider trade war between the United States and the European Union, one that would have negative consequences for both economies. Meanwhile, although no discussions about subsidies have yet to begin, US Secretary of State Pompeo said that the United States is amenable to talks and is hopeful that “the right outcome” can be achieved.
Finally, the argument about tariffs involves how to punish the United States or the European Union for past violations of rules on subsidies. The ruling has nothing to do with future sales of airplanes. And, in the near future, both Boeing and Airbus are likely to face competition from commercial planes produced by a Chinese state-owned enterprise (SOE), thereby raising new concerns about subsidies. China will soon be the largest airline market in the world, and both Boeing and Airbus are keen to continue their participation. They are likely worried that a subsidized Chinese company might provide unfair competition.
In August, industrial production in Japan fell 4.7 percent from a year earlier.46 This was the eighth time in the last 12 months in which production had fallen. Production was down 1.2 percent from the previous month. There were sharp declines in the production of iron, steel, and nonferrous metals as well as machinery. Production of vehicles was also down. The weakness of Japan’s industrial sector is, in large part, related to the trade war between the United States and China. Indeed, Japanese exports to China have fallen sharply, in part due to weaker Chinese demand for inputs used in products that are re-exported to the United States.47 Likewise, industrial production in neighboring South Korea declined in August as well. Both countries have been hit by the trade war, and the two countries are in the midst of their own trade war. However, the conflict between Japan and South Korea is not believed to have had a significant impact on Japanese output—at least not yet.
Meanwhile, Japanese retail sales soared in August48 as consumers spent heavily in anticipation of the increase in the national sales tax from 8 percent to 10 percent that took effect on October 1.49 In August, retail sales were up 4.8 percent from July. This was the sharpest increase in retail sales since 2014 which was the last time the national sales tax was increased. Retail sales were up 2.0 percent from a year earlier, the steepest increase since October of last year. There were especially strong increases in spending on discretionary items such as apparel and machinery. While any acceleration in spending is welcome, the danger is that, by front-loading spending, households will end up spending far less in the months following the tax increase, thereby leading to a slowdown in economic activity. That is precisely what happened in 2014 when a brief recession followed the tax increase. At that time, the national sales increased from 5 percent to 8 percent. The Japanese government has taken significant steps to alleviate the impact of the tax increase, including providing subsidies for noncash consumer purchases. The government is keen to stimulate domestic demand at a time when external headwinds are hurting the economy. Yet it is also determined to fix the imbalance between expected future tax revenues and expected future pension liabilities. That is why the tax is being increased. However, another way to fix the imbalance is to encourage greater labor market participation, especially on the part of mothers. Thus, the government intends to use some of the extra tax revenue to fund free kindergarten and preschool education.50 The hope is that this will lead to an increase in the number of working mothers.
Although the headline last week was that the US unemployment rate fell to a 50-year low, the overall monthly employment report issued by the US government indicates that job growth is slowing and that wages are decelerating. Still, the pace of job growth was reasonably good in September, exceeding what is required to absorb new entrants into the labor force. As such, the job market is not yet signaling a downturn. Rather, it is signaling slower economic growth. In a sense, it was a Goldilocks report: not too hot, but not too cold either. Consequently, investors reacted favorably.51 They evidently saw the report as signaling continued moderate growth but an absence of inflationary pressures. As such, it portends a relatively easy monetary policy on the part of the Federal Reserve. Investors, therefore, boosted equity prices. Here are the highlights of the employment report:
The government issues two reports; one based on a survey of establishments, the other based on a survey of households. The establishment survey found that 136,000 new jobs were created in September.52 This is less than investors had anticipated, but more than the roughly 100,000 needed to stabilize the job market. By industry, there was a decline in manufacturing employment, led by a sharp fall in automotive employment. Within the broad services sector, employment fell in the retailing sector and grew feebly in financial services. The only areas with relatively strong job growth were professional services and health care. The leisure and hospitality sector, often a source of robust job growth, saw only modest expansion of employment. In addition, average hourly wages were up 2.9 percent from a year earlier, which is a deceleration from the 3.2 percent gain clocked in the previous month. This is despite a tight labor market.
The separate survey of households found that the unemployment rate in September fell to 3.5 percent, the lowest since December 1969.53 In addition, while overall participation remained steady, the participation rate for working age men and women hit a post-recession high. Evidently, formerly discouraged workers are returning to the labor force, thus helping to hold down wage pressures.
