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Cover image by: Sofia Sergi
Yet things are starting to change quite dramatically. Japan is now experiencing the highest inflation in 40 years, the economy is rebounding from the COVID-19 doldrums, and the labor market is tight—largely due to their demographics. Moreover, Japan’s commitment to lifetime employment means that fast-growing industries face a labor shortage because workers are not leaving other industries. Consequently, many high-profile employers are now offering stunningly large wage increases, meant to attract or retain quality workers. For example, one fashion retailer announced recently that it will implement a 40% wage increase for its employees. Moreover, it said that this will not be a one-off event. The company’s CFO said that “we want workers to work hard under this new system and if sales and profits rise, there will be room to raise our remuneration to a much higher level.”
Other Japanese companies have begun to offer significant wage increases for their employees. Some high-profile companies have provided wage increases in the past year between 4% and 6%, very high by recent historical standards. Japan’s largest trade union has urged employers to boost wages. The largest business lobby in Japan has urged members to boost wages as part of an effort toward “corporate social responsibility.”
This new pattern is what the Bank of Japan has been hoping for during the past decade of unusually easy monetary policy meant to boost inflation. Only when the pandemic started to abate did inflation begin to surge. This, in turn, is driving wage behavior. Moreover, Prime Minister Kishida has urged companies to boost wages, offering tax incentives to companies that comply. His predecessor, the late Shinzo Abe, did the same. Kishida is also talking about more government investment in training to help workers move up the value chain and achieve higher compensation.
If this new trend persists, it could have significant implications for Japan’s economy. First, it could bode well for faster consumer spending growth. That, in turn, would help drive economic growth even when Japan’s large export sector faces global headwinds. Second, it could eat into the profit margins of companies, especially if they are unable to raise prices or boost productivity accordingly. Third, it could compel more investment in labor-saving or labor-augmenting technologies meant to boost productivity. Finally, it could lead some employers to accelerate the process of offshoring some processes, leaving the highest value-added processes at home.
One of the factors noted above that are driving labor market behavior in Japan is demographics. Japan’s population is declining while its working-age population is declining even faster. The result is a sharp decline in the ratio of workers to retirees, thereby putting stress on the pension and health care system. Indeed, Prime Minister Kishida has warned that this trend will mean that Japan is “on the brink of being unable to maintain social functions.” He said that, as a result, “we place child-rearing support as our most important policy.” Another solution might be more immigration, something that has accelerated in recent years.
A few numbers can tell the story: China’s birth rate last year was 6.77 babies per 1,000 population, the lowest on record. There were 9.56 million live births, the lowest in modern history. China’s working-age population (those between 16 and 59) fell by almost seven million people last year alone. At the same time, the number of Chinese 60 years and older increased by almost 13 million last year. One way to reverse the sharp decline in the worker/retiree ratio is to boost the retirement age, currently very low (55 for women, 60 for men) compared to many other countries. Another way to boost the size of the productive urban population is to remove obstacles to internal migration from rural areas.
To keep the economy growing at a healthy pace will require rising productivity rather than a growing pool of labor. As one Chinese official put it, “The demand for the quantity of labor will be replaced by the quality of labor.” This will mean more investment in technology, more investment in human capital, and likely more inbound foreign investment meant to further the process of technology transfer from abroad. Given the fraught political relationship with the West, the latter could be undermined by protectionist measures implemented abroad. In addition, growth of productivity will likely come from the private sector (as it has in the past), rather than the state sector.
If, going forward, China grows far more slowly than in the recent past, it will likely mean a smaller footprint in the global economy, including less impact on global commodity markets. It will likely mean higher Chinese labor costs and more labor arbitrage in which companies shift resources from China to other emerging countries. It could mean more diverse global supply chains. Finally, it will likely mean a bigger global footprint for younger, faster-growing emerging markets such as India and Africa.
The government numbers for the fourth quarter reveal areas of strength and weakness. Overall, real GDP grew at an annualized rate of 2.9% from the third to the fourth quarter. Looking at the components of GDP, real consumer expenditures were up 2.1%, with the lion’s share of spending growth going to services rather than goods. Spending on durable goods increased at a very modest rate of 0.5% while spending on services grew 2.6%. Within durables, there was very strong growth of spending on automobiles but weakness in other categories. Interestingly, real disposable personal income was up at a rate of 3.3%. The personal savings rate increased from 2.7% in the third quarter to 2.9% in the fourth quarter.
Nonresidential fixed investment grew at a modest pace of 0.7%. This included a sharp decline in investment in business equipment (down 3.7%) offset by a sharp rise in spending on intellectual property (up 5.3%). Intellectual property encompasses software, which grew rapidly, and R&D, which declined modestly. The decline in equipment investment was due to a sharp decline in purchases of information technology equipment. Other forms of equipment investment grew. Purchases of equipment tend to be volatile. In the past eight quarters, the trend was up but purchases declined in three of those quarters. Also, investment in structures, after having declined sharply in 10 of the last 12 quarters, increased a modest 0.4% in the fourth quarter.
Meanwhile, residential investment fell sharply, down at a rate of 26.7%. To put it in perspective, real GDP growth for the fourth quarter would have been 4.2% absent the housing debacle. In addition, investment in inventories increased sharply, accounting for roughly half of economic growth. Inventory investment had made a negative contribution to GDP growth in the second and third quarters. Thus, businesses needed to replenish inventory or, more likely, they faced weaker demand than anticipated and weren’t able to sell all the goods they produced or imported. If so, then there will likely be weaker inventory investment in this quarter, which could mean much slower economic growth as 2023 begins.
