Weekly global economic update

What’s happening this week in economics? Deloitte’s team of economists examines news and trends from around the world.

Ira Kalish

United States

US inflation continues to recede

  • The US inflation news for October was good, with both headline and core inflation decelerating more than investors had expected. Investors reacted positively, driving down bond yields and driving up equity prices. The value of the US dollar fell against major currencies. The inflation report can be interpreted to mean that the Federal Reserve needn’t tighten monetary policy further. The main uncertainty now is when the Fed will start to loosen policy. The conventional wisdom is that it will happen in the second half of 2024 or beyond. Yet if inflation continues to fall and the economy weakens, the Fed could decide to act sooner.

In any event, here are the details of the inflation report: In October, the consumer price index (CPI) was up 3.2% from a year earlier after having risen 3.7% in September. Prices were unchanged from the previous month. Notably, energy prices were down 4.5% from a year earlier and food prices were up only 3.3%, the lowest increase since June 2021. Food price inflation had peaked at 11.3% in August 2022. When volatile food and energy prices are excluded, core prices were up 4% from a year earlier and up 0.2% from the previous month. Annual core inflation was the lowest since September 2021. 

Inflation is now concentrated in a small number of categories while many other categories have either low or negative inflation. Prices of durable goods were down 2.1% in October versus a year earlier. This included a 7.1% decline in prices of used cars, a 9.4% decline for televisions, a 3.7% decline for toys, a 2% decline for home appliances, and a 7.6% decline for technology commodities such as computers and smartphones. Meanwhile, prices of nondurable goods were up only 1.7%. Excluding food, nondurable prices were up 0.1%.

The lion’s share of inflation stemmed from services where prices were up 5.1% from a year earlier. Notably, airline fares were down 13.2%. Excluding shelter, service prices were up 3%. Regarding shelter, prices were up 6.7% in October versus a year earlier, the lowest rate since August 2022. Shelter inflation had peaked in March of this year at 8.3%. It is likely that shelter inflation will continue to decelerate due to the lagged effect of stable home prices. Given that shelter is playing a disproportionate role in sustaining inflation, a further decline in shelter prices bodes well for further reductions in overall inflation. 

Going forward, the major risk to progress on inflation is oil. That is, if events in the Middle East continue to get complicated, then a sharp rise in oil prices would likely take place, thereby boosting inflation. That, in turn, could lead the Fed and other central banks to tighten monetary policy, or at least prolong high interest rates. Yet barring an unexpected event in the Middle East, the most likely scenario is downward pressure on oil prices. 

In any event, following the release of the inflation data, the yield on the US Treasury’s 10-year bond fell 17 basis points, hitting the lowest level since mid-September. Yields also fell in other countries. The S&P 500 index of US equities increased 1.85% and equity prices in other countries increase commensurately. In addition, the value of the euro versus the US dollar increased 1.5%, hitting a two-month high. Thus, not only was the US inflation report favorable; it also surprised many investors in a positive way.  

US retail sales weaken. Expectations for consumer are modest

  • The consumer slowdown has begun. After rising rapidly in September, US retail sales declined slightly in October. Several factors explain this. First, employment growth decelerated in October. Second, inflation fell considerably. Third, many households with student debt resumed making payments. Finally, the savings rate might have hit bottom, with consumers choosing not to spend faster than their income is growing. 

Here are the details: In October, retail sales (not adjusted for inflation) fell 0.1% from the previous month. Spending was dragged down by weak demand for durable goods. As such, sales at automotive dealerships were down 1.1%, sales at furniture stores were down 2%, and sales at home improvement retailers were down 0.3%. Still, sales at electronics retailers were up 0.6%. The weakness of durable goods might reflect an aversion to taking on more credit card debt at a time when the job market is weakening

Meanwhile, department store sales were down sharply while apparel store sales were flat. Nonstore retailers saw a modest increase in sales, as did restaurants. Overall, the retail sales report paints a picture of a consumer sector that is weakening. This was expected. The stunning growth of the economy in the third quarter was not expected to be sustained in the fourth quarter.  

Does the decline in retail sales portend a recession? Not necessarily. Retail sales data mainly involves goods while demand for services is likely continuing to grow. Thus, overall consumer spending might still be growing. 

  • The stellar US economic growth recorded in the third quarter was largely due to strong growth in consumer spending. However, it is widely expected that consumer spending will decelerate in the holiday season, thereby putting financial stress on retailers and their suppliers. Indeed, the retail sales number for October offer affirmation of this view. The reasons for this expectation include expected slower growth of employment, rising household debt and debt service payments, the reinstatement of student debt repayment, and the fact that the personal savings rate is now quite low and might not go lower. That suggests a likelihood that households will no longer boost spending faster than income. 

