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Cover image by: Sofia Sergi
Meanwhile, more specialized chips are not yet seeing a glut. This includes the chips that are used in automobiles. The market for cars continues to exhibit strong pent-up demand. On the other hand, recent US government restrictions on the sale of certain types of sophisticated chips and other equipment to China will effectively reduce demand for sophisticated chips, thereby potentially contributing to a glut. Plus, in response to incentives provided by the US CHIPS Act, many semiconductor manufacturers are rapidly investing in new capacity in the United States. While it will take time for this new capacity to reach fruition, the end result could be a glut that leads to downward pressure on prices. In any event, I remain hopeful but not optimistic about getting my new car soon.
The semiconductor situation is not the only area of disruption to global supply chains. Earlier this year a surge of shipments of goods from Asia to the United States led to severe bottlenecks at ports and other transport hubs, thereby creating delays and higher costs that contributed to inflation. Now it turns out, transport bottlenecks are easing, for both supply and demand reasons. The ports of Los Angeles and Long Beach in Southern California, which handle about 40% of the goods imported to the United States, report that port congestion has eased dramatically.
For example, while there were over 100 ships waiting to dock last January, this number was down to seven last week. One reason is that US retailers purchased holiday goods early to avoid shortages and delays. Another reason is that disruptions of Chinese supply chains due to China’s COVID-19 policy have limited the flow of goods from China. Also, fear of labor unrest at West Coast ports led some companies to divert goods from California to Gulf and East Coast ports, some of which are now reporting delays.
A good measure of the degree of stress in supply chains is the cost of shipping. It has come down sharply in the past year, suggesting that the shortage of capacity early in 2022 has disappeared and that pressure has eased. This bodes well for a reduction in overall inflationary pressure.
In addition, Chinese retail sales unexpectedly declined in October, down 0.5% from a year earlier compared to a 2.5% increase in September. The decline was attributed to pandemic-related restrictions, which limited consumer mobility. In addition, a weak housing sector likely had a negative spillover effect on consumer demand for home-related goods. Some categories experienced especially sharp declines in sales. These included cosmetics (down 3.7% from a year earlier), clothing (down 7.5%), furniture (down 6.6%), home appliances (down 14.1%), and communications equipment (down 8.9%). Sales of automobiles, however, were up modestly. The decline in retail sales in October was the first since May.
Finally, while fixed asset investment grew 5.8% in the first 10 months of 2022, property sector investment fell 8.8% in the same period. Evidently, troubles in the property sector are having an outsized impact on overall economic performance. Indeed, it was reported that home prices in 70 major cities were down 1.6% in October versus a year earlier, the sharpest decline since 2015.
Specifically, retail sales (not adjusted for inflation) were up 1.3% from the previous month and up 8.3% from a year earlier. If this is adjusted for inflation, it implies that real spending was up 0.8% from the previous month and up 0.5% from a year earlier. Keep in mind that, in five of the last 10 months, real retail sales were down from the previous month. The real increase in October was the strongest since February. This hardly suggests an economy either in or on the verge of recession.
Looking at the monthly increase in nominal (not adjusted for inflation) retail spending by category, spending was up 1.3% at automotive dealers, up 1.1% at both furniture retailers and home improvement retailers, up 1.4% at grocery retailers, up 1.6% at restaurants, and up 1.2% at nonstore retailers. Part of this growth was due to inflation (especially in the food category), but part of it was real. Meanwhile, rising gasoline prices meant that spending at gasoline stations was up 4.1% from the previous month. In contrast, spending at electronics stores fell 0.3%, spending at department stores fell 2.1%, while spending at apparel stores remained unchanged.
The strength of spending on furniture and home improvement is surprising given the weakness of the US housing market. These categories will likely face headwinds in coming months as housing activity continues to falter. The drop in electronics is not surprising given that people are going back out again and no longer spending furiously on home technology. The weakness in apparel spending is harder to explain.
The strength of the retailing industry implies that consumers continue to save less and dip into their accumulated savings. Moreover, recent data indicates an increase in credit card debt. This means that consumers are intent on avoiding a cutback in spending. The big question now is whether this trend will continue in November and December. These are months for holiday shopping and account for a disproportionate share of annual retail spending. We know that many US retailers bought products early and now have substantial inventory ready for the holiday season. If spending turns out to be weak, retailers might have to offer deep discounts to dispose of inventory, thereby suppressing inflation.