Finally, US exports of goods fell at a rate of 7% while exports of services increased at a rate of 12.4%. Imports of goods were down 5.6% while imports of services were up 0.4%. In addition, government purchases were up at both the federal and state/local levels. Federal nondefense purchases were up very rapidly.
How can we interpret the fourth quarter GDP data? First, it is a look at the past. It tells us the economy grew but tells us little about where we are right now or where we are going. Still, it indicates that the economy is decelerating. Second, after a period of rapid tightening of monetary policy, it is notable that both consumer spending and business investment continued to grow, albeit modestly. The only part of the economy that appears to have been significantly stifled by monetary policy is housing. Third, the weakness of goods exports signals the impact of the weakening global economy, especially the sharp deceleration in China that was related to the COVID-19 outbreak. Given that China is now reopening, this could bode well for US exports later in 2023. Fourth, the modest surge in inventory investment likely means a reversal in the current quarter, thereby slowing growth.
Fifth, the report signals underlying weakness. Real final sales to domestic private sector purchasers were up only 0.2% in the fourth quarter. This is calculated by excluding inventory investment, foreign trade, and government purchases. This signals a sharp slowdown in underlying demand by the private sector. This was the slowest growth of this metric since the second quarter of 2020.
Finally, we know that the Federal Reserve intends to continue raising the benchmark interest rate, although at a slower pace than in 2022. This could further stifle growth, which is the Fed’s intention. Whether this leads to a recession cannot be known. Despite underlying weakness and significant headwinds, the economy also demonstrates some resilience as evidenced by a surprisingly robust job market.
The IRA is part of a growing trend in which countries engage in industrial policy to achieve certain goals, often at the expense of free market considerations. Many advocates of the IRA say that this is nothing new and that past episodes of adjustment often involved substantial government support. They point to the impact of military investment on technology development, the impact of investment in infrastructure on the transportation industry, and the impact of past subsidies for oil and gas development.
Because of the incentives in the IRA, many European companies are now planning to make new investments in the United States that enable them to take advantage of government incentives in clean energy. This includes automobile and battery manufacturers. For the United States, the principal goal is to reduce carbon emissions. Yet a boost to employment and capital expenditures will likely be a side benefit.
Meanwhile, EU leaders are debating about how to respond to the IRA. Two EU Commissioners recently wrote that the IRA creates incentives for “the (re) location of industry to the US, thereby potentially putting the EU industrial base for clean technologies at a disadvantage. It has led some in Europe to call for an IRA-like response of our own. But a tit-for-tat reaction risks significant economic self-harm. Instead, to make Europe the home of industrial innovation as we transition to net zero, we need common action through an EU green deal industrial plan. This should cover four pillars: the business environment, financing, skills, and trade.” They note that the EU’s emissions-trading platform is expected to generate 700 billion euros in revenue. The European Commission will propose that this revenue source, as well as others, be used for a fund to support “upstream research, innovation, and strategic industrial projects.”
What are the fundamental reasons to expect higher borrowing costs? And what are the reasons to expect a reversion to low interest rates?
First, rates have risen from historic lows because of the surge in inflation and the resulting tightening of monetary policy by major central banks. If you believe that inflation will remain high in the future, then it makes sense to expect higher borrowing costs. Even if you expect inflation to decline sharply, one might still expect higher borrowing costs if you believe that supply and demand conditions in the market for loanable funds will change significantly. That would entail a reduction in saving, perhaps due to a decline in income inequality, a rise in the number of retirees, or perhaps due to pent-up consumer demand as the pandemic ends. It might also entail a rise in investment, especially if businesses need to make significant changes to accommodate a new age (involving supply chain diversification, greater digital intensity, transitioning to clean energy). Finally, given the sharp decline in the ratio of workers to retirees in numerous countries, governments might need to borrow more to fund pensions and health care. That, in turn, would mean higher borrowing costs. These are the reasons to expect high interest rates to persist.
On the other hand, borrowing costs might revert to the very low level of recent years. This would likely mean higher savings, due to the rise in the number of people approaching retirement age. Or it could be due to greater retained earnings by companies that are reluctant to invest. Indeed, it could mean a lower level of investment if businesses expect slower economic growth, mainly due to onerous demographics. It could also mean less investment because of changes in technology and work habits. For example, if more people work remotely, then less office space is needed. If there is further digital transformation, businesses need fewer file cabinets and the like. And if businesses put more processes in the cloud, they need fewer servers for themselves.
My own view is that, following the decline in inflation and the reversal of the current tight monetary policy, it is likely that borrowing costs will revert to the low levels we experienced in the decade prior to the pandemic. My view is that global savings will be elevated relative to the level of investment, thereby putting downward pressure on borrowing costs. Moreover, inflation is likely to revert to a low level, especially due to the persistent excess capacity generated by poor demographics. Still, as former Treasury Secretary Larry Summers recently said, anyone who confidently makes a prediction about this is foolish given that there are too many moving parts and, therefore, the future cannot be known.
Kristalina Georgieva, managing director of the International Monetary Fund (IMF), said that the outlook for the global economy has improved in recent months. This follows last year’s downgrading of the global outlook by the IMF. Georgieva said, “My message is that it is less bad than we feared a couple of months ago but that doesn’t mean good. What has improved is that inflation seems to be leaning in the right direction—that is, down.” She also noted the reopening of China and how this will likely lead to somewhat faster growth. Moreover, she hinted that the IMF’s next outlook, due out in a month, will likely involve an upgrade to the outlook. Still, she warned, “Don’t go from being too pessimistic to being too optimistic.”