Assuming that spending decelerates, this will have significant implications. First, retailers could get stuck with excess inventories. An analysis by Reuters found that the volume of inventory held by major retailers could be a problem. About two-thirds of retailers surveyed have relatively low inventory turnover, boding poorly for profitability in the holiday season.  

Retailers are evidently aware of a burgeoning problem and are preparing accordingly. That is, they are hiring less than usual. A survey by Challenger, Gray, and Christmas found that, during this Autumn, the number of seasonal positions advertised dropped to the lowest level in a decade. In addition, a survey by the National Retail Federation found that the number of seasonal workers retailers intend to hire is 40% lower than the peak reached in 2021. 

This is important because the retail industry employs an enormous number of workers, especially during the holiday season. Moreover, a decline in retail industry activity will have a negative spillover effect on other industries such as transportation, warehousing, and even production of consumer goods. A drop in hiring will affect household income, thereby affecting spending. It is ironic that an expected deceleration in consumer spending will lead to less hiring, thereby leading to less spending.

Moreover, the deceleration in hiring of relatively low wage workers has led to deceleration in the wages of low wage workers. Despite that, wages of low-income workers are still rising faster than wages of high-income workers. While the deceleration of wages will help to bring inflation further down, it will also weaken consumer spending and, consequently, economic growth. 

Weakened US job market confirms optimism on inflation

  • ·The US job market is weakening. The government reported that the number of initial claims for unemployment insurance in the most recent week was 231,000, up 13,000 from the previous week and the highest level in almost three months. The four-week moving average was 220,250, up 7,750 from the previous week, also the highest in almost three months. This means that the number of people losing jobs is up. Still, the numbers are historically low, suggesting that, although the job market is weakening, it remains relatively strong.

Another key measure is the number of people continuing to receive unemployment benefits. Having bottomed in early September, it has been slowly but steadily rising ever since. In the most recent week, the number of insured unemployed was 1,865,000. This was up 32,000 from the previous week. A year ago, the figure was 1,454,000. This implies that people who have lost jobs are taking longer to find new ones. This suggests that jobs might not be as plentiful as they had been. 

This data was welcomed by investors. Following release of the initial claims data, the yield on the US Treasury’s 10-year bond fell 10 basis points to 4.41%, the lowest level since mid-September. With initial claims for unemployment rising and above what markets had expected, investors see more evidence that the economy is potentially weakening. This is seen as boosting the likelihood that the Federal Reserve will hold the benchmark interest rate steady rather than raising the rate.

Meanwhile, investors are downwardly revising their expectations for inflation. The “breakeven rate” is an excellent measure of bond investor expectations of inflation. It is calculated by subtracting the yield on inflation protected bonds from the yield on regular 10-year bonds. The yield on inflation protected bonds is a measure of the real (inflation-adjusted) yield. Thus, the difference between the two yields (the breakeven rate) reflects investor expectations of inflation. The breakeven rate on the five-year bond is now 2.24%. This is down from a recent high of 2.52% hit on October 19. The breakeven rate had risen sharply following the Gaza-Israel conflict. Yet once investors determined that the war would not widen, and thus cut oil prices, they downwardly revised their inflation expectations. Moreover, the recent inflation data combined with weak retail sales and employment data is evidence that the economy is weakening sufficiently to drive down inflation.   

China: Some economic improvement, but property troubles remain

  • China released several key economic indicators that offer a mixed picture. On the one hand, retail sales and industrial production performed better than expected. On the other hand, business investment and property market activity remained quite weak. As such, China continues to experience a modest economic recovery. A significant rebound has not begun. 

Here are the details: First, retail sales in China were up a relatively strong 7.6% in October versus a year earlier. That is the biggest increase since May. It is likely that the recent Golden Week holiday played a role in boosting consumer engagement. Moreover, sales were poor a year ago when much of the country’s urban core was under lockdown due to COVID-19. Thus, the base effect of a weak October 2022 contributed to strength in October 2023. 

In addition, Chinese industrial production continued to grow at a moderately healthy pace, rising 4.6% in October versus a year earlier. This was the fastest growth since April. The manufacturing component was up 5.1%. 

On the other hand, fixed asset investment continued to decelerate. In the first 10 months of the year, fixed asset investment was up only 2.9% from a year earlier. Although this included a 6.2% increase in investment in manufacturing, it also included a 9.3% decline in investment in property. Moreover, sales of new homes were down 7.8% in October and the volume of unsold properties increased by 18.1%.  

