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Cover image by: Sylvia Chang
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The Federal Funds rate directly affects what banks charge one another for short-term funding, but importantly, it provides a benchmark for such credit products as adjustable-rate mortgages, consumer loans, and interest rates on credit cards. As such, the Fed action will likely have a rapid negative impact on credit market conditions, thereby quelling activity in the credit markets. This is meant to reduce the growth of aggregate demand in the economy so as to reduce inflationary pressure. The policy can no doubt succeed in reducing inflation. The question remains as to whether it can do so without setting off a recession.
In its announcement, the Fed noted that, although spending and production have softened, employment growth has been robust in recent months. This fact exacerbates inflation, which is already high due to the pandemic and the war in Ukraine. Thus, monetary policy is meant to suppress demand in the economy but cannot affect the pandemic or war situations.
In his press conference, Fed Chair Powell said that another 75-basis-point increase could happen in September, but that it will be data-dependent. More notably, he said that “as the stance of monetary policy tightens further, it likely will become appropriate to slow the pace of increases.” Powell also said that, although he is not trying to engineer a recession, and although he thinks one can be avoided, “we think it’s necessary to have growth slow down. We actually think we need a period of growth below potential in order to create some slack, so that the supply side can catch up.” In choosing policy, Powell said the Fed would closely watch economic growth, labor market conditions, and inflation itself.
In response to the Fed action, equity prices increased sharply while bond yields fell moderately. Investors evidently saw the Fed’s action as increasing the likelihood that inflation will be suppressed. Moreover, they were likely pleased that Powell spoke about eventually easing the pace of tightening.
o Employment, the most important measure of the economy’s economic performance, has been growing at a very strong pace.
o Nondefense capital goods shipments grew in June and have been growing steadily for some time.
o A decline in inventories subtracted two percentage points from growth. This means that final demand was still positive (about 1.1% growth). Inventory swings of this magnitude do happen and may impel businesses to try to rebuild inventory levels, something that could add to growth in the third quarter.
Although the United States is not likely in a recession, the GDP report was troubling in that it shows a significant deceleration in economic activity. Although the decline in inventories explains the decline in GDP, it also points to weakness in demand, which could bode poorly for growth in production. Among the components of GDP that declined were private nonresidential fixed investment, residential investment, Federal nondefense spending, state and local spending, and inventories. The categories that saw growth included consumer spending, exports, imports, and Federal defense spending.
Within business investment, there was strong growth of investment in intellectual property (software, research and development) but declines in spending on equipment and structures. Within consumer spending, there were declines in spending on both durable and nondurable goods, but a strong increase in spending on services.
The weakness of the GDP report likely reflects the negative impact of the Federal Reserve’s policy. It’s sale of government bonds led to a sharp rise in bond yields. This in turn caused the sharp rise in mortgage interest rates, which explains the decline in residential investment. The decline in business investment likely reflects a worsening of sentiment combined with fears of higher borrowing costs. On the other hand, the exceptionally strong growth of exports of both goods and services suggests that global demand for US products remains strong—despite the rise in the value of the dollar.
Finally, consumer demand remained moderately strong despite declining real incomes. This suggests that consumers have been dipping into the massive savings they accumulated during the pandemic. The sharp rebound in spending on services suggests a return to normalcy, with a drop in demand for home-related goods more than offset by a sharp increase in spending at restaurants and other service providers.
Moreover, in June, the US government also released more recent data on consumer income and spending. Despite a real (inflation-adjusted) decline in consumer disposable income, real spending grew modestly as consumers continued to save less.
Here are some details: In June, real disposable personal income was down 0.3% from the previous month and down 3.2% from a year earlier. The decline was due to two factors. First, government transfers were down from a year earlier as stimulus funding receded. Second, and more importantly, wage income did not keep pace with inflation. Thus, consumers fell behind in real terms. However, they offset this by reducing their saving. The personal savings rate fell from 5.6% in May to 5.2% in June. The result was that real consumer spending increased 0.1% from the previous month and was up 1.6% from a year earlier. Still, the spending numbers have decelerated in recent months, evidence of a weakening of the consumer sector. But the ability of consumers to dip into their savings has stabilized spending and helped to prevent a recession—at least for now.
Over the past year, consumers have been shifting away from spending on goods and toward spending on services. This reflects the view that the pandemic is no longer a problem and that it is safe to go out and interact with other people. As such, real spending on durable goods in June was down 3.1% from a year earlier, spending on nondurables was down 2.9%, and spending on services was up a strong 4.1%. However, this trend appeared to temporarily reverse in June when real spending on durables increased a robust 0.9% from May to June, nondurables fell 0.4% from May to June, and spending on services increased a paltry 0.1%. It is not clear why this happened.
The government also reported on the Federal Reserve’s favorite measure of inflation, the personal consumption expenditure deflator, or PCE-deflator. The report found that consumer prices were up 6.8% from a year earlier in June and up 1% from the previous month—a big increase. When volatile food and energy prices are excluded, the core PCE-deflator was up 4.8% from a year earlier and 0.6% from the previous month. The latter figure is relatively high and suggests that underlying inflation got worse in June. Given that this is the inflation data that the Federal Reserve most closely follows, it is expected to influence their decision-making in the coming month.
Going forward, the US economy is at risk of recession, especially if the Fed (as is likely) continues to tighten monetary policy. Moreover, the rapid weakening of the European and Chinese economies bodes poorly for continued strong US export growth. If, however, commodity prices come down further, this will ease pressure on consumers and might lead to an acceleration in consumer spending. Thus, a recession might be averted. Or, at the least, a recession in the next year could be relatively mild.