Indeed, the IMF deputy managing director, Gita Gopinath, warned that “the fight against inflation is not over.” When asked if the US Federal Reserve had finished its job, she replied, “Absolutely not.” She noted that inflation in the United States has come down quickly and believes that investors are betting on a further quick decline. Consequently, they are also betting that the Fed will reverse course relatively soon. Yet the Fed has indicated otherwise, which she thinks is sensible. She expects the Fed to tighten further, despite investor expectations.
Former US Treasury Secretary Larry Summers agreed with Gopinath. He said that it would be a big mistake if the Fed, or other central banks, were to “lurch away” from their determination to fully suppress inflation. He said that “if inflation was allowed to surge back, that would put not just price stability and standards of living for low-income people at risk, but also pose substantial risks to cyclical stability.” He suggested that failure to get inflation under control would mean that central banks would have to return to a policy of tightening relatively soon, thereby stifling longer-term growth. In fact, this is what happened in the 1970s, an experience that most central banks are not keen to repeat.
Meanwhile, regarding Europe, Gopinath said that, although inflation may be peaking, it is mainly due to the decline in energy prices. Core inflation (which excludes the impact of volatile food and energy prices) “is stubbornly high and will probably only start to fall toward the end of the year. Whether the 2-percent inflation targeted by the ECB will be reached as early as 2024 is uncertain. The fight against inflation may take somewhat longer than in the US.”
Adding to the commentary about Europe, European Central Bank (ECB) President Christine Lagarde said that the reopening of China, while good for global growth, could lead to an increase in global inflation. She said that “the change of this Covid policy will revive the economy. That is positive for the rest of the world, but there will be more inflationary pressure.” Regarding inflation in the Eurozone, she acknowledged that it might be peaking but said it remains much too high. She said that “there is determination at the ECB to bring inflation back in a timely manner and we should stay the course until we have been in restrictive territory for long enough to bring it down.” In other words, don’t expect the ECB to stop raising rates or to reverse course anytime soon.
Moreover, she said that, although declining energy prices are currently helpful, she worries that the tightness of labor markets in Europe could become a problem. She said, “The job market in Europe has never been as vibrant as it is now. The unemployment number is at rock bottom compared with what we’ve had in the last 20 years. And the participation rate, which matters as well, is also [at a] very, very high level and that is pretty much homogenous through the Euro area.” The risk is that persistent tightness in the job market could lead to a wage-price spiral that would restrain the ability of the ECB to suppress inflation sufficiently.
Finally, there has been much discussion about the reopening of China and its potential impact on global growth and inflation. At Davos, Chinese Vice Premier Liu He held a private meeting with leading Western business leaders. One leader quoted Liu as saying that “China is back.” There is a widespread expectation that, once the current outbreak of COVID-19 in China recedes, the Chinese economy will accelerate significantly. However, there are serious headwinds for China that could restrain the recovery. These include the troubled property market, weakness of external demand, poor demographics, and efforts by Western governments to restrict trade and cross-border capital flows with China.
If China grows strongly, there is serious concern about the potential impact on oil prices and, consequently, global inflation. The head of Norway’s massive sovereign wealth fund said that the “biggest downside is if the starting up of China will reaccelerate inflation in the EU and US. I think it’s a high likelihood and very bad for financial markets.” Yet this expectation is not reflected in financial markets. Rather, measures of inflation expectations for the United States continue to decline. Perhaps the investment community thinks that China’s headwinds will be substantial.
Moreover, despite Vice Premier Liu’s evident interest in attracting foreign investment to China, there is concern by some observers that global companies will be reluctant to invest more in China for fear of political risk. As former Australian Prime Minister Kevin Rudd said regarding China, “Whether private investors will have the confidence to invest in new plants and equipment for the future” is a “question mark.” He added that, because of geopolitical tensions, “there is a real risk that we will still face a high level of technological decoupling,” which could undermine Chinese growth and China’s move up the technology value chain.
Now, however, things appear to be changing. EM equities and bond yields have risen while EM debt issuance has lately surged (up more than 200% in the first two weeks of 2023 versus a year earlier). In fact, EM equities have increased faster than equity prices in advanced economies. Why? There are several possible explanations. First, since October, the US dollar has fallen in value, thereby taking pressure off EM central banks. Rising currency values in EMs mean less inflationary pressure, lower import costs, and more room for monetary policy flexibility. Second, the impending reopening of China has caused excitement for many investors. They evidently expect that EMs will benefit from the opportunity to export more to a growing China. Third, the prices of oil and many other commodities have fallen. This is hugely beneficial to oil-importing and commodity-importing EMs. Finally, recovery of the global economy is on the horizon, even though it is widely expected that there will be a slowdown/recession in 2023.
Then why did spreads decline in the second half of the year? And why are spreads now close to the level normally associated with a strong economy? One possible explanation is that investors are confident that inflation will rapidly decline, thereby setting the stage for the Fed to ease up on its tightening path. Moreover, since mid-2022, the broad money supply has been declining, something that almost never happens. Thus, the Fed’s policy has been unusually tight. This suggests that the Fed could be on the verge of halting the path of tightening. Meanwhile, US inflation peaked in June at 9.1%, hitting 6.5% in December. It is widely expected to decline much further in 2023. Thus, if investors expect only a modest and short-lived downturn followed by a quick recovery, it makes sense to be optimistic about the kinds of companies that issue junk bonds.
