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During the recent US presidential campaign, Joe Biden had promised that, if elected, he would be tough on China on such issues as human rights, geopolitics, and intellectual property protection. However, he said that, unlike the previous administration, he would approach these issues in unison with democratic allies rather than unilaterally. We now have the first example of this policy shift, as well as its consequences. Last week, the United States, European Union (EU), United Kingdom, and Canada jointly imposed sanctions on four Chinese officials and one Chinese security agency. The sanctions were in response to China’s treatment of Uyghurs in Xinxiang Province. The sanctions involve travel bans and the freezing of financial assets.
The sanctions are modest and relatively focused but are important symbolically in that they represent a new confluence of decision-making by the United States and its allies. These sanctions augur further collective action and are likely meant to inform China that, on key issues of interest to the West, its actions could have consequences. Indeed, China quickly took umbrage and responded with its own sanctions. Specifically, China imposed a travel ban on 10 EU officials and four EU entities. The EU quickly responded that China’s action puts an EU-China market access agreement in peril. Meanwhile, at a NATO meeting in Brussels, US Secretary of State Blinken lauded the notion of collective action and said that NATO should be “focused on some of the challenges that China poses to the rules-based international order.” This is interesting in that NATO was originally created to counter the threat from the Soviet Union. Now it sees China as a threat to Atlantic interests. In addition, the NATO Secretary General said that the organization will look to develop “new partnerships” with other Asian nations including Australia, Japan, and South Korea. US President Biden recently held a virtual summit with the leaders of Australia, Japan, and India to discuss collective security in the Asia-Pacific region.
The joint US, EU, UK, and Canada action on sanctions came a week after a contentious meeting between top US and China officials in Alaska. That meeting was followed by unilateral action by the United States to impose sanctions on officials from China and Hong Kong related to China’s actions undermining the autonomy of Hong Kong. The Alaska meeting and the actions that followed signal that the United States is taking a tougher stand on China than many observers had anticipated. The US administration has been quite vocal in criticizing Chinese actions with respect to human rights and geopolitics. At the same time, it has not been as vocal in criticizing Chinese trade and investment policies. This implies that the Biden administration might take a two-pronged approach to China—that is, it will be tough on China with respect to human rights, geopolitics, and other national security concerns, while at the same time potentially easing economic tensions.
Although the Biden administration says that trade agreements are not yet on the agenda and that the first priority is to stabilize the US economy, it is unlikely that the United States will seek further restrictions on trade and investment with respect to China. Moreover, it is possible that, once domestic priorities are addressed, the administration will start negotiations with China to reduce tariffs and other restrictions.
As for China, it has a strong interest in maintaining an open economic relationship with the West. Indeed, it continues to encourage inbound foreign direct investment from foreign technology companies. Yet it also will not likely change its geopolitical views and actions in response to foreign pressure. The challenge for Chinese policymakers will be to keep foreign interference at bay while, at the same time, pursuing a mutual interest in more economic interaction.
Meanwhile, the US Congress is about to consider a US$100 billion plan to fund research on cutting edge technologies in order to counter the perceived threat from China. What is interesting is that support for this effort is bipartisan and substantial. It seems that, in order to generate enthusiasm for increased spending in the US Congress, it helps to position that spending as a response to the threat from China. It is reminiscent of what happened in 1957 when the Soviet Union launched Sputnik, the first satellite to orbit the earth. In the Unites States, this led to fear that the country was falling behind and substantial bipartisan support for boosting science education and investment in technology. In any event, US trade negotiator Kathryn Tai recently noted that the country has traditionally relied on free markets to determine the allocation of investment, while China has relied heavily on the state. She added, “We need to revisit how we conduct our economic activity ... not to become China, but how to be true to ourselves and our traditions and be more strategic, knowing the quantity and the strategy and ambition that we are up against.”
Then again, the history of industrial policy shows mixed results, both in the United States and around the world. Around the world, subsidies sometimes go to relatively uncompetitive and politically connected businesses rather than the most potentially competitive. Subsidies have often been provided in conjunction with protection from foreign competition. This does not usually lead to better competitiveness. Rather, history suggests that, when countries expose themselves to competition, allow capital to be allocated freely, and provide support for R&D and development of human capital, success often follows. From a US perspective, one could argue that China’s policy of massive government support for state-run companies will, in the end, likely negatively impact its competitiveness.
Several emerging markets have lately seen a significant increase in consumer price inflation. In part this was due to currency depreciation that followed outflows of capital. The latter was due, in part, to higher bond yields in the United States and other developed economies. Moreover, supply chain disruptions and increases in commodity prices have also played a role in boosting inflation. The central banks of many emerging markets have lately increased their benchmark interest rates in order to reduce capital outflows and stabilize the currency, with the hope that this will ultimately quell inflationary pressures. In Turkey, this happened last week when the central bank surprised markets by boosting the benchmark rate by 200 basis points. This was due to an increase in annual inflation from 11.9% in October to 15.6% in February. Yet Turkey’s President Erdogan was not happy about this and, over the weekend, he fired the head of the central bank. Moreover, this was the third such firing in the last two years. The market reaction to Erdogan’s action was swift. The currency initially fell 16% against the US dollar before rebounding to a 10% decline. Equity prices fell 9%. The yield on the government’s 10-year bond increased from 13.6% last week to 16.0% today.
Erdogan replaced the previous central bank governor with a little-known academic who had recently written that higher interest rates will likely cause higher inflation—a novel idea that has been promoted often by Erdogan. It is not an idea that is respected among most economists. The latest action is evidently undermining market confidence in economic policy, especially as the independence of the central bank has been completely eliminated. It is now likely that the new governor will cut interest rates, thereby spurring further capital outflows and further currency depreciation. That, in turn, will boost inflation, lift borrowing costs, and undermine economic growth. This is unfortunate given that, in January, industrial production was up 11.4% from a year earlier. Thus, the industrial side of the economy has been strong. Although a weaker currency should boost exports, it will also boost the cost of imported inputs and components. Thus, it is not clear that depreciation will be beneficial to Turkey’s exports. Meanwhile, tourist arrivals in February were down 68.9% from a year earlier, thereby starving the economy of much-needed foreign currency earnings.
Turkey is not alone in facing higher inflation. Consumer price inflation has lately accelerated in Brazil, Russia, and Nigeria as well as many smaller emerging markets. In response, the central banks of both Brazil and Russia have lately increased their benchmark interest rates. In the case of Brazil, this halted currency depreciation and potentially sets the stage for a deceleration in inflation. That will be important for reducing bond yields which are relatively elevated, thereby hurting business investment. In the case of Russia, the central bank acted to address accelerated inflation. The currency, however, has been relatively stable, given the rise in oil prices.
The Institute for International Finance (IIF) says that the problem for many emerging markets stems, in part, from outflows of portfolio capital driven by higher bond yields in the United States and elsewhere. These outflows have caused downward pressure on currency values, thereby leading to higher inflation because of higher priced imports. Central banks are responding in a way that will likely cause a slowdown of economic growth. It can, however, be argued that the massive US fiscal stimulus, combined with more modest stimulus programs in Europe and Japan, will boost demand for exports from emerging markets. That, in turn, should help to offset the negative consequences of financial market turmoil. The problem, however, is that the countries that are most likely to benefit from increased US demand are not necessarily the same countries that have lately experienced accelerating inflation. The IIF estimates that the US stimulus will mostly benefit rich countries but that, among emerging nations, will have the greatest impact on China, Mexico, Vietnam, and India. Yet the financial reaction to higher US bond yields is centered in Russia, Brazil, Turkey, and Nigeria among others. On the positive side, Russia and Nigeria will surely benefit from higher oil prices that could result from the global stimulus. In any event, it appears likely that, in 2021, there will be increased financial market volatility in emerging markets. This could have an impact on the global financial services sector.