In the second quarter, real GDP in the Eurozone was up 4% from a year earlier and up 0.7% from the previous quarter. The latter number means growth was at an annual rate of 2.8%. Compare that to the negative GDP growth in the United States in the second quarter. Evidently, the Eurozone economy was in excellent shape. This was likely due, in part, to strong consumer demand for tourist services. With the pandemic receding, people were eager to return to their previous love of travel. This was reflected in strong growth in France, Italy, and Spain—significant tourist destinations. On a quarterly basis, real GDP was up 0.5%, 1%, and 1.1% in these countries, respectively—very strong rates of growth. Moreover, in these three countries, real GDP was up from a year earlier by 4.2%, 4.6%, and 6.3%, respectively. On the other hand, GDP stalled in Germany, not rising at all from the previous quarter and up only 1.5% from a year earlier.
Looking forward, there are several factors that bode poorly for continued strong growth. These include a continued tightening of monetary policy by the European Central Bank (ECB); declining real incomes as inflation exceeds wage gains; and the risk of a Russian cutoff of gas during the winter months.
Here are the details: Consumer prices in the Eurozone were up 8.9% in July versus a year earlier, a record increase since the birth of the euro. Yet prices were up only 0.1% from the previous month, the lowest monthly rate since July 2021. Moreover, when volatile food and energy prices are excluded, core prices were up 4% from a year earlier, also a record high. Yet core prices actually declined 0.2% from June to July. Of course, the main difference between headline and core inflation was the behavior of energy prices, which were up 39.7% from a year earlier but were up a relatively modest 0.4% from the previous month. Oil prices have declined but natural gas prices have increased.
By country, consumer prices declined 1.1% in Italy from June to July, declined 0.5% in Spain, and increased a modest 0.3% in France. On the other hand, prices were up a more robust 0.8% in Germany. Prices also declined in Belgium and Greece. Prices increased the most in the Netherlands, up 2.1% from the previous month.
The cutback, if sustained, will reduce the likelihood that EU members will be able to accumulate sufficient stocks by the winter to avert shortages. The current goal is to hit 80% of storage capacity, but this is increasingly unlikely. Meanwhile, EU governments have jointly pledged to reduce consumption of gas by 15%, with exemptions for those member states that are less dependent on Russian gas. At the same time, the evident shortage of Russian gas deliveries to Europe has led consumers of liquid natural gas (LNG) to furiously seek new supplies, setting off competition between European states and such countries as Japan and South Korea. The latter are reported to be fearful that shortages in Europe will lead to increased European demand for LNG.
What happens next? If the cutback in supplies from Russia is sustained, and assuming European governments are unable to fully offset the cutback with alternative supplies, it is likely that, in some countries, there will be rationing of gas. This will likely mean limits on industrial use, thereby leading to a sharp decline in manufacturing output. Moreover, the sharp increase in the cost of heating homes will eat into consumer purchasing power. The result will likely be a recession.
For the ECB, this will create a conundrum. Its policy of tightening monetary policy is meant to address inflation. Yet the lion’s share of inflationary pressure is coming from the rise in energy prices over which the ECB has no control. All it can do is engineer a slowdown or recession by suppressing aggregate demand. Yet if a recession is already coming, the ECB might be reluctant to tighten severely and make it worse. Indeed, the ECB has been far more cautious about tightening than the central banks of the United States, the United Kingdom, and Canada.
The good news is that, with the help of Turkey and the United Nations, an agreement was recently reached between Russia and Ukraine to ease constraints on the export of grain that were due to a Russian blockade of Black Sea ports. This blockade contributed to a sharp rise in prices and shortages in key markets. The Ukrainian Navy reports that export operations have resumed at three Black Sea ports that had been closed since the start of the Russian invasion. This is important because Ukraine and Russia are among the biggest grain and fertilizer producers in the world. They supply some of the most populous countries in the world. The biggest purchasers of Russian and Ukrainian wheat, for example, are Egypt, Turkey, Indonesia, Bangladesh, and Nigeria.
Also, even before this deal was reached, global food prices had begun to decline. This might have reflected a strong harvest in Russia combined with expectations that restrictions would eventually be eased. Also, the weakening global economy probably contributed to the downward movement of prices. On the other hand, the decline in prices does not mean that the crisis in global food distribution is over. The war, plus climate problems, are hurting food production. A US official said, “I’m more worried about 2023 than 2022.” One problem is that, in the last few months, production of grain in Ukraine fell sharply due to the war. This, combined with restrictions on distribution, meant that farmers had limited income. That, in turn, limits their ability to invest in next year’s production. The fear is that output in 2023 will be substantially limited.
Meanwhile, climate change is rearing its ugly head in the global food market. This year has seen unusually high temperatures in numerous locations, declines in water levels, and drought. This means more crop failures and shortages of water used for food production. Here in southern California, much of our water comes from the runoff when snow melts at nearby mountains. Yet, with higher temperatures, there is less snow and more rain. Hence, there is less accumulated snow available for runoff. In Italy, drought has led to a shortage of water that could reduce grain production this year by 50%. Similar stories abound in many parts of the world.
Unless climate change reverses, which seems unlikely in the near term even if governments take major steps to reduce carbon emissions, then the world likely faces problems in food production and distribution in the coming years. Not only will this mean more hunger and malnutrition, it could also mean more political and social unrest. Moreover, this trend could undermine the progress and benefits of globalization. That is, if producing countries seek to limit exports of food to guarantee domestic supplies, there could be a reduction in trade that would reduce the efficiency of food production and distribution.
Cover image by: Sylvia Chang