First, the retail sales data is seasonally adjusted. That is, actual spending moves quite violently from month to month due to seasonal factors. For example, sales tend to drop sharply following the winter holiday season. Thus, the government takes this into account based on past patterns of spending to determine the underlying (seasonally adjusted) monthly change in sales. In this case, the seasonal factors used by the government could be wrong. That is, if people did their holiday shopping especially early, then spending in December could have been less than would normally be the case. Thus, the data should be taken with a grain of salt.
Second, retail sales mainly involve the sale of goods rather than services, with the exception of restaurant meals. In the past half year, US consumers have been shifting away from goods and toward services as part of a trend toward normalization following the disruption of the pandemic. Thus, if spending on services increased in December, overall consumer spending might have been stable or growing. We don’t yet know.
Still, the weakness of retail sales in December was notably substantial, likely indicating some weakening of the economy. This was to be expected given the continuing tightening of monetary policy. Moreover, spending increases in past months were helped by people dipping into their savings and saving a smaller share of their incomes. Yet that cannot go on indefinitely. Indeed, the last reading of the savings rate was quite low. It could be the case that consumers are tapped out. In fact, credit card usage has increased. That, too, has its limits. Thus, it is reasonable to expect that spending in the coming months will be weak.
As for the details, there was a decline in sales in most retail categories. On a month-to-month basis, sales at automotive dealers were down 1.2%, furniture stores down 2.5%, electronics and appliance stores down 1.1%, drug stores down 0.9%, gasoline stations down 4.6% (reflecting lower prices), department stores down 6.6%, nonstore retailers down 1.1%, and restaurants down 0.9%.
In response to the news about retail sales and industrial production, US equity prices fell sharply as investors evidently feared that these data points suggest a further weakening of the US economy. Bond yields also fell sharply, likely due to fears of further economic weakening. Such weakening might lead the Federal Reserve to ease the pace of monetary tightening. Finally, the value of the US dollar fell, reflecting the effect of lower bond yields.
To summarize, there was very good news on the inflation front, but not good news regarding the strength of the economy. The retail sales and industrial production numbers likely increase the probability of recession in 2023.
GDP was not the only data point released this week by China’s government. In addition to GDP, China released data on retail sales, industrial production, and fixed asset investment for December. In December, retail sales were down 1.8% from a year earlier. This followed a 5.9% decline in November and a 0.5% decline in October. Among the categories that experienced a very sharp decline in December were cosmetics (down 19.3%), clothing (down 12.5%), home appliances (down 13.1%), and jewelry (down 18.4%). The weakness probably reflected low mobility in the face of the COVID-19 outbreak.
In addition, industrial production increased 1.3% in December versus a year earlier, the slowest increase since May 2022. Evidently, the outbreak, by reducing mobility, hampered output at the nation’s factories. Moreover, the slowdown in the global economy likely played a role by suppressing export orders.
Meanwhile, fixed asset investment continued to decelerate in December. For all of 2022, it was up a modest 5.1% from 2021. However, property investment was down 10% from the previous year. In addition, sales of property by square footage were down 24% in 2022 versus the previous year. Thus, the problems in the property market played a role in weakening economic performance at the end of the year.
The weak numbers for all of 2022 were largely the result of the COVID-19–related restrictions that suppressed consumer mobility and spending, industrial production, and product distribution. Yet the weak numbers in December were due to the COVID-19 outbreak following the rapid removal of restrictions. By the end of the year, amid popular protests, the government decided to go all in on economic growth. To the surprise of many, it removed all restrictions and provided incentives meant to stabilize the troubled property market and stimulate demand. The goal, evidently, is to revive economic growth in the world’s second-largest economy. The current growth target at 5.5% is very low compared to China’s recent history and was not attainable in the past year with the old COVID-19 policy.
Given the current massive outbreak of COVID-19 infections, it is likely that economic activity will remain suppressed in the first quarter of 2023. Yet once this wave of infections recedes, there will be plenty of pent-up consumer demand, thereby stimulating an acceleration in economic growth. On the other hand, other headwinds remain that might suppress the rebound. These include the festering property market problems, weak external demand, and troubled relations with the United States.
One longer-term headwind involves demographics. It was announced that, in 2022, China’s population declined from the previous year for the first time in 60 years. It is estimated that the population declined by 850,000 from the previous year. The last time the population declined was during the Great Leap Forward, during which there was a serious famine. This time has more to do with a voluntary change in household behavior with respect to parenting decisions. People are choosing to have fewer children, despite government encouragement of childbirth and incentives to make child-rearing less stressful.
Currently, the birth rate is now the lowest on record. Plus, there has been a sharp decline in the number of women of child-bearing age. That is the lagged result of China’s now-defunct one-child policy. Interestingly, since that policy was abandoned in 2016, the birth rate has fallen every year since.
Not only is the total population declining. The working-age population is declining even faster. That implies slower economic growth absent an acceleration in productivity growth. It also implies less investment in residential property, a market that is already troubled. The drop in the size of the labor force, which has been under way for several years, has contributed to rising labor costs as it has led to a shortage of labor. Going forward, this situation will provide employers with an incentive to invest in technologies that will boost productivity.
Finally, as the working-age population declines, the elderly population continues to increase. The ratio of workers to retirees is falling, thereby putting pressure on the country’s pension and health care systems. China is not unique in this respect. It is a problem that afflicts many countries, both affluent and middle income.
Last week, I began the year with predictions about 2023. This week, I look at six big unknowns—things that are less predictable—that will likely contribute to the path of the global economy and the global business environment in the coming year.Impact of China’s reopening on the global economy.