The slowdown in the German economy has largely been due to the weakness of the large industrial sector, which has suffered from external headwinds. A decline in global trade and weakness in global business investment have hurt Germany’s massive manufacturing sector. Meanwhile, the services sector has, until lately, been relatively robust. Yet that now appears to be changing, thereby putting the larger economy at risk. The latest purchasing manager’s index (PMI) for Germany’s services sector fell from 54.8 in August to 51.4 in September, the lowest level in three years.54 When the services and manufacturing PMIs are combined, the composite PMI for Germany fell from 51.7 in August to 48.5 in September, a number indicating a decline in overall economic activity. This was the lowest composite PMI since April 2013 and the composite PMI fell at the fastest pace in seven years. IHS Markit, which compiles this survey data, said that “the slowdown in the service sector in September was even worse than first feared, with the final results showing the weakest business activity growth for three years. A technical recession now looks to be all but confirmed. The drop in new business at services firms is an indication that domestic demand is struggling to offset the loss of new work from abroad and is a downside risk to the sector's immediate growth prospects. The worry is … that staff shedding across manufacturing could soon outweigh the employment growth in the service sector.” Germany’s weak composite PMI caused the overall Eurozone composite PMI to fall to 50.1 in September, the lowest in six years.55
Germany, which is often the engine of growth for Europe, is lately holding back growth in Europe. Meanwhile, there is a near consensus among outside observers such as the International Monetary Fund (IMF) and the European Central Bank (ECB), as well as German business leaders, that the solution to Germany’s woes is a fiscal stimulus. The argument is made that, because the German government can borrow at negative interest rates, and because it currently runs a budget surplus, it has room to engage in fiscal stimulus without doing damage to its finances. The argument is that such spending would stimulate growth in Germany and Europe and, if spent on infrastructure, would boost longer-term productivity growth. The government so far has rejected this argument.
Finally, despite the emerging weakness of Germany’s economy, its retail sector—and that of the eurozone overall—remained strong in August.56 The European Union reports that, in August, German retail sales were up 0.5 percent from the previous month and up 3.2 percent from a year earlier. The latter was the strongest growth since March. For the eurozone, retail sales were up 0.3 percent for the month and up 2.1 percent from a year earlier. However, given the September services PMI, as well as Markit’s comments on the outlook for services, it could be that retail sales will decelerate in the months ahead as the negative effects of Germany’s weak industrial sector spill over into the broader economy.
It was reported recently that the US government is considering forcing Chinese companies to delist from US equity exchanges. In addition, the United States is considering banning US government pension funds from investing in Chinese equities and bonds. Although the United States says that no decision has been made, investors on both sides of the Pacific are already alarmed. It is widely believed that, at the least, the United States is considering this. In China, there is concern that an inability to raise funds in US capital markets will stymie the ability of globally oriented Chinese companies to expand. In the United States, there is concern that the absence of Chinese companies will hurt the development of US capital markets. For example, a common venue for listing foreign companies is the market for American Depository Receipts (ADRs). About 90 percent of the ADR market comprises Chinese companies.57 Thus, restricting Chinese listing in the United States could cause the US$860 billion ADR market to collapse. Although many in the US administration and the US Congress are inclined toward restricting capital flows to China, one very important leader in the United States thinks otherwise. Senate Majority Leader Mitch McConnell said that such restrictions “could end up hurting us. Whatever tactics we use with regard to China need not be ones that hurt us.”
If the United States follows through with the restrictions discussed, this would not only be an extension of the existing trade war. It would likely contribute to a burgeoning decoupling of the economies of the United States and China. In addition, there is fear that China might choose to retaliate by dumping some of its holdings of US Treasury securities, thereby pushing up US bond yields. Meanwhile, China continues to impose restrictions on capital outflows even as it attempts to lure inflows of foreign capital. The restrictions on outflows are meant to avoid downward pressure on the value of the Chinese renminbi. If the United States restricts flows of funds to China, it could have the effect of depreciating the renminbi, something the US government clearly wants to avoid. It is not known if a discussion about capital flows is or will be part of the broader trade negotiations taking place between the United States and China. Finally, the fact that investors are concerned about the possibility of US action to restrict outflows of capital to China means that the global economy faces yet another degree of uncertainty. It means that investors face not only economic risk, but political risk as well.