The value of the US dollar versus major currencies has been rising since the start of the year. Why is this and what are the potential implications? First, the dollar had weakened through most of 2020. This was likely due to more aggressive monetary policy in the United States than elsewhere; slower policy response to the pandemic; and relative pessimism about the prospects for economic revival. By the start of 2021, however, some things began to change. In the United States, the number of new infections has plummeted and the number of vaccinations has soared. This has boosted investor optimism about the prospect for economic revival. Moreover, since December, the US Congress has passed two stimulus bills totaling US$2.8 trillion in additional expenditures. This has resulted in a significant increase in bond yields. Yet, despite rising bond yields, equity prices have continued to rise on expectations of faster economic growth. The combination of higher stimulus-induced bond yields and upwardly revised forecasts for economic growth have likely contributed to the increase in the value of the dollar. US monetary policy has remained extraordinarily easy, characterize by low interest rates and massive asset purchases, a fact that would normally push down the value of the dollar because of higher expectations of inflation. However, many investors evidently remain sanguine about the outlook for inflation, especially given considerable slack in the labor market and confidence that the Fed will reverse course if needed. Consequently, monetary policy has not played a dominant role in the movement of the dollar in the last two months.
What can we expect from a rising dollar? First, a higher valued dollar suppresses import prices, thereby helping to suppress overall inflation. It also boosts the demand for imported goods and creates more competition for domestic companies that are globally exposed. Second, a higher dollar tends to boost foreign currency prices of US exports, thereby reducing the global competitiveness of US exports. Alternatively, exporters might choose to cut dollar prices in order to maintain market share, but at the cost of lower profit margins. Third, the higher dollar partly reflects the impact of capital inflows that are driven by higher US bond yields. This has been a particular problem for many emerging markets. They have seen capital outflows put downward pressure on their currency values, thereby boosting inflation and creating greater difficulty in servicing foreign currency debts. Several emerging market central banks have reacted by boosting their policy interest rates. That, in turn, could hurt economic growth. Finally, a higher valued dollar will change the dynamics of global M&A activity. US assets will become more expensive and non-US assets will become cheaper. Expect to see US investors looking for bargains in Europe, Asia, and emerging markets.
Now that the United States is embarking on a massive yet relatively short-term US$1.9 trillion fiscal stimulus, the Biden administration is planning another longer-term bill aimed at setting the stage for more robust, inclusive, and sustainable economic growth in the coming decade. It is reported that the Administration would like to spend US$3 trillion on this effort (some analysts had predicted US$4 trillion). The money would go to transportation infrastructure, 5G deployment in poorer locations, retraining for disrupted workers, electric vehicle charging stations, subsidies for “industries of the future,” and other climate-related initiatives. It is expected that some of the increased expenditure would be funded by increased taxes on upper income households and on corporations. It remains unclear as to whether the administration will seek one large bill or a series of smaller bills. The latter strategy might entail seeking bipartisan support for transportation infrastructure while using the reconciliation process (which averts filibusters in the Senate) for those proposals with less bipartisan support, such as tax increases and climate initiatives.
Opponents of this initiative will probably make two arguments. First, they will say that the increased spending, largely financed by debt, will likely create a huge long-term obligation that will be a burden on future generations and that will reduce the government’s fiscal flexibility. Second, they will argue that higher taxes, especially on corporations, will have a negative impact on overall economic activity and especially on business investment. Supporters of the initiative will make two counterarguments. First, they will likely say that borrowing costs are historically low, so much so that the real (inflation-adjusted) cost of borrowing is negative. Plus, they will argue that investment in infrastructure and worker retraining will boost productivity, thereby accelerating economic growth and government revenue. Thus, the program could theoretically pay for itself. Second, they will argue that higher corporate taxes will not necessarily stymie business investment. After all, the reduction of corporate taxes in 2018 did not boost business investment. Rather, it led to massive share buybacks. They will argue that boosting corporate taxes will hurt equity prices but not investment.
Investors waited with great hope and some anxiety last week to hear from the Federal Reserve’s policy committee after it held its periodic meeting. The Fed kept short-term interest rates and the pace of asset purchases unchanged. In its statement, the committee said, “Following a moderation in the pace of the recovery, indicators of economic activity and employment have turned up recently, although the sectors most adversely affected by the pandemic remain weak.” The Fed upwardly revised its expectations for GDP growth in 2021, from a prediction of 4.2% in December to 6.5%. The increase reflects the belief that the pace of vaccinations will be greater than previously anticipated as well as the expected impact of the massive stimulus bill recently passed by Congress. Fed Chairman Powell said, “While we welcome these positive developments, no one should be complacent. At the Fed, we will continue to provide the economy the support that it needs for as long as it takes.” While most of the committee members expect to hold short-term interest rates steady until the end of 2023, an increasing minority among the committee members expects to boost rates sooner, possibly in 2022. This means that these members are concerned that an overheated economy might generate excessive inflation. Powell, evidently, is not concerned and remains focused on employment and economic growth rather than inflation.
Initially, investors were clearly neither disappointed nor thrilled as evidenced by the collective yawn exhibited in the relative nonmovement of asset prices. However, bond yields increased sharply the next day after investors had time to digest the implications of Fed policy. The yield on the 10-year government bond hit 1.74%, the highest in 14 months, although still low by historical standards. One way to interpret a bond yield is to assume that it is a forecast of future short-term rates, with a risk premium thrown in. Thus, if the yield on the 10-year bond increases, theoretically it reflects a change in investor expectations about the Federal Reserve’s short-term interest rate policy. That is, it means investors expect the Fed to tighten policy sooner and by more than previously expected. The last time bond yields went haywire was during the so-called “taper tantrum” when the Fed scaled back asset purchases following the last recession. In the current case, the Fed has signaled that there will be no tapering anytime soon. Thus, bond investors can sleep comfortably. As Powell said, “when we see actual data coming in that suggests that we’re on track to perhaps achieve substantial further progress, then we’ll say so. And we’ll say so well in advance of any decision to actually taper.”
Regarding inflation, the committee upwardly revised its expectation for 2021 to 2.4% from 1.8% at the December meeting. This increase reflects expectations of the economy growing and unemployment declining rapidly this year. What is notable is that the Fed now expects inflation to surpass the target of 2.0% yet does not expect to do anything about it. Last year the Fed stated that, unlike in the past, it does not intend to react when inflation exceeds the target. Indeed, it sees the target as an average rather than a maximum. It is comfortable with inflation exceeding the target for a limited period. It would, however, react if it believed that inflation will exceed the target for a sustained period. In the current situation, the Fed evidently believes that higher inflation will be temporary and will be due to temporary factors. Their forecast is for inflation to recede next year.