China’s zero-tolerance COVID-19 policy is over. Currently, China is experiencing a massive wave of new infections and it is widely estimated that this could result in fatalities in the next few months. Moreover, it is widely expected that this will suppress economic activity in the short run by stifling mobility and, therefore, shopping and industrial production. Yet COVID-19 comes in waves. When this wave ends, it is also widely expected that China’s economy will rebound sharply. Moreover, the government is taking significant steps to stabilize the troubled housing market, and thereby stimulate growth.
The question, then, is to what extent the rebound will have a significant impact on the global economy? The Economist says that “China’s reopening will be the biggest economic event of 2023.” Whether true or not, there can be no doubt that the path China’s economy takes will affect the trajectory of trade, commodity prices, inflation, and economic growth in the world’s largest economies. If, for example, China grows very rapidly in 2023, then oil prices could surge, thereby leading to an acceleration in inflation in multiple markets. This in turn could cause central banks to shift toward a tighter trajectory of monetary policy. If, in contrast, China fails to take off, it could mean weaker exports to China from many other countries, thereby stifling economic recovery while suppressing inflationary pressure.
A survey of 167 foreign policy experts conducted by the Atlantic Council found that almost half (46%) of those surveyed expect Russia to become a failed state, or even break up, by 2033. The main cause would be its failure in the war in Ukraine. But what about 2023? It appears likely that Russia will continue to pursue war against Ukraine and that a peace deal will not come about. The US Congress has just passed a massive package of aid to Ukraine and the United States continues to provide Ukraine with increasingly sophisticated weapons.
Meanwhile, Russia continues to struggle with insufficient manpower and an inadequate supply of sophisticated weapons. The result, so far, has been a series of military setbacks for Russia. Yet, at the same time, Russia has unleashed massive missile attacks on civilian infrastructure in Ukraine, hurting electricity generation. Yet students of World War Two know that bombing of civilian targets in the United Kingdom, Germany, and Japan did not play a major role in the war’s outcome.
Russia’s attempt to damage Europe’s resolve and unity through the weaponization of energy has failed to change European policy, although it has damaged the European and global economies. What is left for Russia to do? It could further disrupt energy and other commodity markets. It could unleash cyberattacks. Also, if Russia takes further steps meant to hurt its detractors, it will likely further damage its own already weak domestic economy.
Europe’s economy has performed better than expected. There are several reasons. First, a weak global economy has brought down energy prices, despite efforts by Russia and the Organization of the Petroleum Exporting Countries to stifle output. Second, many European governments are providing massive subsidies to households and businesses meant to offset the impact of elevated energy prices. This fiscal stimulus is helping to reduce inflation and stabilize consumer spending. Third, Europe has been successful at finding alternative sources of energy as Russia’s role recedes. European imports of liquid natural gas have nearly doubled in the past year. Finally, despite a tightening of monetary policy, Europe’s labor market remains surprisingly robust as companies evidently expect only a brief and mild downturn.
Going forward, it is possible that the benign performance will continue, especially given the mild winter now taking place. Earlier in 2022, there was fear that a harsh winter would lead to a surge in gas demand, thereby necessitating rationing and industrial shutdowns. Instead, temperatures have been historically high, thereby stifling energy demand. Weather could be the ultimate determinant of Europe’s economic path in the months to come.
Sometime later this year, the US Congress must pass a bill to either raise or suspend the debt ceiling. Failure to do this will mean that the Treasury cannot borrow other than to roll over existing debt. This could mean that the Treasury will have insufficient funds to pay bills such as Social Security payments, or especially interest on existing debt.
As for default, it could mean many things. It could mean failure to make a monthly Social Security payment on time. It could mean failure to pay interest on some bonds. That is the scenario that could be hugely problematic. It is not that anyone believes the government won’t ultimately service its debts. It is that the uncertainty created will lead investors to seek safety by liquidating risky positions. It could cause financial markets to seize up, requiring the Federal Reserve to step in and provide liquidity at a time when it is trying to remove liquidity from the economy to fight inflation. My guess is that a default would initially lead to a sharp rise in bond yields, a rise in spreads, a drop in equities. But bond yields might also quickly fall as global investors perversely seek the safety of US bonds. This is uncharted territory. It is very hard to predict how default would unfold.
At one point during the pandemic, a very large share of sovereign debt offered negative returns. That era is now over as central banks tighten. Yet, when interest rates were historically low, there was a strong incentive to borrow. And governments, businesses, and households borrowed, leading to an historically high level of debt in both advanced and, especially, emerging countries. This poses some risk.
Carmen Reinhardt, former chief economist of the World Bank, says that “as debt levels increase, it makes it more difficult for central banks to tighten and raise real rates when they're worried about financial stability. So, they may keep rates lower than they would have otherwise liked them to be.” That, in turn, might hurt the ability of central banks to suppress inflation. In fact, Dr. Reinhardt notes that “if central banks are increasingly constrained by high levels of public and/or private debt, strained by the fragility and the risks posed by high levels of public and private debt, do they, de facto, lose their independence and lose their ability to fight inflation effectively? I think that is a real concern.”
One of the ways that the pandemic disrupted the global economy was to change the nature of the labor market. In many countries, labor-force participation fell sharply and has not yet fully recovered. Many people are still absent from work because of long-term effects of COVID-19. And many countries stifled cross-border migration during the pandemic, which has also not been fully reversed. Thus, there is a shortage of labor.