For the Federal Reserve, the latest retail spending data implies that Fed tightening has not yet had a significant impact on the consumer sector, which is the largest part of the economy. If the Fed believes that the economy needs to decelerate further to stifle inflation, then it will feel compelled to continue raising interest rates. Yet, monetary tightening works with a lag. It is possible that the Fed has gone far enough and that it can now wait to see what happens. There is debate about this among economists and others. Fed leaders have lately suggested that more tightening is needed, but perhaps at a less furious pace.
The big difference between headline and core inflation was due to a very sharp rise in energy prices, especially the prices of natural gas and electricity. From a year earlier, gas prices are up 130% and electricity prices were up 66%. The government has promised to cap the prices some households pay. As energy prices rise, the cost to the government of such subsidies will increase. This raises questions as to how the government will achieve its goal of avoiding a ruinous increase in government debt. Such an increase would likely lead to even higher bond yields, thereby hurting economic growth. Recall that the expansive fiscal proposals of former Prime Minister Truss led to a sharp rise in bond yields and the demise of Ms. Truss’s administration.
For the Bank of England (BOE), the inflation report reinforces the likelihood of a major rate hike in December. The BOE has said that it expects double-digit inflation to persist well into 2023. However, it also expects a deep and prolonged recession starting in the current quarter and, consequently, a sharp decline in inflation starting in the second half of 2023. As such, it expects to halt monetary tightening within a few months. Yet monetary policy will be adjusted as needed depending on data. The latest data suggests more monetary tightening than previously expected.
Noting that monetary tightening has led to a drop in asset prices, the ECB said that “further corrections in market valuations could be triggered if the outlook for growth, inflation and financial conditions deteriorates further. In particular, more persistent inflation might require further monetary policy responses by major central banks than currently expected by market participants.” The ECB concludes that “the risk of disorderly adjustments has risen with increased market volatility, knock-on effects for margin demands and lower liquidity in some market segments.” To respond to the current situation, the ECB recommends that “macroprudential policies, and in particular capital buffers consistent with the prevailing level of risk, help to ensure banks’ resilience and their ability to support the economy when systemic risk materializes.” However, the ECB noted that, currently, banks have strong balance sheets.
Growth of business investment slowed from 2.4% in the second quarter to 1.5% in the third quarter. Government expenditures were flat in the third quarter. Most importantly, trade had a sharp negative impact on GDP growth, with exports up 1.9% while imports were up 5.2%. Export growth weakened due to weaker global demand. Plus, the government said that “increased imports [of goods] due to the easing of supply constraints and a temporary increase in payments for external services contributed to the negative growth.” The only other negative contributor to GDP growth was the residential property sector, which experienced a sharp contraction.
Moreover, when volatile food and energy prices are excluded, core prices were up 6.3% from a year earlier, down from 6.6% in the previous month. Core prices were up 0.3% from the previous month, a relatively low rate. Meanwhile, the category that fueled the initial surge in inflation, durable goods, saw very little inflation. Recall that durable goods prices were up more than 18% from a year earlier back in late 2021. Now, durables prices are up only 4.8% from a year earlier. This reflects declining demand and an easing of supply chain disruption. This indicates that the fundamental factors that first drove inflation are easing. That, in turn, could make the Federal Reserve’s job a bit easier.
Notably, prices of new cars continued to rise rapidly in October, likely reflecting the shortage of semiconductors. Moreover, even as home prices have started to decline, the shelter component of the CPI increased sharply. This component tends to move slowly and with a lag. Thus, there remain significant inflationary pressures in the US economy. Still, the trend is favorable.
In any event, the nearly unambiguously good news on inflation was greeted with enthusiasm in financial markets. In the United States, equity prices soared, with the S&P 500 index up more than 4% shortly after the report was released. Bond yields fell sharply as well. The US dollar declined in value, with the Japanese yen hitting a six-week high. The market reaction reflected a belief that, with inflation coming down more quickly than anticipated, the Federal Reserve will be more likely to pause interest rate normalization in the near future. It also reflects the belief that a Fed pause reduces the likelihood of recession, or at least a deep recession. It is notable that several Fed regional presidents have spoken about pausing the interest rate normalization process.