Given that growth remains unsatisfactory compared to recent history, the government has taken steps to stimulate more activity. Monetary policy has been gradually eased. In addition, the government will boost borrowing, thereby moderately increasing the budget deficit in an effort to provide stimulus. 

  • In China, despite government efforts to stabilize the residential property market, new home prices continued to fall sharply in October. The government reported that, in October, prices of new homes in 70 major Chinese cities were down 0.5% from the previous month. This was the biggest decline since February 2015. Of the 70 cities, prices fell in 56, up from 54 in the previous month. 

Keep in mind that, in China, many residential properties are unoccupied, having been built and purchased as speculative investments. The government said that, of properties in which people have chosen to reside, prices fell in 67 of the 70 cities. It is reported that many developers have been offering substantial discounts to unload properties they built. Also, the sale price of existing homes fell 0.8% in October versus a year earlier. 

Meanwhile, several developers face financial difficulty while many have cut back sharply on new construction. As previously reported, investment in property fell 9.3% in the first 10 months of this year versus the previous year. In addition, sales of homes by the country’s top 100 developers fell 27.5% in October versus a year earlier. 

Although the government has provided subsidies to developers to complete properties that were sold but not finished, the reality is that the market continues to be characterized by excess capacity. As such, the weakness in property sector activity is expected to continue having a dampening effect on overall economic activity. Moreover, given that households hold about two-thirds of their wealth in property, the decline in prices means a loss of wealth. Households restore their wealth by saving more and spending less. That explains the relative weakness of consumer spending in the past year.

As property investment wanes, state-run banks are providing credit instead to state-run companies that invest in building capacity in key industries. This includes electric vehicles, electric car batteries, and solar panels to name a few. In addition, the government is restricting exports of key minerals, such as graphite, that are used to make electric car batteries. The result will likely be excess capacity in these industries, especially electric vehicles. In this industry, there is already much unused capacity, and capacity far exceeds the needs of the domestic market. Thus, China is keen to sell the vehicles overseas, especially in Europe. As a result, the European Union is examining the possibility of antidumping duties on imports of Chinese vehicles.

The latest on China: Inflation, reserves, foreign direct investment, and trade

  • China experienced deflation in October. The consumer price index (CPI) fell 0.2% from a year earlier and 0.1% from the previous month. This was the second time in the last four months that prices fell from a year earlier. It is also the sixth time in the last nine months that prices have fallen from the previous month. These facts have created some concerns that China is entering a new era of deflation, similar to what Japan experienced in the 1990s.

The decline in prices, meanwhile, is largely attributable to food. Food prices fell 4% in October versus a year earlier, led by a 30.1% decline in the price of pork. This was the biggest drop in food prices in 25 months. When food prices are excluded, the CPI was up 0.7% in October versus a year earlier. When both food and energy prices are excluded, core prices were up 0.6% from a year earlier. This suggests that the underlying situation is not deflation. However, underlying inflation is still extremely low. 

Inflation data is often considered a signal about the strength of China’s economic recovery. Very low or negative inflation is seen as an indication of weak demand. It can also be seen as the result of excess capacity. Unlike the world’s other major economies, China is not struggling to contain inflation. Rather, the primary focus of monetary policy is to restore economic vitality. As such, there is no current need for tight monetary policy. The main question is how accommodative monetary policy ought to be. 

Although China’s central bank, the People’s Bank of China (PBOC), has eased monetary policy in the past year, it has taken a cautious approach. The problem with too much easing is that it boosts the gap between Chinese and US interest rates, thereby fueling outflows of capital and putting downward pressure on the value of the currency. China manages the exchange rate, intervening in currency markets to prevent rapid depreciation. This has entailed the sale of foreign currency reserves. Doing so reduces the PBOC’s balance sheet, which is equivalent to a tightening of monetary policy.  

Why worry about currency depreciation? Countries sometimes worry about depreciation because it leads to higher import costs, thereby fueling inflation. Yet China does not have an inflation problem. Rather, concern about depreciation stems from three things. First, a lower-valued renminbi increases the domestic cost of servicing foreign currency debt. Second, a lower-valued renminbi boosts the competitiveness of exports, potentially inviting protectionist actions by China’s trading partners. Finally, a cheap currency is inimical to the prestige that accompanies a strong and stable currency.  

  • China’s holdings of US Treasury securities peaked in 2014 and has been declining ever since. Selling foreign currency assets is a way for China’s central bank to boost the value of its currency (or prevent a depreciation) at a time when there is downward pressure on the currency. Hence, it is not surprising that China has reduced its exposure to the US dollar. 

However, there is another important reason. China is looking to minimize risk associated with holding dollars. Given the current relationship between China and the United States, there is risk that the United States could impose restrictions on the ability of China to obtain access to its dollars. 