Meanwhile, US equity prices remain elevated, if a bit volatile. Equities have performed stunningly in recent months, despite rising bond yields and fears of higher inflation. The cyclically adjusted price-earnings ratio is now the second highest it has ever been. That could be evidence of a speculative bubble. Recall that bubbles ultimately pop, leading to a sharp decline in prices. This remains a possibility. Yet even if it happens, it does not imply trouble for the economy. Currently, there appears to be a decoupling of equity markets and the real economy. Moreover, the collapse of bubbles is usually preceded by a pre-emptive tightening of monetary policy by the Federal Reserve. That is not likely anytime soon.
Finally, every time in the past two decades that bond yields suddenly started to rise on expectations of a shift in Fed policy, many investors thought that the long bull market in bonds was finally over—but it wasn’t. Indeed, bond yields quickly reversed, and bond market vigilantes got burned. This could be another such time. If Powell and Yellen turn out to be correct about the impact of policy, inflation will rise modestly and temporarily, Fed policy will be steady, and bond yields will stay relatively low.
That being said, even the best scenario could involve some temporary market turmoil. A temporary surge in US bond yields could have significant implications for emerging markets. It could lead to an outflow of capital from emerging markets, downward pressure on emerging market currencies, greater difficulty in servicing emerging market debt, and a need for emerging market central banks to raise their own interest rates in order to stifle such volatility. That, in turn, could hurt economic growth. Huang Yiping, a former top official of China’s central bank, warned about this recently, saying, “We all remember what happened in 2014-15. The US [Federal Reserve] is the world’s major central bank. Once it quits quantitative easing and raises rates, we could encounter capital exodus, currency depreciation and falling asset prices. In some cases, like South Africa, Russia, and Turkey, it led to financial crisis. I don’t think such things will happen to China, but some emerging markets could face disastrous results.” Nonetheless, an overheated US economy will likely import more goods from emerging markets, helping to boost export revenue. Indeed, the OECD has increased its forecast for growth in numerous countries because of the US fiscal stimulus. Thus, the mix of US policy is a double-edged sword for the rest of the world.
In January, US retail sales increased a substantial 7.6% from the previous month. It was largely attributed to the December stimulus that had been passed by the US Congress. The rebound in retail sales, combined with other favorable economic indicators, led some observers to question why another government stimulus was needed. Their view was that the US economy was already on track for a robust recovery and that added government stimulus would be a waste of money that would overheat the economy and lead to inflation. Nevertheless, the government did pass a massive stimulus package that will involve direct payments to households in the coming weeks. Meanwhile, high-frequency credit and debit card data on consumer spending indicated that, after the surge in January, spending declined in February. This led observers to anticipate that retail sales in February would be down modestly. Last week we learned that sales did, in fact, decline in February, but by more than anticipated. This fact is expected to be used by supporters of the stimulus as evidence that the economy is not out of the woods and that government help is needed.
In any event, we learned that, in February, retail sales fell 3.0% from the previous month, although sales were up a strong 6.3% from a year earlier when things were already starting to deteriorate. Spending was down for the month in most categories. Sales were down 4.2% at automobile dealers, down 3.8% at furniture stores, down 1.9% at electronics stores, down 3.0% at home improvement stores, down 2.8% at clothing stores, down 8.4% at department stores, down 2.5% at restaurants, and down 5.4% even at nonstore retailers. Sales at gasoline stations were up 3.6% due to higher prices and sales at grocery stores were up 0.1%.
While these numbers suggest some underlying weakness of the US consumer sector, most analysts are optimistic about the near-term future, given the massive amount of cash about to be disbursed to US households. The stimulus bill passed by Congress two weeks ago will involve US$1,400 payments to about 85% of Americans, including payments for each child. Many people have already received their money. In addition, unemployment insurance will be extended, child tax credits will be paid, and other forms of assistance and protection from financial disruption will be provided. It appears that Americans saved roughly 80% of the US$600 stimulus payments they received in December.1 Yet even the small amount spent had a big impact on the retailing industry. If Americans similarly spend a modest share of the US$1,400 payments, it will still have a very big impact on retailing. Even the money saved could eventually have a big impact. That is, once the vaccine is fully distributed—perhaps by end of summer—people will likely become confident that the virus is no longer a threat. This could lead to a surge in spending, not only at retail stores, but also for services that have lately been avoided, such as airlines, hotels, restaurants, and entertainment venues. The saved stimulus money will provide fodder for the surge. This increase in aggregate demand will likely compel businesses to boost investment and output. It will also likely boost demand for imported goods, thereby stimulating the global economy. Indeed, the OECD estimates that the US stimulus will increase the rate of global GDP growth by one percentage point in 2021. If US businesses struggle to meet the increased demand, then there could be inflationary bottlenecks. Yet sustained higher inflation will only come about if a tightening of the job market leads to a surge in wages. There remains debate about whether this will happen.
Because the timing of the Lunar New Year holiday varies year to year, it is not feasible to report economic data for either January or February alone. That is because it becomes impossible to make year-to-year comparisons. Instead, China’s government reports the combined numbers for January and February for several indicators. This allows for a meaningful comparison with previous years. This year, of course, is exceptional because there was such a dramatic decline in economic activity in the first two months of 2020. Thus, it was long expected that economic performance in the first two months of 2021 would compare very favorably with the previous year. This turns out to be true, with huge increases in retail sales, industrial production, and fixed asset investment. However, the challenge for analysts is to infer how much of the increase is simply a rebound from last year and how much represents real progress.
First, let’s look at industrial production. In the first two months of 2020, industrial production was down 13.5% from the previous year—a catastrophic decline. This year, industrial production is up 35.1% from last year, meaning that it is now 16.9% higher than two years ago. That is a strong gain compared to what transpired for much of the past decade. In other words, China’s industrial economy is growing at a healthy pace and is doing at least as well as would have been the case without the pandemic. This strength has been driven by very strong exports, fiscal stimulus, and success in suppressing the virus. In addition, some segments grew especially rapidly in the first two months of this year. They include transport equipment (up 48.9%), machinery (up 69.4%), and communications equipment (up 48.5%).
Meanwhile, the retail sector bounced back, but not as much. Specifically, in the first two months of 2020, retail sales fell a record 20.5% from 2019. This year, retail sales were up 33.8% from a year earlier. That means that retail spending is now 6.4% above where it was two years ago. That suggests a slow annual rate of increase, certainly slower than what took place before the pandemic. In other words, retail spending is likely lower than where it would have been had the pandemic not happened. This means that, although China’s industrial sector has been boosted by export demand and fiscal stimulus, the consumer sector has lagged somewhat. That likely reflects consumer caution in the face of a persistent virus. Still, some categories grew strongly in the first two months of the year. These included automobiles (up 77.6%), telecoms (up 53.1%), jewelry (up 98.1%), and clothing (up 47.6%).
Finally, although fixed asset investment has been growing rapidly in recent months, it has not been sufficient to substantially offset the catastrophic drop that took place a year ago. Specifically, in the first two months of 2020, fixed asset investment fell 24.5% from 2019. This year, it was up 35.0% from a year earlier. It means that fixed asset investment is now only 1.9% higher than it was two years ago, suggesting that investment is far below where it would have been without the pandemic. This is a bit surprising, given the recent scale of government-funded investment in infrastructure. It also means that the decline in early 2020 was especially damaging.