The New York Fed has created an “underlying inflation gauge (UIG)” that is meant to signal when inflation is on the verge of reversing course. The UIG is designed to find the persistent part of inflation. The New York Fed says that “the design of the UIG is based on the idea that movements in underlying inflation are accompanied by related changes in the common persistent component of other economic and financial series. Consequently, we examine a large dataset and apply modern statistical techniques, known as dynamic factor models, to extract a small number of variables that capture the common fluctuations in the series. These summary factors serve as the basis for constructing the UIG.”
The most recent data on underlying inflation suggests that inflation in the United States is turning the corner. The “full-set” version of the UIG has been steadily declining since March. Headline inflation, on the other hand, has only be receding since June. Thus, the UIG was an early indicator that inflation would soon turn the corner. The trend makes sense in that, not only is the Fed tightening monetary policy, but other factors are driving an easing of inflationary pressure. These include a shift in consumer spending behavior away from goods, an easing of supply chain stress, and a decline in oil prices.
Now, the midterms of 2022 can be added to the short list of exceptions. There are a variety of explanations for the exception. One is that young voters (those under 30) came out to vote in much larger numbers than pollsters had anticipated. Moreover, as expected, they tended to vote overwhelmingly for Democrats.
Although the much-heralded Republican wave failed to materialize, as of this writing we still don’t know who will control both houses of Congress. It seems likely that the Republicans will control the House, although this is likely to be by a very small margin—very different from the wave they expected. In the Senate, the Democrats will retain control of the chamber with the remaining seat in Georgia to be decided on December 6.
What will the outcome mean? Going forward, there will be little chance of significant new legislation if the Democrats lose either or both houses. Instead, expect more regulatory action on the part of the Biden Administration. There are, however, two issues that could be very important.
First, the debt ceiling will soon need to be increased. Republicans have said that they will want some fiscal restraints in exchange for agreeing to raise the debt limit. Democrats say that fiscal policy is already very contractionary and that, regardless of the spending situation, the government’s obligations must be funded. This is a game of chicken. No one really wants to see the government default on its obligations. Financially, this could wreak havoc with asset markets. Politically, a government failure to fully pay Social Security benefits would be perilous for the party perceived as responsible for failing to raise the debt ceiling. Thus, there is reason to expect that something will be done. The question is how?
One possibility is to do it during the lame duck session of the current Congress that remains controlled by Democrats. However, doing this will require the support of some Senate Republicans due to Senate rules. They might prefer to wait in order to extract concessions from the Democrats. If raising the debt ceiling is delayed, then the new Congress must address the issue. With Republicans likely in control of the House by a narrow margin, this means that a small number of members have leverage, thereby potentially creating difficulties. Or, it can be argued, a narrow margin makes it easier to gather up the small number of Republicans willing to raise the debt ceiling without a fight. At the end of the day, it will depend on what the new speaker, likely Kevin McCarthy, is willing to do.
Second, many Republicans in the House, including their leader Kevin McCarthy, have said they want to scale back or halt aid to Ukraine. If they are successful, it would likely have broad geopolitical implications. It could possibly embolden Russian President Putin and weaken US links with its European allies. It would be a sea change in the foreign policy of the Republican Party, which, since the end of World War Two, has been highly internationalist. This would be a reversion to the isolationist role the Republicans had played before World War Two.
The weak export data is not especially welcome given that domestic demand in China is already weak. This partly reflects the impact of the zero–COVID-19 policy that constrained consumer social interaction and, consequently, spending. Lately there have been rumors of an impending easing of the government’s COVID-19 policy. These rumors drove increases in asset prices. Yet the government has recently offered mixed signals, reiterating the correctness of its COVID-19 policy and imposing new restrictions in Shenzhen, but also easing some restrictions at the same time. For example, the government will reduce the quarantine period for visitors from seven days to five days.
Meanwhile, one of the key drivers of China’s export prowess in recent decades was massive foreign investment in export-oriented manufacturing. In addition, inbound investment helped to develop a more sophisticated domestic market. Thus, at the China International Import Expo in Shanghai, China’s leader said that the country will continue to welcome and encourage inbound foreign investment.
In addition, the country will seek membership in the Comprehensive and Progressive Trans-Pacific Partnership (CPTPP), a free trade agreement of Pacific rim nations. The CPTPP was originally meant to be a partnership that included the United States, but the United States withdrew in 2017 and has indicated it will not return. Thus, China is attempting to play a dominant role in trade rules in the region. It is not clear if the other members of the CPTPP will be amenable to China’s entry.