It is notable that the pace at which China has reduced holdings of US Treasuries accelerated starting in 2021. Today, China’s dollar holdings are at the lowest level in 14 years. It is likely that this reflects a desire to avert a sharp decline in the value of the renminbi. Since 2021, outflows of capital from China have accelerated, thereby putting downward pressure on the currency. Despite having sold reserves, China has experienced a modest and steady decline in the value of the renminbi. 

Meanwhile, as Chinese reserves dropped sharply, yields on US Treasury bonds increased, especially recently. The principal reasons for the rise in yields are unrelated to China. However, there is a view that China’s sale of Treasuries contributed to the rise in US bond yields. Is this possible? My view is probably not. Over the course of nearly a decade, China has shed roughly US$400 billion in US Treasuries. Yet the market for Treasuries is roughly US$20 trillion. It is a highly liquid market with a large amount of turnover. Thus, China’s sale, even as it accelerated recently, was probably inconsequential relative to the volume of transactions in the market. 

  • The factors that are applying downward pressure on the renminbi remain. Inbound direct investment has fallen sharply while outflows of capital have accelerated. The result is that, in the third quarter, and for the first time since records began in 1998, there was a net deficit in foreign direct investment for China. 

The decline in inbound investment reflects the effort of global companies to “de-risk” supply chains by reducing exposure to China and increasing supply chain investment in other locations such as Southeast Asia, India, and Mexico. It also reflects global companies in China repatriating earnings more quickly. In addition, the acceleration in outflows reflects an effort by Chinese nationals to take advantage of rising interest rates overseas. Plus, global companies are removing assets from China. The weakening pace of inbound investment into China could have negative ramifications for economic growth.

  • The International Monetary Fund (IMF) is slightly more optimistic about China’s near-term economic prospects than a few months ago. Previously, the IMF expected real GDP growth of 5% in 2023. Now it expects growth of 5.4%. For 2024, the IMF upgraded the forecast from 4.2% to 4.6%. The upward revision is due to expectations of added government support to the economy, especially for the troubled property market. IMF Deputy Managing Director Gita Gopinath said that “the authorities have introduced numerous welcome measures to support the property market. But more is needed to secure a quicker recovery and lower economic costs during the transition.” In addition, Gopinath said that “third-quarter GDP growth came out stronger than we expected, and it was driven by stronger consumption that we had expected.”

Despite the upgrade for 2023 and 2024, the IMF still expects Chinese growth to gradually decelerate in the coming years, with growth expected to be 3.5% by 2028. The weakness is due, in part, to changing demographics, with a steadily decline in the working-age population. Moreover, after a long period in which productivity was fueled by migration from rural to urban areas, migration has now petered off, thereby suppressing productivity growth. Finally, Gopinath said that persistent troubles in the property market are likely to curtail economic growth in the next several years.

Notably, the upgraded forecast came on the same day that China announced weaker-than-expected export growth. Specifically, exports (evaluated in US dollars) fell 6.4% in October from a year earlier. Exports have fallen in 10 of the last 12 months. The weakness stems from a weakened global economy as well as trade tension with the United States and other Western governments. Despite the overall decline, exports increased strongly for refined products, steel, and rare earth minerals. 

By country, exports were down from a year earlier by 8.2% to the United States, 13% to Japan, 12.6% to the European Union, 15.1% to ASEAN, 4.4% to Taiwan, and 17% to South Korea. On the other hand, exports increased 5.9% to Australia and 17% to Russia. 

Meanwhile, China’s imports were up 3% in October versus a year earlier. Imports from Europe and Southeast Asia were up strongly, while imports from the United States, Japan, South Korea, and Taiwan were down. Imports of many commodities were up strongly while imports of steel and rubber were down.

  • The trade war between China and the West continues. After the United States recently intensified restrictions on technology trade and cross-border investment with China, the Chinese government has chosen to intensify restrictions on exports of rare earth minerals. This announcement comes ahead of an imminent meeting between the presidents of China and the United States.

European Central Bank pledges to keep interest rates high. Investors are skeptical.

  • It is the intention of the European Central Bank (ECB) to keep interest rates elevated for a long time. That is according to ECB President Christine Lagarde. She said that the ECB will not cut interest rates for at least “the next couple of quarters.” She said that rates will remain high for “long enough” to bring inflation down to the 2% target. She said that “long enough has to be long enough.”

Recall that the ECB recently held rates steady after 10 months of having raised rates. This new policy is similar to that of the US Federal Reserve, the Bank of England, and the Bank of Canada. The policy is based on the assumption that the rate increases that have already taken place are sufficient but will likely take time to influence the economy. 