In the wake of the two big policy meetings recently, the government has released its fourteenth five-year plan. It is a blueprint for economic policy and goals for the 2021–2025 period. There are some notable aspects to the latest plan that are different from the past. First, unlike in the past, there is no specific target for GDP growth. This is likely meant to give policymakers some flexibility. Still, it is also likely that officials will continue to pay close attention to the growth statistics. Second, the plan puts considerable focus on the manufacturing sector and, unlike the past, puts almost no emphasis on boosting the share of the services sector in the economy. However, the goal will be to push the manufacturing sector up the value chain with a greater focus on higher value-added processes. There will also be a focus on government support for technology development, especially technology developed domestically. That implies government protection of domestic production at the expense of imports. Such protectionism could be harmful to economic efficiency and potentially problematic for the global economy. Meanwhile, it is not clear if a substantial focus on industry will be consistent with the government’s stated climate goals.
Third, the plan notes the demographic challenges faced by China and attempts to address the issue. Specifically, the plan recognizes that, because of a relatively low birth rate for the past few decades, the labor force is likely to continue to decline. This means that, in order for the economy to grow, productivity must accelerate through investment in new technologies. Still, the plan attempts to slow the decline in the labor force by boosting support for childcare (in order to encourage people to have babies) and increasing the retirement age. China has relatively low retirement ages for men and women. Increasing the age could significantly boost the size of the labor force, at least temporarily. This action could be unpopular, but it could also contribute to faster economic growth, increased consumer income, and a healthier pension system.
Finally, the plan calls for a slowdown in the growth of infrastructure spending. This appears to be an acknowledgment that such investment has been too large a source of economic growth in recent years and that the economy needs to be more driven by consumer demand. Thus, while investment in urban rail transportation grew at an annual rate of 18.7% during the past five years, the plan calls for annual growth of 6.9% in the next five years. Similarly, investment in expressways increased 5.6% each year in the last five years and is now set to grow 2.9% per year in the next five years.
Last week I saw the headline “US inflation rate jumps to one year high.” This was accurate. Yet on the same day, bond yields were flat and equity prices were up. What did investors know that the headline writers ignored? The answer is that core inflation, which excludes volatile energy and food prices, declined. That is, the much-touted rise in underlying inflation has not yet arrived. This raises two important questions: first, will higher inflation arrive sometime soon? Second, if it arrives, will it be temporary? Or will it indicate a new era of higher inflation?
Before answering these questions, let’s look at the data. The US consumer price index (CPI) increased 0.4% from January to February, the biggest monthly gain since August 2020. In addition, the CPI was up 1.7% from a year earlier, the highest rate of annual inflation since February 2020. However, there were significant increases in energy prices in February and, to a lesser degree, in food prices. These tend to be highly volatile. Thus, when volatile food and energy prices are excluded, core prices were up only 0.1% from January to February and were up 1.3% from a year earlier. Notably, that was the lowest rate of annual core inflation since June 2020. Therefore, it appears that underlying inflation has declined, not accelerated. This reflected actual declines in the prices of used cars, apparel, medical equipment, hospital services, and transportation services. The last item included a very sharp decline in airline fares. As such, it appears that there were substantial changes in the relative prices of many goods and services, but no general rise in prices. The latter is what we call inflation.
Now, to our important questions. First, some analysts are saying that, although inflation has remained muted, this is about to change. They note that global demand for goods is picking up and that there has already been a big increase in shipping costs that will soon find its way into the prices of final goods. In addition, many commodity prices have risen sharply, also auguring an increase in the prices of final goods. They also note that the United States is about to embark on an unprecedented degree of fiscal stimulus that will lead to inflationary pressures. Indeed, the stimulus bill was passed last week and signed by President Biden.
All the above comments on inflationary pressures are true. Indeed, it is likely that inflation will accelerate sometime later this year and into next year. The really important question, however, is whether this acceleration will be sustained. Higher inflation will not simply come from shortages of container ships. It will come when wages accelerate in response to a much tighter labor market. First, it is worth noting that the cost of shipping a container from China to the United States rose rapidly from January to October and then stabilized over the past five months. Evidently, the shortage is not getting worse and may soon get better. Second, air freight costs have been stable since the first half of 2020. As for the upcoming stimulus, one argument is that the extra money will be spent on services, rather than goods, especially once the vaccine is widely distributed. Thus, the stimulus will not necessarily cause further tightness in the market for goods. It may simply help to resuscitate the moribund services sector.
But getting back to the labor market: The main question is whether the fiscal spending bill will so stimulate the economy as to drive the job market back to full employment too quickly. It depends on how much of the stimulus money is spent versus saved, whether the saved money is massively spent after the pandemic ends (perhaps in the second half of 2021), and how much of the extra spending drives imports rather than domestic production. My guess is that the stimulus bill will drive the US economy toward full employment by 2022, which is what Treasury Secretary Yellen has suggested. It will likely boost inflation temporarily. But I doubt it will create a significant boost to wages. After all, the US labor market was roughly at full employment before the pandemic and there was barely any wage inflation at that time. Plus, even when the United States hits full employment, there will still be plenty of discouraged workers who will have dropped out of the labor market. A tighter labor market will likely lead many discouraged workers to reenter the labor market, thereby putting downward pressure on wages. Finally, if inflation or expectations of inflation rise above the Federal Reserve’s comfort level, the Fed might react in a way meant to anchor market expectations. The Fed could raise interest rates and/or reduce asset purchases. That, in turn, would likely affect the behavior of workers and employers, and help to keep inflation suppressed.
Meanwhile, investors evidently expect a short-term burst of inflation in the United States following implementation of the massive fiscal stimulus. Yet they do not expect a longer-term problem of higher inflation. That fact can be discerned by examining the so-called breakeven rate for bonds of different maturities. The breakeven rate is the best measure of investor expectations of inflation. It is derived from the difference between a headline bond yield and the yield on an inflation-protected bond. There are breakeven rates that are derived from bonds of different maturities, thereby enabling us to know the inflation rates expected over different periods of time. For much of the past half-decade, the breakeven rates have been higher for longer maturity bonds and vice versa. That is, investors have generally expected low inflation in the short term but higher inflation in the long term. That has now changed. In recent months, the breakeven rates have flipped, with higher rates for short maturity bonds and lower rates for long maturity bonds.
What does this mean? Investors evidently believe the stimulus bill that was just signed will temporarily lead to a burst of inflation. However, investors also believe that the higher inflation will be short-lived. Perhaps they expect that supply chain disruptions and shortages will be resolved within a short period of time. Perhaps they expect that the surge in consumer spending stemming from the stimulus will be short-lived and not overheat the economy. And perhaps they believe that, should there be a wage-price spiral, the Federal Reserve will quickly take action to suppress inflation. In any event, investor expectations appear to be consistent with what US Treasury Secretary Yellen has predicted.
The bottom line is that there are many reasons to expect that the impending acceleration in inflation will be temporary. If true, that has implications for borrowing costs. That is, bond yields would likely stay at a relatively low level. Lately they have risen but still remain historically low.