Although China appears to be encouraging more inbound foreign investment, the retention of COVID-19 restrictions makes it difficult for foreign business leaders to travel to China, thereby limiting their ability to make agreements. Moreover, there is anecdotal evidence that many global companies are attempting to reduce exposure to China by diversifying supply chains, if only as an insurance policy against future unexpected disruptions.
Spending volume on automotive fuel was down. On the other hand, real spending on nonfood, nonfuel goods increased by 1% from the previous month. Real spending by mail order or internet was up a strong 2.6%. By country, real retail sales increased from the previous month by 0.9% in Germany, 0.2% in France, 0.2% in Spain, 1.3% in Netherlands, and 1.1% in Belgium; and declined by 0.1% in Italy.
The rebound in retail spending could be a temporary anomaly. Real incomes are declining, consumer confidence has plummeted, and the economy is set to move toward recession as the European Central Bank continues to tighten monetary policy. On the other hand, some governments are offering sizable subsidies to households to offset the impact of elevated energy prices. Plus, oil and gas prices have lately fallen. These factors are helpful to retail sales.
Moreover, this is not the end of the story. The FOMC intends to keep going. It said that “ongoing increases in the target range will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2% over time. In determining the pace of future increases in the target range, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments. In addition, the Committee will continue reducing its holdings of Treasury securities and agency debt and agency mortgage-backed securities.” It said that it is strongly committed to achieving inflation at 2%.
Although headline inflation has peaked, core inflation surprisingly increased in the most recent monthly report. Thus, inflation is far from being beaten. Plus, aside from the troubled housing market, the economy continues to perform far better than expected. I recall many economists, analysts, and even CEOs claiming that the economy was already in recession this past summer. They were wrong. Other than housing, where the typical interest rate on a 30-year mortgage now exceeds 7%, interest-sensitive sectors of the US economy have mostly not responded to the tightening of monetary policy. For example, business investment continues to grow. This could be due to the large pile of cash that many businesses continue to retain. Moreover, although interest rates have risen, they remain historically low and below the rate of inflation. Thus, it will likely take further rate hikes to slow the economy.
On the other hand, monetary policy tends to work with a lag of unknown and variable length. Thus, the measures already taken by the Fed could have a negative impact on the economy and on inflation in the coming year. That is why some pundits suggest that the Fed ought to slow or halt the pace of tightening for fear that it might push the economy into a deeper than necessary recession. Still, the Fed is likely fearful that failure to act credibly could lead to higher expectations of inflation and, consequently, higher bond yields. Thus, most observers now expect the Fed to boost the benchmark rate beyond the 4.6% level that Fed Chairman Powell previously discussed.
Investors were not surprised by the Fed action. Still, they were pleased, as evidenced by the initial modest decline in bond yields and rise in equity prices. However, the good times did not last long. After the Fed’s announcement, Fed Chairman Powell held a press conference in which he said that further large rate hikes are possible and that rates could peak at a higher level than previously anticipated. This removed any credibility to the idea that the Fed might soon pause. Thus, bond yields rose while equity prices fell.
Although there was growth in every major sector, employment growth was somewhat concentrated. Four categories, accounting for 47% of employment, accounted for 67% of job growth. These were manufacturing, professional and business services, health care and social assistance, and leisure and hospitality. On the other hand, there was relatively weak growth in financial services, information, retail trade, and transportation and warehousing. The concentration of job growth in certain industries suggests that the overall strength of job expansion might be too narrow for comfort.
The establishment survey also provides data on wages. Average hourly earnings of workers were up 4.7% in October versus a year earlier, the smallest increase since August 2021. It was a sharp deceleration from September when earnings were up 5% from a year earlier. In addition, earnings were up 0.4% from the previous month. Thus, it appears that wage inflation is not only tame but decelerating. This bodes well for keeping inflation under control, but it also means that households continue to lose purchasing power. From a year earlier, earnings were up 5% in professional and business services, up 3.6% in manufacturing, up 3.8% in financial services, up 4.2% in retailing, and up a notable 6.5% in leisure and hospitality.