The big unknowns are whether people will return to the labor force, whether governments will ease restrictions on migration, whether wages will finally start to rise faster than inflation, and whether workers will be willing to return to the office or will insist on working remotely. The outcome of these uncertainties will have a big influence on the human resource environment that major companies will face. It will influence their decisions about hiring, compensation, investments meant to boost productivity, and investments in office space versus remote technology.
Here are the details: The US government released December data for the CPI. The index was up 6.5% from a year earlier, the lowest rate since October 2021. The CPI was down 0.1% from the previous month. When volatile food and energy prices are excluded, core prices were up 5.7% from a year earlier, the lowest rate since December 2021. Core prices were up 0.3% from the previous month.
Notably, energy prices were up only 7.3% from a year earlier and were down 4.5% from the previous month. Food prices, however, were up sharply from a year earlier. They were up 10.4% from a year earlier, but only 0.3% from the previous month. The most worrisome component was shelter (which includes imputed rent from home ownership as well as rents), which was up 7.5% from a year earlier and up 0.8% from the previous month. This plays a big role in the CPI and only moves gradually.
In addition, airline fares were up 28.5% from a year earlier but down 8.2% from the previous month. Meanwhile, used car prices were down 8.8% from a year earlier and down 2.5% from the previous month. This means that the supply chain disruption (especially the semiconductor shortage) that created havoc in the automotive industry has largely abated.
Going forward, the Federal Reserve will continue raising the Federal Funds rate, but probably at a slower pace than previously. The Fed has expressed determination to continue on this path until it is clear that underlying inflation has turned the corner. Moreover, it is keen to prevent expectations of inflation, which are currently modest, from rising sharply.
Meanwhile, there are several factors that are likely to drive down inflation in the coming year, especially in the second half of the year. These include improved supply chain efficiency, declining energy prices, and weakened domestic demand due to monetary tightening. There are two major things that could undermine this forecast. First, if the global energy market is again disrupted, perhaps due to the war in Ukraine, then a rise in energy prices would be inflationary. Second, if China’s rebound this year is much greater than anticipated, it too could lead to much higher energy prices, thereby fueling inflation.
By contrast, if the economy weakens more than currently anticipated, perhaps due to excessive tightening by the Fed, then inflation might decline even faster and further. This might be driven by an even sharper decline in energy prices. If that happens, the Fed will likely turn around quickly and start to loosen monetary policy.
The good news, however, is that there was a significant surge in net migration in 2022. Specifically, after net international migration to the United States of only 376,000 in 2021, the number increased to 1.011 million in 2022—the highest level since 2017. This likely reflected the impact of economic opening as the pandemic faded. Still, it will take several years of strong levels of immigration to reach the level that would have been obtained absent the disruption of the last few years. If that happens, it could partly offset the current shortage of labor.
Even if immigration is ultimately restored to past levels, this will be offset by the aging of the population, which implies a declining labor force. Moreover, due to an historically low birth rate, the overall population is growing exceptionally slowly. Thus, the labor shortage is likely to endure for a while, unless there is either a massive increase in immigration and/or a sudden surge in labor-force participation.
Why do countries keep foreign currency reserves? There are several reasons. First, reserves enable countries to intervene in currency markets to stabilize their currency values. Second, reserves are effectively an insurance policy against disruptions that might cause a loss of export revenue, thereby hurting the ability to service debts or pay for imports. Third, reserves are part of a country’s monetary base and are one of the tools of monetary policy.
The decline in reserves varied by country. Reserves are especially important for emerging nations, and the decline in many emerging countries was significant. Among the countries that experienced a sharp decline in reserves were Turkey, Sri Lanka, Egypt, and Pakistan. Egypt and Sri Lanka are now working with the International Monetary Fund to resolve balance of payment issues. Often, this involves agreeing to currency depreciation and fiscal probity in exchange for temporary loans. For richer nations, such as Japan and South Korea, a sharp drop in reserves reflects an effort to stabilize the currency. It does not represent a threat to financial stability.
Going forward, it is likely that the US Federal Reserve will stop raising its benchmark interest rate within the next six months. When that happens, or even before, upward pressure on the value of the dollar will ease or reverse, thereby giving many countries breathing room and enabling them to stabilize or replenish reserves. In the past, episodes of US monetary policy tightening created financial stress for emerging markets, sometimes leading to crises. This was the case in 1982, 1994, and 1998.
Today, many emerging markets have better financial regulations, more realistically valued currencies, and stronger bank balance sheets than during those past crises. Moreover, during the first weeks of 2023, there was a surge of international borrowing by emerging market governments. Perhaps this was meant to replenish reserves. Perhaps it was based on the expectation that, with inflation in the United States declining, the Fed will ease up on tightening and the dollar will decline in value. If that happens, then servicing these new debts will be easier.
o Rapid increase in inflation in major economies
o Big increases, and then decreases, in commodity prices
o Extraordinarily tight labor markets
o Rapid tightening of monetary policy
o Sharp decline in asset values
o Increased currency market volatility
o The first major land war in Europe since 1945
o The most intense use of sanctions in the post-war era
o A dramatic slowdown of the Chinese economy
o Continued stress on global supply chains
o Increased use of industrial policy and sanctions in technology
o Substantial economic disruption due to climate change
Given this, what can we expect in 2023? It is likely that the new year will, in part, be characterized by a reversal or stabilization of some of these events. Here, then, are predictions for the new year.
The factors that drove inflation in 2021–22 are already reversing. These factors included supply chain disruption, increases in commodity prices, and expansive fiscal and monetary policy. Moreover, inflation has already peaked in the United States and may soon peak in Europe. Inflation remains moribund in Japan and China. Expect a rapid decline in inflation in the United States and a more moderate decline in Europe. The expectation of this pattern is already embedded in bond yields, which is partly why they remain relatively low.