The global shortage of semiconductors has led both the United States and the European Union (EU) to embark on new policies meant to boost domestic production of semiconductors. These policies entail subsidies for investment in domestic production. The goal is to assure the supply of semiconductors for domestic customers. In part, this reflects concern about the current global shortage. However, it also partly reflects concern that China’s large share of global capacity could be used as political leverage with the West. The EU has said it will spend up to EUR150 billion to develop a larger domestic capacity to produce semiconductors. The goal is that Europe will eventually account for 20% of global capacity. In the case of Europe, the concern is not only about China, but about Europe falling behind the United States when it comes to technology prowess. The Biden Administration has launched a 100-day review of global supply chains related to key products, especially semiconductors. In addition, the US Congress recently passed legislation to provide subsidies to companies that develop capacity in the country. The government already provided substantial support to Taiwanese companies that are building capacity in the United States. China, however, has not sat still. Its government is subsidizing a massive expansion in capacity as well.
While these governmental efforts are likely to pay off in terms of added capacity and an easing of shortages, they raise important questions. Subsidies, as a rule, are generally a violation of WTO rules. There is a reason for this. Subsidies are a form of protectionism that create market distortions. When governments decide who gets help, it is often the weakest who get the help. Subsidies can make an unprofitable investment become profitable. And, subsidies can result in excess capacity as evidenced by what happened with state-owned Chinese companies involved in heavy industry. Thus, the global acceptance of a liberal, rules-based system of trade appears to be diminishing significantly.
Still, this is not just about industrial policy. It is also about geopolitics, especially US and European concern about the rise of China. As US President Biden said recently, “In some cases, building resilience will mean increasing our production of certain types of elements here at home; in others it will mean working more closely with our trusted friends and partners, nations that share our values so that our supply chains can't be used against us as leverage.” His comments were not only about semiconductors but also about other technology products.
There has been an unprecedented surge in Los Angeles in the number of container ships bringing goods from Asia. The combined Ports of Los Angeles and Long Beach are the busiest shipping hub in the United States. In February, the number of containers handled at the combined port was up 43.3% from a year earlier, the largest annual increase in the port’s more than century history and hitting a historic peak in volume. The increased volume was due to a 50.3% increase in imports and a 4.9% increase in exports. What happened? First, the size of the increase partly reflects the fact that volume was down sharply a year ago during the first quarter shutdown of the Chinese economy. But that is not all. After all, volume at the port is now historically high. The increase also reflects strong consumer and business demand in the United States, partly fueled by the December government stimulus. The growth also reflects the fact that the Lunar New Year holiday did not lead to the usual shutdown of factories this year. Instead, because people were not traveling to visit family, companies let them continue to work. Thus, exporters in China were able to meet the huge demand in the United States.
Finally, the US$1,400 stimulus checks that will soon be sent to 85% of Americans will likely boost demand for traded goods even further. Thus, the surge in activity at ports around the United States is likely to grow. Meanwhile, it is reported that freight rail volume during the first week of March was up 6.7% from just before the pandemic began.2 Activity on the part of package delivery services is up substantially as well, partly reflecting increased online spending. In any event, the consumer goods sector appears to be on fire and about to get an injection of fuel.
Still, some negative economic signals remain. In the first week of March, electricity3 generation in the United States was down 4.2% from the prepandemic level, steel4 production was down 9.0%, the number of vehicle trips taken by individuals5 was down 11.3%, and passage through airport security checkpoints6 remained 45.7% below the prepandemic level. In addition, the government reported that there were 712,000 initial claims for unemployment insurance7 last week. While better than the previous week, this was still a number far in excess of anything ever seen prior to the pandemic. In other words, the job market continues to exhibit stress. Thus, the economy continues to be pushed in two different directions. Going forward, the two factors that are likely to boost activity are mass vaccination (which should help to unleash demand for services) and the stimulus money.
Bond yields in Europe have risen to the highest levels since early 2020, but still remain historically low. At the same time, the European Central Bank (ECB) has reduced the pace of asset purchases. These two facts are likely related. The yield on the 10-year German government bond rose from –0.6% near the end of January to about –0.3% now. This remains historically low. Similarly, yields remain negative in France and several other European countries. Even yields in southern Europe remain historically low, but positive.
With the global economy recovering, inflation rising in Europe, and the global economy about to get an injection of demand from the US fiscal stimulus, there has been concern that bond yields might move even higher, thereby stifling business investment and retarding the economic recovery. As such, it is not surprising that the ECB last week announced that it will speed up the pace of asset purchases over the next three months. ECB President Christine Lagarde said that the recent rise in bond yields could “translate into a premature tightening for financing in all sectors of the economy.” She committed to continuing to engage in asset purchases until March 2022. She also said that the ECB can adjust the program again if need be. In response to this announcement, bond yields fell today. For example, the yield on Italy’s 10-year government bond fell 11 basis points, hitting a three-month low.
The extent of the disruption stemming from Brexit is becoming more evident. The British government reports that, in January, British exports to the EU fell sharply, while exports to the rest of the world increased modestly. Specifically, British exports of goods to the EU were down 40.7% from December to January, a record decline. By country, the biggest decline was in export to Ireland, down 47%. Nonetheless, exports to the rest of the world increased modestly. Consequently, total British exports of goods were down 19.3%, with exports to the EU accounting for about 40% of the total. Exports to the rest of the world would need to surge in order to offset the weak exports to the EU. Imports from the EU were down 28.8%.
In addition, it was reported that German imports of goods from the United Kingdom were down 56.2% in January versus a year earlier. By comparison, all German imports were down 9.8% from a year earlier and German imports from EU countries were down 5.9%. Adjusted for inflation, Germany’s imports from the United Kingdom fell to the lowest level since 1991. In addition, German exports to the United Kingdom were down 30.0% in January versus a year earlier. In comparison, all German exports were down 8.0% from a year earlier. Meanwhile, a survey found that more than one third of British manufacturers have seen a loss of revenue following implementation of Brexit. Almost a third say that they are facing delays of more than two weeks in obtaining needed imported parts or processing exports.
The weakness of trade with the EU likely played the dominant role in causing real GDP to decline 2.9% from December to January. The British government justified the decline, with a spokesman saying that “a unique combination of factors, including stockpiling last year, COVID-19 lockdowns across Europe, and businesses adjusting to the new trading relationship, made it inevitable that exports to the EU would be lower this January than last.” However, the head of the British Chamber of Commerce suggested that the problems are more than short-term. He said that “the significant slump in UK exports of goods to the EU, particularly compared to non-EU trade, provides an ominous indication of the damage being done to post-Brexit trade with the EU by the current border disruption. The practical difficulties faced by businesses on the ground go well beyond just teething problems.”
While much attention has been focused on the historically expansionary fiscal policies of the United States and the countries of the European Union, the less publicized fact is that fiscal policy has shifted substantially in China as well. Former Chinese Finance Minister Lou Jiwei said that China’s fiscal stance is “extremely severe with risks and challenges.” He was especially concerned about the rise in local government debt as well as China’s onerous demographics. As for the latter, the working age population is declining, thereby likely leading to slower economic growth and more stress on the system of pensions and health care. Lou warned that “the arrival of the aging society is speeding up, which will change the size and structure of fiscal spending in China, add to the financial burden of elderly care and put pressure on government finances.”