Meanwhile, despite Lagarde’s comments, financial markets are pricing in a 75% probability that the ECB will cut rates by April 2024. This likely reflects the view that inflation is already substantially lower than previously expected and that the Eurozone economy is weak and likely to fall into recession (if it is not already in recession). 

Eurozone inflation had peaked last year at 10.6%. As of this past October, it was 2.9%. Yet Lagarde’s view is that this low number might be transitory. She said that “we should not assume this 2.9 per cent respectable headline rate can be taken for granted. Even if energy prices were to remain where they are, there will be a resurgence of probably higher numbers going forward and we should be expecting that.”   

  • After rising steadily since the beginning of this year, yields on European government bonds have lately fallen sharply. This likely reflects expectations that the ECB will hold rates and cut them in 2024. In addition, it likely reflects expectations that inflation will fall faster than previously expected. Finally, it likely reflects the impact of the recent decline in US bond yields. 

Lower yields will be favorable for credit market conditions. On the other hand, they will effectively offset the impact of a tight monetary policy pursued by the ECB. If yields fall sufficiently to boost credit market activity and, consequently, economic activity, the ECB might choose to prolong high short-term rates to fight inflation. Central bankers are evidently worried that investors are getting ahead of themselves. This week, Federal Reserve Chair Powell said that investors should not be “misled” by good inflation data and that the Fed stands ready to raise rates again should inflation remain a problem.  

US population set to grow more slowly than previously expected

  • The US Census Bureau has dramatically revised its population predictions. It now expects significantly lower birth rates and higher death rates in the coming decades than previously estimated. As recently as 2015, the Census Bureau projected US population of 380 million in the year 2040. Now it expects the population to reach 355 million by 2040, a difference of 25 million. Moreover, it expects population to continue growing very slowly until it peaks at 370 million in 2080 and then start to decline. The Census Bureau noted that annual population growth was 1.2% in the 1990s and is now 0.5%. It is expected to be lower in the years to come.

The projections are subject to change. Changes in birth rates and changes in the amount of immigration could significantly influence the projections. Moreover, projections of births and deaths are likely to be more accurate than predictions about migration. If the Census Bureau is correct that deaths will exceed births by the late 2030s, then immigration becomes critically important. Immigration has rebounded strongly since the pandemic ended, but the issue of immigration is politically toxic.

Assuming the new projections are reasonably correct, what are the implications? First, the Census Bureau anticipates that the working-age population will stop growing in the mid-2040s. This implies much slower economic growth absent an offsetting acceleration in productivity growth. However, accelerated productivity could happen if a shortage of labor drives employers to invest more in labor-saving and labor-augmenting technologies. Many generative AI enthusiasts hope that this technology will boost productivity sufficiently to make demographics irrelevant. In addition, a shortage of labor could drive interest in more immigration. 

Second, slower population growth will lead to a decline in the ratio of workers to retirees, thereby putting more pressure on pension and health care expenditures. That could lead to higher budget deficits, higher taxes, less government spending on other services, or some combination thereof. However, in recent years, health care expenditures as a share of GDP have stabilized after a long period of rising. Health care costs are no longer growing faster than other prices. Expected productivity improvements in health care could lower future health care costs, even as the population ages. Thus, there is some hope that exploding budget deficits could be avoided.

The United States is not alone in witnessing a dramatic shift in demographic patterns. Birth rates have declined sharply in many other countries including much of Europe, China, Japan, Russia, and even many poorer emerging economies. China, Japan, and Italy are expected to see rapid population decline. Since the dawn of the industrial age in the early nineteenth century, population growth has been a given (population barely grew in the prior centuries). It could be that, for most of the major countries in the world, the age of population growth is coming to an end, creating new challenges as well as opportunities. In contrast, some countries are expected to have relatively strong population growth in the coming decades, either because of youthful demographics (India, Nigeria) or rapid immigration (Australia, Canada).

More evidence the US economy is likely headed toward a soft landing

  • It is usually the case that a slowdown in job growth is considered bad news. Yet not recently. The US government reported that job growth slowed in October and investors rejoiced. Bond yields fell and equity prices rose. Why? The answer is that the slowdown in job growth signals a greater likelihood that the Federal Reserve will not have to raise rates any further and might be able to cut rates sooner than previously anticipated. The jobs report adds to evidence that the era of monetary tightening is over. Slow job growth means a weaker economy with less inflationary pressure. Indeed, the report included news that wage inflation continued to recede. 