The separate survey of households found that the civilian labor force contracted as participation fell. Plus, that survey found a decline in employment. The household survey includes self-employment. In any event, the result was a rise in the unemployment rate from 3.5% in September to 3.7% in October. This survey offered possible evidence of weakness in the job market.
The favorable job growth reported in the establishment survey is good news in that recession has, so far, been averted. It is bad news in that the tightening of monetary policy is not suppressing economic growth sufficiently to fight inflation—at least based on current data. We do know that monetary policy acts with a lag, so it is possible that the actions of the Fed will, over time, restrain the economy sufficiently to curtail inflation. Still, the Fed evidently intends to keep tightening.
Meanwhile, here are the growth numbers for the Eurozone’s largest economies:
Country m/m (%) y/y (%)
Germany 0.3 1.1
France 0.2 1.0
Italy 0.5 2.6
Spain 0.2 3.8
The deceleration of real GDP was largely a story of weaker consumer spending. That, in turn, was driven by higher energy and food prices, which had the effect of reducing real incomes. In France, for example, real GDP growth was fueled principally by rising business investment while consumer spending was flat. Moreover, high-frequency data on consumer activity indicates a deceleration or decline in European consumer spending on automobiles, theaters, and hotels. In addition, measures of consumer sentiment are down sharply in recent months, largely due to the stress of higher energy prices.
Going forward, there are conflicting influences on the Eurozone economy. On the one hand, the European Central Bank (ECB) continues to tighten monetary policy, which is likely to restrain credit growth. In addition, the winter months could involve greater financial stress on households due to potential energy shortages. The war in Ukraine and lockdowns in China continue to disrupt supply chains, thereby creating shortages of inputs that limit production. This is especially true for the automotive industry.
On the other hand, many Eurozone governments are starting to provide substantial fiscal support to households meant to offset the impact of rising energy prices. This should help to alleviate inflation and stabilize household purchasing power. In addition, the weakening of the global economy has already led to a decline in oil prices. In Europe, gas prices are down sharply due to milder-than-expected weather, growth of non-Russian sources of gas, and success at storing gas for the winter. Thus, the trajectory of the Eurozone economy remains uncertain. While a recession still seems likely, it could be less onerous than previously expected.
By country, there was considerable variation, with the monthly increase in Italy especially alarming. Here are the inflation numbers by country:
Country m/m (%) y/y (%)
Germany 1.1 11.6
France 1.3 7.1
Italy 4.0 12.8
Spain 0.1 7.3
Netherlands 1.3 16.8
Belgium 2.7 13.1
The very high inflation numbers in the Eurozone almost assure that the ECB will continue its path of rapidly raising the benchmark interest rate. The goal, of course, is to stifle credit market activity, slow the economy, and ease inflationary pressure. The problem is that the ECB cannot directly control the fundamental factor driving inflation, which is the war in Ukraine and the resulting disruption of the markets for energy and food. Thus, raising rates could slow the economy while not necessarily dealing a major blow to inflation. On the other hand, the good news is that oil and gas prices have recently fallen, boding well for easing inflation.
Interestingly, with high inflation and decelerating growth, there continue to be tight labor markets across Europe with the unemployment rate historically low. In Germany, for example, workers at one of the country’s largest industrial unions are seeking the biggest wage increase sought since 2008. High inflation has more than eaten into their wages and, with the labor market remaining tight, they evidently feel they have leverage with employers. In response, employers are offering a one-off payment rather than a permanent increase in wages. They probably don’t want to get stuck with much higher wages if inflation quickly dissipates. The gap between the union and the employers could lead to an increase in strike activity.
This suggests that the BOE is on a somewhat less hawkish path than the US Federal Reserve. Although the Fed as well as the ECB raised their benchmark rates by 75 bps in the past week, the BOE action is more restrained, mainly due to the guidance offered about future rate increases. Given the expectation that UK rates will peak sooner than those of the United States, the pound fell sharply today against the US dollar and the euro.
The main difference between the outlook of the BOE and the other central banks is the expectation of a long UK recession. The BOE says that economic activity is likely to contract for five consecutive quarters. This will be due to elevated energy prices, elevated mortgage interest rates, declining real incomes, and external headwinds. As such, the BOE expects inflation to recede quickly, from double digits now to 2.2% by the end of 2023 and below the 2% target by the end of 2024. The forecast does not incorporate the impact of the expected fiscal policy from the new government of Rishi Sunak. That policy, which will likely entail a sharp fiscal contraction, could significantly deepen the recession and possibly stifle inflation more rapidly.