During the pandemic, China has engaged in its own form of fiscal stimulus, somewhat different than what is found in the United States and Europe. In China, local governments and state-owned enterprises (SOEs) have borrowed heavily through bond issuance and by obtaining loans from state-run banks. This increase in debt has funded investments that have stabilized the economy during the period of stress. Yet the increased debt must be serviced. Unlike the government in Beijing, local governments and SOEs cannot print money. Local governments have limited powers to boost revenue, and SOEs must turn a profit or be compelled to roll over debts. It is estimated by the government that about one quarter of China’s provinces now use more than half their revenue to service their debts. Meanwhile, Beijing has allowed some SOEs to default on bonds, sending a message not to engage in foolhardy investments.
At the same time, it is possible that central government fiscal stimulus in China could be scaled back, with likely negative implications for economic growth. The central government in Beijing saw revenue fall 3.9% in 2020, the first decline since 1976. In addition, spending increased 2.8%. The result was a sharp increase in debt and debt-servicing costs. Still, the fiscal expansion by the central government last year paled in comparison to what happened during the global financial crisis in 2009.
Former Minister Lou also said that China faces risk emanating from the United States. Specifically, he noted that the United States is monetizing its debt through bond purchases made by the Federal Reserve. He also noted that this has led to a surge in asset prices that goes far beyond economic fundamentals. He worried saying, “Once the pandemic has been brought under control and the [global] economy begins to recover, fiscal and monetary policies will make a turn that will impact on global financial stability and the economic growth of various countries. Emerging market countries are facing a double blow to both their economies and finances, with the economic risk transforming into fiscal and financial risks, raising the risk of a debt crisis.”
Lou’s warnings come when China’s leaders are engaged in two big meetings, known as the “two sessions,” in which decisions are expected to be made concerning the future direction of central government fiscal policy as well as the amount of debt that local governments can issue. Lou’s comments, which were made in December, have lately been publicized, an indication of the internal debate taking place among top officials.
Meanwhile, a senior official of China’s central bank, the People’s Bank of China, said that he is “very worried” about the potential collapse of the asset price bubble in the United States. Guo Shuqing, who leads China’s Banking and Insurance Regulatory Commission, said that “financial markets are trading at high levels in Europe, the United States and other developed countries, which runs counter to the real economy.” Indeed, many observers have expressed concern or surprise at the dichotomy between the real economy and the financial economy in the United States. That is, until recently, the real economy performed poorly even as asset prices soared. Things are starting to change, however. The economy is starting to accelerate while asset prices have become more volatile. The recent rise in US bond yields, driven in part by expectations of stronger economic growth, suggests the possibility of a correction for asset prices. In any event, the dichotomy to which Guo referred is a source of concern. He said, “Financial markets should reflect the situation of the real economy. If there's a big gap in between, problems will occur and the markets will be forced to adjust. So, we are very worried about the financial markets, particularly the risk of the bubble bursting of foreign financial assets.”
I suspect that part of Guo’s concern is due to the recent inflow of capital into China, driven in part by a wide interest rate differential. If bond yields in the US rise sufficiently, that differential will decline or disappear, thereby stifling capital flows to China. That, in turn could put downward pressure on the Chinese renminbi, which would be inflationary. At the least, it could create financial market volatility in China. In addition, Guo expressed concern about the impact of volatility on China’s property market. He said, “It is quite dangerous that many people are buying homes not for living in, but for investment or speculation.” He said that mortgage interest rates are likely to rise in line with market rates. If rates in China rise in response to higher yields in the United States, then China’s frothy property market could face a decline, thereby wiping out the wealth gains of numerous households. In response to Guo’s remarks, Chinese equity prices fell.
While officials worry about fiscal policy, there are clear indications that the Chinese economy is decelerating. The latest official purchasing managers’ indices (PMIs) for China suggest as much. There are actually two sets of PMIs for China; one published by the government, the other by IHS Markit. The official PMIs are more heavily weighted toward state-run companies while the ones published by Markit are more heavily weighted to the private sector. PMIs are forward-looking indicators meant to signal the direction of activity in the manufacturing and services sectors. They are based on sub-indices, such as output, new orders, export orders, employment, pricing, and sentiment. A reading above 50 indicates growing activity; the higher the number, the faster the growth.
The latest official readings show a notable deceleration in activity in February. Specifically, the official manufacturing PMI fell from 51.3 in January to 50.6 in February, a number indicating very slow growth in activity. Separately, IHS Markit reports that its PMI for manufacturing fell from 51.5 in January to 50.9 in February, a similar decline. The decline in recent months likely reflected the negative impact on global demand stemming from the recent outbreak of the virus, especially in Europe. Indeed, the official sub-index for export orders indicated a decline. In addition, new outbreaks of the virus in northern China led to economic restrictions that had a negative impact on domestic demand. Finally, manufacturing output was suppressed because of a shortage of labor.
Also, China’s services PMI issued by Markit dropped from 52.0 in January to 51.5 in February, a 10-month low. Although Chinese business optimism improved, there was a decline in export orders and a deceleration in domestic orders, the latter likely driven by worries about new outbreaks of the virus. There was also a slowdown in hiring by service enterprises. At the same time, there was a sharp rise in costs, similar to what is happening around the world. Separately, the official Chinese PMI for services declined from 52.4 in January to 51.4 in February, the lowest level since May 2020. The decline was likely influenced by outbreaks of the virus in northern China which suppressed travel during the critically important Lunar New Year holiday season. Indeed, the government urged workers not to return to their hometowns during the holiday in order to avoid transmitting the virus.
US Federal Reserve Chairman Powell reinforced the view that monetary policy will remain easy, that the Fed will continue bond purchases until “substantial further progress has been made,” and that he is not especially worried about inflation. His remarks were followed by a sharp increase in the yield on the US 10-year Treasury bond. Specifically, Powell said, “Today we’re still a long way from our goals of maximum employment and inflation averaging 2% over time.” He said that it will take some time to reach the Fed’s goals and that it is not likely that the labor market will return to normal this year. Indeed, the government reported that there were 745,000 new claims for unemployment insurance last week. While better than numbers seen in recent months, this number remained far above the highest level ever reached prior to the pandemic. In other words, there remains considerable stress in the labor market. Meanwhile, Powell said that the recent rise in bond yields had “caught my attention.” In addition, he said that he would be concerned by disorderly conditions in markets or a persistent tightening in financial conditions that threatens the achievement of Fed’s goals.
Investors are listening closely to comments from Powell and others as they attempt to figure out the potential impact of the impending stimulus package. The volatility of bond yields in recent weeks reflects investor uncertainty about what the mix of monetary and fiscal policy is likely to do. It is now a near certainty that the US Congress will pass something akin to the US$1.9 trillion package proposed by President Biden. Estimates suggest that the US economy is operating at about US$1 trillion below capacity. One big question is what the multiplier of the stimulus will be. If the multiplier is one, meaning that each dollar spent by the Federal government will add a dollar to GDP, then the package could cause the economy to overheat, thereby boosting inflation. However, we don’t know what the multiplier will be. Several factors could lead to a smaller multiplier. For example, if consumers save a large share of the money they receive, the multiplier will be lower. If imports are boosted significantly by the increased demand, then the multiplier will be lower. Both scenarios seem likely.
Two other issues are relevant. First, is the economy operating farther below capacity than traditional measures suggest? This is possible given the large number of people who have exited the job market, not only during the pandemic but during the preceding decade. Second, even if the unemployment rate falls sharply in the coming year as a result of stimulus, will this necessarily boost wage inflation? The answer is unclear. After all, the unemployment rate was very low just prior to the pandemic and the economy was assumed to be operating above capacity. And yet wage and price inflation were extremely tame. That could be true again given that the economy appears to be characterized by a disinflationary psychology.