Here are the details: The government releases two reports on the job market; one based on a survey of establishments, the other based on a survey of households. The establishment survey found that, in October, 150,000 jobs were created. This was the slowest job growth since June and follows blistering growth of 297,000 jobs in September. It should be noted that the October report includes a 33,000 decline in automotive employment, mostly due to the strike at the time the survey was conducted. Thus, the underlying growth of employment should have been more than 180,000. Still, the slowdown is consistent with the widely held view that economic growth will decelerate in the fourth quarter.  

By sector, the biggest job gains were in health care/social assistance and government. The two categories combined accounted for 85% of job growth. This means that the non–health care private sector had almost no job growth. The manufacturing sector saw a 35,000 loss of jobs, but mainly due to the automotive strike. Absent that, manufacturing employment was steady.

Meanwhile, there was a 23,000 increase in construction employment, with a big part of that due to increased employment by residential contractors. In addition, employment was steady for retailing, fell moderately for transportation/warehousing and information, was steady for financial services, and increased moderately for professional and business services (our industry). In addition, there was a healthy increase in employment in leisure and hospitality. Finally, the strong increase in government employment was almost entirely due to increases for state and, especially, local government.

Also, the establishment survey reported that average hourly earnings of workers were up 4.1% in October versus a year earlier. This was the smallest increase in wages since June 2021. Hourly earnings were up only 0.2% from the previous month. This suggests that the labor market is loosening sufficiently to reduce wage pressure. With wage inflation receding and productivity accelerating (as indicated by yesterday’s productivity report for the second quarter), it seems possible that the Federal Reserve might soon stop worrying about the impact of the job market on inflation. In fact, it is concern about the job market that is the basis for continued tight monetary policy.

Finally, the separate survey of households indicated a decline in labor-force participation and a small rise in the unemployment rate from 3.8% in September to 3.9% in October. It remains historically low.

The reaction of investors to the employment report was notable. The yield on the US government’s 10-year bond fell 16-basis-points today before reverting slightly. Meanwhile, equity prices rose moderately as investors upwardly revised expectations of earnings.

  • As expected, and in line with other central banks, the US Federal Reserve left the Federal Funds rate unchanged in its last meeting. The rate is targeted to be in the range of 5.25% and 5.5%. The rate has been left unchanged for two consecutive meetings. Prior to that, the Fed had been consistently raising the rate each month since early 2022. The decision by the Federal Open Market Committee (FOMC) was unanimous. Although the Fed left interest rates unchanged, it said that it will continue to reduce its balance sheet by selling Treasury securities and agency debt and agency mortgage-backed securities. This is expected to put upward pressure on bond yields.

What the Fed said in its statement would suggest a tightening of monetary policy is warranted. It noted strong economic growth, a tight labor market, and continued high inflation. In addition, it said that the banking system is sound. However, it also noted that “tighter financial and credit conditions for households and businesses are likely to weigh on economic activity, hiring, and inflation. The extent of these effects remains uncertain.” In other words, there is reason to expect lower inflation, even in the absence of further monetary tightening. The tightening of credit conditions is likely related to the recent surge in bond yields, itself partly driven by the Fed selling bonds.

In his press conference, Fed Chair Powell said that “inflation has moderated since the middle of last year, and readings over the summer were quite favorable. But a few months of good data are only the beginning of what it will take to build confidence that inflation is moving down sustainably toward our goal. The process of getting inflation sustainably down to 2% has a long way to go.” On the other hand, he noted that investor expectations of longer-term inflation are low. Evidently, investors are confident that the Fed will succeed.

Regarding the labor market, Powell said that, although the labor market remains tight, the gap between supply and demand is narrowing. Moreover, he said that “strong job creation has been accompanied by an increase in the supply of workers: The labor force participation rate has moved up since late last year, particularly for individuals aged 25 to 54 years, and immigration has rebounded to prepandemic levels.” The result has been a deceleration in wage increases. Still, he said that more progress is needed on the labor front. That, in turn, is why the Fed intends to keep rates elevated for a long time.

Investors initially reacted to the Fed decision by pushing down bond yields and pushing down the value of the US dollar.

  • Since March of this year, the US job openings rate (share of available jobs that are unfilled) declined as the labor market weakened modestly. Yet in the last two months, the job-openings rate has rebounded, suggesting that the US labor market is not weakening rapidly and might be stabilizing. The openings rate, having bottomed at 5.4% in July, has been at 5.7% in both August and September. The rate had peaked in March at 7.4%. As of now, at 5.4%, the job-openings rate remains far higher than the prepandemic level of 4.4%. Thus, the labor market remains historically tight, despite nearly two years of tightening monetary policy.