Finally, in several presentations here in the United States in recent weeks, I’ve been asked the following question by clients: Will a sharp downturn in the UK hurt the US economy? My answer is probably not. Although the United Kingdom is the world’s sixth largest economy, it is relatively small in the larger scheme of things. The principal channel by which a UK recession will affect the United States is through trade. If the UK economy contracts, demand for imports from the United States will decline. Yet US exports to the United Kingdom are a very small share of US GDP. Thus, a UK recession will have only a very modest impact on the US economy, although some companies that are heavily exposed to the United Kingdom might suffer. The UK downturn, however, could have a meaningful impact on neighboring countries such as Ireland, Netherlands, Belgium, and the Nordics.
Looking at the components of real GDP, consumer spending was up at a modest rate of 1.4%. Spending on goods was down 1.2% while spending on services was up 2.8%. This is consistent with the trend of consumers reverting to prepandemic spending patterns. The continuing decline in the demand for goods should help to alleviate supply chain stress and, therefore, inflation.
Nonresidential fixed investment was up at a healthy rate of 3.7%. The structures component continued to decline, falling at a rate of 15.3%. This measure, which includes business construction of offices, shopping centers, and factories, has fallen in every quarter since the second quarter of 2021. The decline could indicate a structural shift in the postpandemic economy. That is, it could mean lower demand for office and retail space as more work and shopping are done remotely. Meanwhile, investment in equipment (computers, telecoms, transport equipment) increased at a strong rate of 10.8%. Finally, investment in intellectual property (software, R&D, brands) increased at a rate of 6.9%.
The weakest component of real GDP growth was residential investment. It declined at a rate of 26.4%. This was the sixth consecutive quarter of declining investment in housing. It reflects the onerous impact of rising mortgage interest rates, the principal impact of tightening monetary policy by the Federal Reserve. So big was the drop in housing investment that, if residential investment were to be excluded from the GDP numbers, real GDP would have grown at a rate of 4%.
The main factor that drove the decline in real GDP in the second quarter was a sharp drop in inventory accumulation, which subtracted 1.9 percentage points from GDP growth. In the third quarter, this continued at a slower pace. As a result, declining growth of inventories subtracted 0.7 percentage points from GDP growth. Excluding inventory decline, final sales of domestic product were up at a rate of 3.3%. However, if government spending and net exports are excluded, final sales to domestic private purchasers were up only 0.1%. This is a good measure of underlying domestic demand and it grew exceptionally slowly—mainly because of the severe decline in housing investment. This number garnered a lot of press on the day the GDP report was released and is seen as evidence of a very weak economy.
Meanwhile, government purchases were up 2.4%, led by a 4.7% increase in defense spending. Exports of goods and services were up a strong 14.4% while imports were down 6.9%. Thus, trade made a positive contribution to real GDP growth. Finally, after five consecutive quarterly declines, real disposable personal income increased at a rate of 1.7%, reflecting continued healthy job growth.
Overall, the latest GDP report signaled that, while the economy continued to grow in the third quarter, it faces important headwinds. These have already been signaled in the latest purchasing managers’ indices that suggest that the US economy could be on the verge of recession. Investors reacted by pushing down bond yields.
On the positive side, the strength of nonstructure business investment is notable, especially after the Federal Reserve raised interest rates significantly. Higher rates are meant to curtail credit market activity, thereby hurting investment. Yet many companies are flush with cash that can be used to finance investments—although cash balances are down from the pandemic peak. Moreover, although interest rates have increased, borrowing costs remain historically low. This suggests that interest rates might need to go significantly higher to stifle business investment. Also, despite all the talk by some business leaders about imminent recession, businesses appeared to be intent on capex in the third quarter, perhaps focusing more on the long term.
Also on the positive side, the price deflator for GDP increased in the third quarter at the slowest pace since the fourth quarter of 2020. The price deflator for consumer spending also increased at the slowest pace since the fourth quarter of 2020. This suggests that underlying inflation has eased, driven by lower oil prices and weakened demand for goods. If so, it could alter the trajectory of Fed policy.