Meanwhile, bond yields have risen because of expectations of faster economic growth and higher inflation. The inflation viewpoint is more uncertain. Still, Powell’s comments did not provide investors with confidence that the Fed is prepared to quickly fight inflation. Powell appears to be more concerned about driving down unemployment than fighting inflation. It is said that he wants to avoid what happened after the global financial crisis of 2008-09 when the Fed started to tighten policy too soon, setting off the so-called “taper tantrum” in which bond yields rose rapidly. Meanwhile, the Biden Administration wants to avoid the perceived mistake of 2009 when the Obama Administration sought a stimulus that was smaller than the gap between potential and actual GDP. Thus, we are now witnessing an experiment in which there will be unusually aggressive monetary and fiscal policy.
The US government’s jobs reports revealed that, in February, employment rebounded sharply in the leisure and hospitality sector as state governments eased economic restrictions and consumers engaged in more social interaction as the number of infections declined. At the same time, employment in all other sectors increased only modestly in February and remained far below the level from a year earlier. There are two reports released by the government: one based on a survey of establishments; the other based on a survey of households. Let’s first consider the establishment survey.
In February, the economy added 379,000 jobs, the biggest increase since October. Still, the number of jobs was 9.5 million less than a year earlier, or 6.2% lower than a year earlier. Of the 379,000 jobs added, 355,000 were in the leisure and hospitality sector. This included 286,000 new jobs at restaurants and 36,000 new jobs at hotels. That means there was almost no growth in the rest of the labor market. However, there was a 61,000 decline in construction employment, likely related to bad weather. In addition, state and local employment of education workers declined by 68,000. The latter likely reflected disruption of school hiring schedules due to the pandemic. Excluding the impact of construction, education, and leisure/hospitality, there was a modest increase in employment of 153,000. By sector, there was an increase of 21,000 for manufacturing, an increase of 41,000 for retailing, an increase of 63,000 for professional and business services, and an increase of 46,000 for health care and social assistance.
The separate survey of households reveals that the labor force participation rate remained unchanged and that the unemployment rate dipped from 6.3% in January to 6.2% in February. Still, the number of working age people not participating in the labor force is about 5 million more than a year ago. Meanwhile, the number of college-educated people participating in the labor force is higher than a year earlier. All of the decline in labor force participation is attributable to less educated workers. Although the unemployment rate for college-educated workers has risen since before the pandemic, it remains low at 3.8%.
Most of the job market gains were in disrupted industries, such as restaurants. As the economy moves back toward a prepandemic normal following mass vaccination, employment will continue to grow rapidly in the leisure and hospitality sector. Meanwhile, despite the big increase in that sector in February, employment remains about 3.5 million less than a year ago. This is about 20% lower than a year ago. Thus, this sector has a long way to go.
Overall, the employment report suggests that the economy continued to grow in February, but only modestly. In a way, it was a Goldilocks report—not too hot and not too cold. It showed that the economy is recovering, but that there remains lots of slack in the labor market. In response to the report, equity prices rose while bond yields were up modestly after having initially jumped sharply. Equity traders saw evidence of growth with only modest risk of a tightening of monetary policy. Bond traders are still reeling a bit from Fed Chairman Powell’s remarks recently in which he expressed little concern about inflation and committed to maintaining a stable monetary policy. With the Congress about to pass a massive stimulus, some investors are worried that the economy could become overheated and generate higher inflation. The jobs report indicates that there is plenty of room for stimulus before full employment is achieved. Treasury Secretary Yellen has said that the stimulus will help the economy get back to full employment by next year.
In the United States, the Federal Reserve and the Treasury are both becoming more focused on climate change and how it affects financial institutions and the clients they serve. More than a decade ago, the US government began conducting stress tests of financial institutions in order to determine their preparedness for low-probability/high-impact financial and economic events. Based on these test results, the government could decide to require higher capital buffers and/or lower dividend payments. Now, Treasury Secretary Yellen says that the government is moving toward conducting climate stress tests as well. That is, it will assess the preparedness of financial institutions for climate-related events. The idea is that climate-related events, such as floods, storms, and fires, could damage or change the value of the physical assets that are behind bank loans and other financial assets and liabilities. In addition, climate policies that push society toward new forms of energy and transportation could disrupt physical assets and change the risk profile for financial institutions. Yellen said that testing for such issues will “be very revealing both to regulators and to the firms themselves in terms of managing their own risks.” However, she also said that, unlike financial stress tests, climate stress tests would not be used to determine capital buffers or limitations on dividends. Still, the focus on climate for bank regulators will likely push financial institutions further on the path to using climate to assess risk and allocate portfolios, something that many are already doing.
Meanwhile, Federal Reserve Governor Lael Brainard said that climate will play a role in Fed policy. She said that “climate change is already imposing substantial economic costs and is projected to have a profound effect on the economy at home and abroad. There is growing evidence that extreme weather events related to climate change are on the rise—droughts, wildfires, hurricanes, and heat waves are all becoming more common. Future financial and economic impacts will depend on the frequency and severity of climate-related events and on the nature and the speed at which countries around the world transition to a greener economy.” She said that private sector financial institutions will have to take account of this issue in how they operate. Moreover, she sees this issue as an important component of how regulators engage in oversight of financial institutions. That is, regulators will examine how these institutions handle this issue. Brainard said that the Fed will “work to develop an appropriate program to ensure the resilience of supervised firms to climate-related financial risks.” Other Fed leaders have made similar statements. The Fed is working with other central banks to coordinate how they address this issue.
The yield on the 10-year US Treasury bond is, as of this writing, about 1.4%, roughly the same as it was a year ago and the highest it has been in a year. A bond yield has two important components: an expected rate of inflation, and a real (inflation-adjusted) yield that reflects supply and demand conditions in the bond market. The expected rate of inflation can be inferred from the so-called breakeven rate. It is calculated by subtracting the yield on Treasury Inflation Protected Securities (TIPS) from the headline bond yield. The principal on the TIPS moves in line with inflation. As such, the TIPS yield is the real component of the bond yield. The difference between the headline yield and the TIPS yield is the expected rate of inflation, also known as the breakeven rate. The breakeven rate is now about 2.2%, the highest it has been since late 2018. One year ago, it was about 1.6%. Thus, the real yield is now about -0.8%, having been -0.2% a year ago. That is, the real yield is even lower than it was a year ago at the start of the crisis. This implies that there is a serious excess demand for bonds in the market. It also means that the real cost of funds is historically low and that the US government can fund its largesse at a negative cost for now. The excess demand for bonds is, in part, due to the massive purchasing of government bonds by the Federal Reserve over the past year.