By industry, the highest job-openings rate is in leisure and hospitality at 7.8%. This is followed by health care at 7.5%, professional and business services at 6.6%, and financial services at 6.6%. The lowest job-openings rates were in wholesale trade at 4.1%, retail trade at 4.2%, and manufacturing at 4.6%.

  • Tightness in the job market leads to rising employment costs. Last week the US government released the latest employment cost index (ECI) data, which measures the wage and benefit costs of employing workers. The ECI was rising at an annual rate of about 2% just prior to the pandemic. The ECI then accelerated, peaking at a growth rate of 5% in late 2022. Since then, it has decelerated moderately, with the annual rise at 4.3% in September, down from 4.5% in June.

Although better than previously, the growth of the ECI remains far higher than the 2% inflation target of the Federal Reserve. If compensation costs continue to rise more than 4%, it will be difficult to bring inflation down unless there is an offsetting increase in labor productivity (unlikely in the short term) or a big decline in corporate earnings (also unlikely). It seems that the Fed is determined to leave monetary policy tight to weaken the labor market and thereby suppress increases in compensation. On the other hand, the latest data on wages and productivity suggest the possibility that the labor market impact on inflation will weaken.

By industry, the biggest increases in compensation costs were seen in financial service, education, health care, and public administration. The smallest increases were in leisure and hospitality, wholesale trade, and manufacturing. It is interesting that leisure and hospitality had small compensation increases given that this industry has a very high job-openings rate. One would expect that a high openings rate would compel companies to offer higher wages to attract workers. 

  • In the recent weeks, the yield on the US Treasury’s 10-year bond has fallen roughly 40 basis points. Yields on bonds issued by other advanced economies also declined. What is happening?

First, in the last two weeks, the major central banks of North America and Europe have made it clear that the era of monetary tightening is likely over. The Federal Reserve, the European Central Bank (ECB), the Bank of England, and the Bank of Canada have all recently held interest rates steady after a prolonged period of rising rates—with the Fed and the Bank of England acting last week. 

Moreover, in each of those countries/regions, inflation has fallen faster than had been anticipated. Also, the recent surge in bond yields has effectively done the work of central banks, curtailing credit creation. As Powell said, “The tighter financial conditions we’re seeing from higher long-term rates, but also from other sources like the stronger dollar and lower equity prices, could matter for future rate decisions.” This contributes to the weakening of inflationary pressure. Thus, from the perspective of investors, the outlook for interest rates and inflation is better than it had been a few months ago. As such, this implies that bond yields ought to be lower.

Yet that is not the end of the story. The US Treasury, as expected, announced a major bond sale. Yet, unexpectedly, the Treasury chose to issue fewer long-dated bonds than anticipated and more short-dated bonds than anticipated. This had the effect of reducing the expected supply of long-dated bonds, thereby putting downward pressure on the 10-year yield. It is possible that this was the intention of the Treasury following a significant surge in long-dated yields. The Treasury is attempting to minimize the cost of funding the government.

In addition, investors are absorbing the fact that the supply of labor is rising faster than previously anticipated. In fact, Chair Powell alluded to that fact in his comments recently. He said, “In the labor market, what we’ve seen is a very positive rebalancing of supply and demand, partly through just much more supply coming online.” He concluded that “with labor demand still clearly remaining very strong, you see wage increases coming down.” Notably, the labor force has lately grown faster than its long-term capacity to grow. That is because of rising participation in the labor force as well as increased immigration. In just the past year, the labor force grew by 3 million people. If this continues, it will dampen wage inflation while also boosting capacity. This sets the stage for a soft landing in which inflation comes down while the economy continues to grow at a healthy pace. 

Finally, investors are likely pleased by the latest government report on productivity and unit labor costs. Labor productivity (output per hour worked) increased at an annualized rate of 4.7% in the second quarter of 2023, the fastest growth since the second quarter of 2020. Note that productivity had temporarily surged during the pandemic when many low-productivity workers were dismissed. When they returned, productivity suddenly dropped. But now it is rebounding strongly, entirely in the services sector. Productivity in manufacturing is falling as output declines while the number of hours worked continues to rise modestly. As businesses invest in labor-saving and labor-augmenting technologies, productivity could continue growing in the coming years.

Meanwhile, with productivity growing faster than wages, unit labor costs declined in the second quarter. Unit labor cost (ULC) is a measure of the labor cost of producing a unit of labor. If output per hour rises faster than hourly wages, then ULC declines, thereby reducing the inflationary impact of an increase in wages. That is what is now happening. It bodes well for reducing overall inflation. Moreover, the increase in productivity bodes well for continued increases in output. Again, this is the soft-landing scenario. 