In September, real (inflation-adjusted) disposable personal income was unchanged from the previous month as inflation ate into the nominal rise in wage income. However, the personal savings rate fell from 3.4% in August to 3.1% in September, thus enabling consumers to spend more. Consequently, real personal consumption expenditures were up 0.3% in September. This included a 0.1% increase in spending on durable goods, a 0.6% increase for nondurable goods, and a 0.3% increase for services.
It is also interesting to note how the latest data compares with a year earlier. Because government stimulus spending has ended, real disposable income in September was down 2.9% from a year earlier. Yet because savings have fallen sharply since then, real personal consumption expenditures were up 1.9% from a year earlier. Moreover, real spending on goods was down 0.5% while spending on services was up 3.1% from a year earlier. This means that, in the past year, American consumers have shifted back toward the prepandemic pattern of spending. The decline in spending on goods should be helpful in alleviating supply chain stress and inflationary pressure.
Meanwhile, the latest report included data on the Federal Reserve’s favorite measure of inflation: the personal consumption expenditure deflator, or PCE-deflator. Fed leaders say that this is the measure to which they pay most attention when assessing the inflationary environment. In September, the PCE-deflator was up 6.2% from a year earlier, the same as in August and down from the peak of 7% in June. When volatile food and energy prices are excluded, core prices were up 5.1% in September versus a year earlier. This was higher than the 4.9% reported in August, but lower than the peak reached in March of 5.4%. In other words, core inflation has trended slightly down. Still, inflation remains historically high. For the Fed, which is currently on a path of rapid tightening of monetary policy, a shift toward an easier policy will only come when Fed leaders are convinced that inflation is on a consistent downward path.
There were especially sharp price declines in San Francisco (down 4.3% from the previous month), Seattle (down 3.9%), San Diego (down 2.8%), and my hometown of Los Angeles (2.3%). The very big declines in San Francisco and Seattle come amidst troubles in the technology industry that dominate those two cities. Plus, the sharp drop in West Coast prices comes following a dramatic surge in prices to record levels. On the other hand, the decline in prices was modest in Cleveland, Miami, New York, and Washington.
Going forward, further tightening of monetary policy and weaker economic growth bode poorly for home prices. On the other hand, if and when the economy dips into recession, and provided that inflation recedes, the Fed will likely ease monetary policy, thereby leading to lower mortgage interest rates. When that happens, housing activity will likely pick up, possibly followed by higher prices.
The big unknown, however, is the degree to which housing demand will have permanently shifted in response to the pandemic. During the pandemic, when people were intent on isolating, there was a mad rush out of cities as households shifted to larger homes with home offices and home gyms. During the pandemic, there was much speculation as to whether people would shift back to smaller urban homes once the pandemic ended. The answer to this puzzle is not yet clear, but it appears that a large share of the professional workforce continues to prefer working from home. This augurs for a permanent shift to larger homes in places people want to live. That, in turn, might sustain higher prices. On the other hand, one might reasonably argue that frothy prices reflected a speculative bubble that is now being corrected. Time will tell.
The overall impact of US tariffs on China was to stifle imports from China. For example, while imports from China are now roughly at the same level as prior to the imposition of tariffs, US imports from the rest of the world have increased 38% during that time. On the other hand, US imports from China of goods not subject to tariffs are up 50% from prior to the trade war. Thus, nontariffed trade with China actually performed better than US trade with the rest of the world. Meanwhile, for those products hit with US tariffs, the analysis found that, the higher the tariff, the weaker the imports from China.
The United States chose not to hit China with tariffs on imports of laptops and monitors. Consequently, imports of these products from China grew rapidly during the pandemic, although imports from other countries grew rapidly as well. China remains the source for 92% of imports of laptops and monitors. On the other hand, IT hardware and consumer electronics are subject to a 25% US tariff. Consequently, imports of these products from China are down 62% while imports from the rest of the world are up 62%. A similar story is true of automotive parts as well as semiconductors.
Restrictions on cross-border investment, especially related to technology, have taken a toll on the economic relationship between China and the United States, and will likely do so going forward as the United States attempts to restrict Chinese access to critical technologies. Moreover, the United States is attempting to prevent China from moving up the value chain in technologies deemed critical to US national security.