Still, judging by commentary in the newspapers, investors and market observers are now focused on the rise in the nominal (headline) yield on government bonds that has taken place in recent weeks, in line with the recent increase in the breakeven rate. Many investors are concerned that inflation is coming and that this will mean higher borrowing costs. Already the interest rate on 30-year mortgages has risen, although it remains historically low. The rise in the breakeven rate reflects several factors, including rising energy prices (on the belief that energy prices have a big impact on inflation), a very expansionary monetary policy that is expected to be sustained, the impending massive (and, some would say, excessive) increase in government spending, global shortages of some commodities and components (including semiconductor chips), an expected surge in aggregate demand once the vaccine is fully distributed, a shortage of labor in some key industries, and rising transportation costs because of supply chain disruptions. However, there remain reasons to be somewhat sanguine about the prospects for avoiding ruinous inflation. These include the continued high level of unemployment and the existence of substantial slack in the economy and in the labor market, the high level of consumer saving, and the likelihood that the Federal Reserve will tighten monetary policy should inflation become a serious concern. Moreover, there is an expectation that the excess demand created by US fiscal policy could partly be drained out of the United States through increased imports, thus reducing domestic inflationary pressures. That drainage, in turn, might stimulate global growth.
Amidst the raging debate about the potential for higher inflation in the United States, Federal Reserve Chairman Jay Powell testified in Congress and defended a continuation of extraordinary monetary policy. He noted that declining infections and a rising number of vaccinations provides “hope for a return to more normal conditions” later this year. But he also said that the US economy has a long way to go. Although he refused to either endorse or condemn President Biden’s fiscal proposal (saying that it is inappropriate for a Fed Chairman to inject himself into a political decision), he did say that achieving an economic recovery is a higher priority than addressing the long-term budget deficit. Moreover, he had previously argued in favor of more fiscal stimulus.
Meanwhile, the two biggest issues of controversy concern the degree to which the fiscal stimulus will result in higher inflation and whether the current Fed stance will result in financial instability by significantly boosting asset prices. On these issues, Powell appeared unmoved. Regarding inflation and the likely Fed response, he said that “following large declines in the spring, consumer prices partially rebounded over the rest of last year. However, for some of the sectors that have been most adversely affected by the pandemic, prices remain particularly soft. Overall, on a 12-month basis, inflation remains below our 2% longer-run objective.” He added, “The economy is a long way from our employment and inflation goals, and it is likely to take some time for substantial further progress to be achieved. We will continue to clearly communicate our assessment of progress toward our goals well in advance of any change.” In other words, he expects very low interest rates and continued asset purchases for a long time to come. He noted that an important job for the Fed is to anchor inflation expectations, something on which he intends to focus. Thus, although the Fed has indicated amenability to inflation rising above the 2%%target, it is also clear that the Fed will act if needed should inflation or expectations of inflation rise precipitously. In fact, Treasury Secretary Yellen has said that she is not worried about inflation because the Fed has adequate tools to fight it.
As for a possible asset price bubble, Powell said that “financial stability vulnerabilities overall are moderate.” When asked if the Fed’s current policy is contributing to rising asset prices, Powell said, “There’s certainly a link. I would say, though, that if you look at what markets are looking at, it’s a reopening economy with vaccination, it’s fiscal stimulus, it’s highly accommodative monetary policy, it’s savings accumulated on people’s balance sheets, it’s expectations of much higher corporate profits. So, there are many factors that are contributing.” Markets reacted to Powell’s comments by not doing much of anything.
As the US Congress debates whether to enact another large stimulus package, the impact of the last package became clear with the release of the government’s report on personal income and expenditures for January. Recall that, in December, the Congress passed a US$900 billion spending package that included direct payments of US$600 to most Americans. It also included increased and extended unemployment insurance for unemployed workers. We now know that these payments substantially boosted personal income. Although household spending increased significantly, the majority of the increase in income showed up as additional personal savings, in part through debt repayment. In any event, the personal savings rate increased from 13.4%% in December to 20.5%% in January, the highest since early 2020 when the pandemic began. As for the increase in spending, it was disproportionately focused on durable goods. Spending on services increased only modestly and remained below the level from a year earlier. Here are some details:
The greatest economic hope for poor countries is that they will ultimately catch up with rich countries. This was the expectation at the dawn of the post-war era. Economists believed that poor countries would grow faster than rich ones, ultimately experiencing a convergence of living standards. This was based on the expectation that poor countries would invest efficiently in new capital, funded by domestic saving or capital inflows. By enabling poor countries to utilize existing technologies, this new capital would have high returns for poor countries, thus fueling rapid growth. Rich countries, however, stuck at the frontiers of technology, could only grow by innovating rather than by adapting existing technologies. Thus, they would grow more slowly than poor countries. For the first 40 years of the post-war era, this theory turned out not to be true—at least for most emerging countries. Indeed, only a few countries experienced convergence such as South Korea, Taiwan, and Singapore. Others were left behind. Consider India. In 1950, US per capita GDP was roughly 17 times higher than that of India. By 1990, the figure was 30 times higher. India fell behind. The good news is that, by 2017, the figure was nine times higher.
Research shows that, until the 1990s, the theory of convergence was mostly wrong. This realization led to the theory of the “middle-income trap.” The idea was that poor countries would stop converging with rich countries once they achieved middle income. Countries with experiences consistent with this theory included Thailand, Turkey, and much of Latin America. Getting past the middle-income hump turned out to be difficult. However, new research suggests that the middle-income theory has not been correct during the last 30 years. That is, convergence is finally taking place—as evidenced by the more recent experience of India and others. Moreover, convergence is happening not because rich country growth has slowed, but because poor country growth has accelerated. Why has this happened? There are several possible factors. These include, cheaper credit in a disinflationary world, freer trade and capital flows, better economic management in many emerging countries, the rise of China and its positive impact on global exports, increasing female participation in the labor force, and higher levels of education for women among others. This is not an exhaustive list, but it does tell us something about the kinds of public policies that are likely to drive future convergence. The good news is that, for now, lower-income countries are catching up, making for a more affluent planet.
During the pandemic, many small- and medium-sized businesses in multiple countries were seriously disrupted, with a large number going out of business. Other companies remained in business, in part with government help. Meanwhile, a large number of workers lost their jobs. Yet in some countries, new businesses were established either to take the place of those that exited the market, or to take advantage of new opportunities that were driven by the pandemic. In some countries, such startups benefitted from government support. The process of business turnover was long ago dubbed “creative destruction” by the great economist Joseph Schumpeter. What is interesting about the pandemic is that such action accelerated sharply in some countries, while it declined in others.
Specifically, a recent study conducted by the Peterson Institute found that, in the United States, the number of new businesses increased by 23% from 2019 to 2020. In Chile the number increased 14%. In the UK, the number increased by 9%. In China, however, there was only a 3% increase in business formations. And in Germany, the number of new businesses fell by 4%, although that number might soon reverse given the government’s creation of a “Future Fund” program for startups. Moreover, the number of new businesses fell 21% in Spain and 26% in Russia.
What explains the variation in experiences? According to the study, “countries with a more expeditious process to start a business have been more likely to experience an uptick in business formation during the pandemic.” This is greatly influenced by the level of government regulation and the competence of regulators. In addition, the study found that, at least in the United States, higher rates of unemployment tend to light a fire under entrepreneurial individuals and compel many to start businesses. In some other countries, high unemployment is not a good predictor of entrepreneurship because the unemployed obtain very generous government benefits, thus removing the incentive to act. Finally, past research shows that business formation is a good predictor of employment growth. A disproportionate share of job growth stems from relatively new businesses, whether large or small. To the extent that government policy can ease the path toward such entrepreneurship, it can have a positive impact on job growth and economic recovery. Moreover, new businesses often incorporate new technologies and new ideas that contribute to higher productivity growth.