Weakening global demand combined with increased capacity to produce and distribute manufactured goods are already causing a decline in delays, shortages, and costs of shipping. Once the COVID-19 situation stabilizes in China, supply chains in China are also expected to normalize. This should help ease inflation and remove bottlenecks that inhibit output in some industries.
Fraught political relations between China and the United States, meanwhile, will lead many companies to buy an insurance policy against political risk by diversifying supply chains. This will likely mean further outflows of capital from China and more investment in supply chain processes in Southeast Asia, India, Central Europe, and especially Mexico.
In many countries, labor has been in short supply as the world recovers from the pandemic. This has been due to reduced labor-force participation, continued COVID-19–related illness, and a sharp decline in migration. These factors are not likely to change soon. Thus, even amid concern about recession, job growth continues to be relatively strong and unemployment low. Many companies, fearful of persistent shortages of labor, are probably hiring to hoard labor that will be needed when the economy rebounds.
Notably, despite tightness in the labor market, wages have failed to keep pace with inflation in most advanced economies. The result has been weaker consumer spending. In 2023, as inflation recedes, it is likely that wage growth will ultimately exceed inflation. This will boost consumer spending. It will also likely put pressure on businesses to accelerate investment in labor-saving technology. Finally, businesses are also expected to put pressure on governments to allow more immigration. It remains to be seen if governments will respond.
We know that monetary policy acts with a lag. Thus, it is possible that the sharp increase in benchmark interest rates in 2022 was sufficient to quell future inflation. Still, it is likely that major central banks will continue to raise rates in early 2023, if only to anchor expectations of inflation. They will likely stop this process in the first half of the year and wait to see the fruits of their labor. Assuming that inflation recedes further, central banks will likely start to reduce rates in 2024.
The tightening of monetary policy has come amid tightening of fiscal policy by governments in advanced economies. Yet, for some governments, the resulting higher bond yields are making it difficult to maintain fiscal probity. This is especially true in the Eurozone where governments are at the mercy of the European Central Bank (ECB). In debt-laden Italy, ECB policy is a big concern as it could lead to a fiscal crisis. Thus, the ECB has created the Transmission Protection Instrument (TPI) that enables it, for example, to purchase Italian bonds while selling German bonds. It has not yet used the TPI, but 2023 could be the year this happens. The ECB will not likely allow a fiscal crisis to threaten financial stability in the Eurozone. Yet the use of the TPI could lead to political tension between the Italian government and the ECB.
This is a scary statement to make given that polls indicate 87% of Americans worry about a near-term recession. And yet the economy has shown remarkable resilience. Despite declining real wages, real consumer spending has grown as consumers have dipped into their saving. Despite higher borrowing costs, business investment has grown as businesses have dipped into their cash reserves and focused on the longer term. The only major sector to experience a sharp contraction has been housing, largely due to higher mortgage interest rates.
Without a doubt, US growth in 2023 will be slower than in 2022 due to tightening monetary and fiscal policy. Yet a recession might be avoided due to declining energy prices, strong employment growth, and easing of supply chain stress. Still, a recession remains a possibility. However, if it comes, it will likely be modest and short-lived.
Europe is different from the United States. As real wages have fallen, real consumer spending has fallen. And, although energy prices have fallen from their peaks, natural gas prices remain historically elevated, thereby fueling inflation and reducing purchasing power for consumers and businesses. The energy shock, a result of the war in Ukraine, will play the key role in driving a recession in Europe. In addition, tightening of monetary policy by the ECB and the Bank of England will play a role. Plus, although many European governments are offering large subsidies to offset high energy prices, the trajectory of fiscal policy remains contractionary.
Although European governments have taken strong measures to protect their economies from the energy shock, it is likely that electricity prices will remain relatively elevated for a prolonged period. Thus, many companies in heavy industry, which used to benefit from cheap Russian energy, are increasingly looking outside of Europe for investment opportunities. This could have a negative impact on the future of European manufacturing.
With the relaxation of COVID-19–related restrictions, China is likely to see a modest rebound in economic activity in 2023—but not immediately. For now, the massive outbreak of infections is suppressing mobility and production, the result of which is likely to be temporarily suppressed economic activity. Yet once this cycle of the outbreak recedes, it is likely that pent-up consumer demand will boost spending.
Still, China faces several headwinds that will restrain growth in 2023. These include a troubled property market, weaker global demand, an outflow of capital by global businesses, and a fraught relationship between China and the West that involves restrictions on cross-border trade and investment.
Finally, there are some things that are too difficult to predict. These include the trajectory and outcome of the war in Ukraine, the degree to which climate change affects the economy in 2023, the trajectory of US-China relations, the trajectory of pandemic, the future of the crypto market, and whether or not equity prices will rebound in the coming year. What can be said with confidence is that the world will likely surprise us once again.
The US government produces two employment reports: one based on a survey of establishments; the other based on a survey of households. The establishment survey indicated that 233,000 new jobs were created in December 2022, the smallest increase since December 2021. Payroll employment is now 0.8% higher than in the month prior to the start of the pandemic. It is clearly far lower than it would have been absent the pandemic and assuming continued moderate job growth after February 2020. This reflects a sharp decline in the size of the labor force due to lower participation and reduced immigration. Indeed, the unemployment rate, at 3.5%, suggests that employment cannot grow much faster unless more people re-enter the labor force.