In addition, to the degree that decoupling is taking place, it is partly driven by decisions made by private sector businesses. Many companies are shaken by the experience of unanticipated shocks that have disrupted supply chains, such as the pandemic and China’s policy response to the pandemic. Many are now seeking to diversify their supply chains, if only as an insurance policy against future unexpected disruptions. Thus, there is evidence of global companies reducing dependence on China by shifting assets and processes from China to other locations such as Southeast Asia, India, and Mexico.
Consider mobile telephones. Although China still accounts for 74% of US imports of phones, imports from China grew 14% since 2018, while imports from the rest of the world increased 70%, with a large share of that coming from Vietnam. Smartphone makers that contract out manufacturing of their products are, evidently, averse to excessive dependence on China and are quickly diversifying. Also, as China has moved up the value chain and as Chinese wages have increased, some low value–added processes, including assembly of apparel and textiles, toys, and footwear, have rapidly moved away from China toward lower-wage locations.
Meanwhile, the Peterson report points out that, as this process of decoupling takes place, it creates new risks. That is, the process of disentangling long-standing relationships imposes costs that might “include product shortages, as supply chains struggle to adjust, as well as inflation, as companies find it expensive to establish new suppliers.” Perhaps current supply chain difficulties partly reflect the impact of this process.
Beyond the issue of cross-border trade, there are other aspects to the potential decoupling of not only China, but of Asia in general, from the West. There is the question as to whether recent actions by the US government will cause a further decoupling between Asia and the West.
The most notable recent action was the passage of the CHIPS Act by the US Congress, which provides US$53 billion in subsidies for the development of the semiconductor industry in the United States. Moreover, the US government has also imposed rules that limit the ability of Chinese companies to participate in the US industry. The CHIPS Act is not just directed at China. The United States currently relies heavily on Taiwan for fabrication of the most important semiconductors, a dependence that is seen as potentially risky given geopolitical conditions in Asia. Thus, the goal of the US government is to assure an adequate supply of chips.
Yet a new study by Goldman Sachs suggests that, by passing the CHIPS Act, the US will impose a cost on its own economy and will also fail to reduce dependence on Asia. The study says that “in the US, it’s significantly more expensive (44% higher) to build and run a new fab than it is in Taiwan. Out of that 44% premium, 21% is coming from higher capital expenditures in the US than in Asia, 18% from higher operational costs over a 10-year period and 5% from operational inefficiencies tied mainly to culture, operation and management style differences, and other factors.” In other words, diversification of supply chains comes at a high cost.
In addition, Goldman Sachs says that the amount of money spent by the Chips Act is not sufficient to make a big difference. It says that “the current incentives in the Act will only be able to ‘fully’ support an increase in the US’s market share of global chip capacity of less than 1%. That’s because the industry’s capital expenditures will continue to trend up as we move towards more advanced technologies, and that capex is expected to double over the next three years and surge by a 17% compounded annual rate of growth, compared to just 8% over the past decade.”
Goldman Sachs concludes that “the CHIPS Act should be viewed more in the context of US geopolitical strategy, ‘hedging’ against future crisis or major supply chain disruptions rather than efforts to replace Asia’s current position and importance within the semiconductor supply chain.” In other words, Goldman Sachs suggests that, when it comes to semiconductors, decoupling appears unlikely despite the efforts of the US government.
Meanwhile, unusually high temperatures in Europe have dampened demand for gas. This, in addition to accelerated imports of LNG and considerable success in building up storage, have resulted in a sharp decline in European gas prices. The price of European gas has fallen by more than 70% since late August and is now roughly where it was in the period from April through June. As for storage, European storage is now at roughly 94% of capacity and that of Germany is at 98%. In addition, although the transmission of gas from Russia by pipeline is down about 86% from preinvasion levels, the total level of gas imports to Europe is down only about 20%. That is because Europe has successfully obtained other sources, especially LNG and gas through pipeline from Norway. Finally, Germany and other European states have been successful in constraining consumption of gas. If the weather during the coming winter is mild, then the energy crisis will be mild as well.
Going forward, Russia could face a problem if European states are successful in substantially reducing dependence on Russian energy, not just gas but oil as well. Prior to the war with Ukraine, Russia had often focused on its reliability as an energy partner for Europe. That is clearly no longer the case. If Russian exports of energy to Europe are substantially reduced in the coming years, Russian export revenue will fall sharply, creating significant challenges for the Russian economy.
Cover image by: Sofia Sergi