Despite the latest drop in long-term bond yields, the reality is that yields remain relatively high compared to recent history. Moreover, there are reasons to expect yields to remain relatively high, at least compared to the experience of the past 15 years. First, US government borrowing is likely to be high as the government continues to run large deficits. Second, business demand for loanable funds will likely be strong given the need to invest in redesign of supply chains, new technologies, climate change mitigation, and clean energy. Third, if political dysfunction in the US continues or worsens, foreign demand for US bonds could weaken. Already many emerging country governments are shifting their reserve portfolios away from US Treasuries and toward gold.  

Eurozone economy falters as inflation decelerates

  • The Eurozone economy contracted in the third quarter, with real GDP falling 0.1% from the previous quarter. Real GDP was up 0.1% from a year earlier. The decline in third quarter GDP follows a 0.2% increase in the second quarter and no change in GDP in the previous two quarters. As such, the Eurozone economy has barely grown for a year. Is this a recession? It depends on how one defines a recession. At the very least, the economy has stalled. The last time real GDP fell was in the fourth quarter of 2020.

By country, real GDP declined in Germany, Austria, Portugal, Ireland, Czech Republic, and Estonia. German GDP was down 0.1% from the previous quarter. However, real GDP was up 0.1% in France, unchanged in Italy, up 0.3% in Spain, and up 0.5% in Belgium.

The weakness of the Eurozone economy stems from several factors. The tight monetary policy of the ECB, which is aimed at quelling inflation, has weakened credit market activity. Inflation has eaten into consumer incomes, hurting spending. Although natural gas prices have fallen, they remain far higher than prior to the Russia-Ukraine war, thereby hurting the competitiveness of heavy industry—especially in Germany. Plus, the weakness of the Chinese economy has hurt exports, especially those of Germany. 

  • The weakening of the Eurozone economy likely contributed to a continuing deceleration in inflation. The European Union (EU) reports that, in October, Eurozone consumer prices were up 2.9% from a year earlier, the lowest rate of inflation since July 2021. Prices were up only 0.1% from the previous month. When volatile food and energy prices are excluded, core prices were up 4.2% from a year earlier, the lowest rate of core inflation since July 2022. Moreover, after having been relatively steady from February to August of this year, core inflation has suddenly dropped sharply in the last two months. As recently as August, core prices were up 5.3% from a year earlier. Thus, underlying inflation is clearly decelerating. Core prices were up only 0.2% from the previous month.

By country, inflation varied. From a year earlier, consumer prices were up 3% in Germany, up 4.5% in France, up 1.9% in Italy, up 3.5% in Spain, down 1% in Netherlands, and down 1.7% in Belgium. 

The inflation news comes shortly after the ECB announced that it would hold interest rates steady. This appears to be the policy of other major central banks as well. The policy is to keep rates high for a prolonged period, hoping that the high cost of borrowing will gradually erode activity among both consumers and businesses, thereby weakening the labor market and easing pressure on wages. Indeed, it is the labor market that principally worries the ECB and other central banks. With low unemployment rates and high wage increases, central banks fear that persistent tightness in labor markets will make it difficult to bring inflation toward the 2% target. Evidently, the last mile of progress on inflation is the hardest.  

Bank of Japan appears to shift policy  

  • In Japan, inflation has abated but remains historically high. Meanwhile, the Bank of Japan (BOJ) has retained a relatively easy monetary policy of low short-term interest rates combined with the so-called “yield curve control” policy, which entails targeting the yield on the 10-year government bond. Given high inflation, and given a declining value of the yen, investors have wondered when the BOJ would shift policy. Three months ago the BOJ increased the range at which it allows the 10-year yield to fluctuate, boosting the upper bound from 0.5% to 1% while leaving the target rate at –0.1%. Yet the overall policy did not change—until now.

Recently, the BOJ said that the 1% upper bound is no longer a cap but, rather, a “reference point.” Moreover, the BOJ said it will allow the yield to rise above 1%. BOJ Governor Ueda said that “in July, we did not think that the 10-year yield would approach 1% so quickly. The biggest factor behind this is the bigger than expected rise in US Treasury yields.” In other words, the new policy, which investors interpret as the beginning of the end of the yield-control policy, was motivated by movements in US bond yields.

High US yields have contributed to the steady decline in the value of the Japanese yen. Indeed, if the yen falls further, it might compel the BOJ to announce a more aggressive shift in policy. Or it might lead Japan’s Finance Ministry to intervene in currency markets. One reason for investor disappointment is that the BOJ’s statement said that “it will continue with large-scale JGB purchases.”


Ira Kalish

United States


Cover image by: Sofia Sergi