By industry, there was strong growth in construction (especially nonresidential), durable goods manufacturing, health care, and leisure and hospitality. There was a decline in employment in nondurable manufacturing, information, professional and business services (including a sharp decline in temporary services), and state government. This suggests that there are significant pockets of weakness.
The establishment survey also found that average hourly earnings of workers were up 4.6% in December versus a year earlier. This was the smallest increase since August 2021. Earnings were up 0.3% from the previous month. We know that, in November, consumer prices were up 7.1% from a year earlier. Thus, real (inflation-adjusted) earnings continued to decline. This is bad news for households but good news for the Federal Reserve, which likely worries about the risk that wage behavior could contribute to prolonged inflation.
The separate survey of households indicated that the rate of labor-force participation increased slightly in December, thereby increasing the size of the labor force faster than the size of the working-age population. Notably, employment increased even faster, thereby causing the unemployment rate to fall from 3.6% in November to 3.5% in December.
The US government reported that, in the last week of December, there were 204,000 initial claims for unemployment insurance, the lowest level since early October and one of the lowest levels in the past year. The four-week moving average has been declining for a while. This means that, despite all the headlines about major layoffs at large companies, the reality is that the number of people losing jobs has been falling, not rising. This is a sign of persistent strength in the job market.
In addition, the latest Job Openings and Labor Turnover Survey (JOLTS) published by the US government found that, although the number of job openings declined slightly from October to November, the number remained far above the prepandemic level. The job-openings rate (share of available jobs that are not filled) was 6.4%, down from a peak of 7.3% in March 2022. However, the job-openings rate was 4.4% just prior to the pandemic. Thus, there remains a shortage of labor. The highest job openings rate by industry was 9.5% for accommodation and food services. Second highest was health care at 8.5%, followed by professional and business services at 8.3%.
The fact that the job market remains relatively tight has several implications. First, it reduces the risk of recession, or at least the risk of a deep recession. Second, it increases the risk that high inflation will be persistent. This, in turn, will clearly inform the decision-making of the Federal Reserve (see below). Third, it suggests that the impact of the pandemic is long-lasting. The pandemic led to a decline in labor-force participation, an increase in long-term illness, and a decline in immigration. These are the factors that are causing the labor shortage. They are likely to persist well after the current downturn is over. That, in turn, augurs for significant wage gains in the years to come.
As such, Fed policymakers are reluctant to commit to easing monetary policy. Specifically, the minutes indicated that “no participants anticipated that it would be appropriate to begin reducing the federal funds rate target in 2023. A number of participants emphasized that it would be important to clearly communicate that a slowing in the pace of rate increases was not an indication of any weakening of the Committee’s resolve to achieve its price-stability goal or a judgment that inflation was already on a persistent downward path. Participants noted that, because monetary policy worked importantly through financial markets, an unwarranted easing in financial conditions, especially if driven by a misperception by the public of the Committee’s reaction function, would complicate the Committee’s effort to restore price stability.”
They said that they will need “substantially more evidence” that inflation is receding before agreeing to a change in policy. Specifically, “participants generally observed that a restrictive policy stance would need to be maintained until the incoming data provided confidence that inflation was on a sustained downward path to 2%, which was likely to take some time.”
Most of the policymakers now expect that the Federal Funds rate will rise to between 5% and 5.25% in 2023 and then start to be reduced in 2024. They expect unemployment to rise by one percentage point as the economy weakens, although they offered no opinion as to whether the United States will dip into recession. They also expect that core PCE inflation will decline by 1.5 percentage points from 2022 to 2023.
In response to the Fed’s release as well as evidence of a strong job market, US equity prices declined while bond yields rose. The value of the dollar strengthened. Investors evidently took the recent news as evidence that further monetary policy tightening is inevitable, thereby likely leading to slower economic growth.
Here are the details: Consumer prices in the Eurozone were up 9.2% in December versus a year earlier, down from 10.1% in November and 10.6% in October. It was the slowest rate of increase since August. Prices were down 0.3% from the previous month. The deceleration was entirely due to a shift in energy price inflation. Specifically, energy prices were up 25.7% from a year earlier, down from 34.9% in November. Energy prices were down 6.5% from the previous month. On the other hand, food prices continued to accelerate, rising 13.8% from a year earlier, up from 13.6% in November. When volatile food and energy prices are excluded, core prices were up 5.2% from a year earlier, up from 5% in November. Core prices were up 0.6% from the previous month. As such, underlying inflation is not improving.
In most countries in the Eurozone, consumer prices fell from November to December, mainly due to declining energy prices. This partly reflected the impact of government subsidies. For example, the German government paid most household gas bills in December. This reduced annual inflation by 1.2 percentage points. But that decline was not a reflection of an underlying shift in inflation. Meanwhile, annual inflation in December was 9.6% in Germany, 6.7% in France, 12.3% in Italy, 11% in the Netherlands, 10.2% in Belgium, and 5.6% in Spain. The latter was the lowest rate of inflation in the Eurozone. The highest rate was 17.5% in Estonia.
In response to the most recent report, European government bond yields fell sharply while equity prices were up strongly. This likely reflected investor expectations that the sharp decline in inflation will lead to less monetary policy tightening. Yet the fact that core inflation accelerated probably means that investor expectations are wrong. Rather, the ECB is likely to maintain a trajectory of rapid tightening of monetary policy, if only to convince investors that it is serious about suppressing inflation. In the process, however, the ECB will contribute to a further deceleration of inflation. The question now is to what extent this tight monetary policy will exacerbate the likely recession in 2023.
Cover image by: Sofia Sergi