Weekly global economic update

Week of August 5, 2024

• Investors revise expectations for Fed policy
• Productivity growth offers hope for lower inflation
• Eurozone growth recovers
• Eurozone inflation might be stuck
• Bank of Japan action leads to a sharp rise in the value of the yen
• China’s currency is becoming more international, but not by much

Investors revise expectations for Fed policy

• Did the Federal Reserve wait too long to start cutting interest rates? That could be what many investors were thinking following an especially weak jobs report last week. There was significant volatility in financial markets. On one day, the yield on the 10-year bond fell 18 basis points to the lowest level seen since December 2023. The S&P 500 index of equities was down 2.3%, with an especially sharp decline in the values of some tech stocks and sharp declines in overseas equity markets. The value of the dollar fell 1.6% against the Japanese yen and fell strongly against other currencies. Finally, the price of Brent crude fell by 3.4%.

Futures markets tell us that, up until recently, many investors believed the Fed will cut the benchmark interest rate by 100 basis points before the end of the year, including a 72.5% chance of a 50-basis-point cut in September. All this was in response to a jobs report that showed the second smallest increase in employment since 2020 and the highest unemployment rate since October 2021. Still, job growth was not poor. Moreover, the rise in the unemployment rate was largely due to a rise in labor force participation, not mass layoffs.

Could investors be overreacting? Possibly, but the reality is that, with inflation having receded, real (inflation-adjusted) interest rates have risen and could be having a negative impact on economic activity. In his comments earlier last week, Fed Chair Powell said, “I would not like to see material further cooling in the labor market. If we see something that looks like a more significant downturn, that would be something that we would have the intention of responding to.” Investors in recent days indicated that they expect Powell to respond.

Let’s examine the details of the jobs report. The US government releases an employment report that has two components: One is based on a survey of establishments; the other on a survey of households. The establishment survey found that 114,000 new jobs were created in July, the second smallest number since early in the pandemic. There was a decline in employment in information, financial services, and professional and business services. The only industries that saw strong job growth were construction, health care, and leisure and hospitality. 

Meanwhile, the establishment survey reported on wage behavior. Specifically, it found that average hourly earnings of workers were up 3.6% in July versus a year earlier, the smallest increase since May 2021, and were up only 0.2% from the previous month. Although wages are still rising faster than inflation, the deceleration of wages is good news from an inflation perspective. It is consistent with a weakening of the job market. 

Finally, the separate survey of households found that the number of people participating in the labor force increased much more than the rise in the working-age population. Thus, with a modest increase in employment, the unemployment rate rose from 4.1% in June to 4.3% in July, a nearly three-year high. However, the sharp rise in participation suggests confidence in the availability of jobs.

In the business press, the word “recession” appeared last week with greater frequency. Could we face a US recession in the coming months? There are some negative indicators: The slowdown in the job market and the rise in the unemployment rate, a decline in new orders for manufacturing according to a survey by ISM, weak new orders for durable goods, and a rise in credit card delinquencies. On the other hand, consumer spending and business investment have both remained strong while job growth is still at a speed that is consistent with moderate economic growth. Thus, there remains uncertainty. My view is that, if the Fed acts strongly in September, investors will likely rejoice, boosting asset prices and engendering confidence. A recession could be avoided. However, predicting the timing of recessions and recoveries is not one of the strongest skills of economists. 

• Meanwhile, before the release of the jobs report, the US Federal Reserve’s policy committee left the benchmark interest rate unchanged. Yet the wording of the Fed’s statement, as well as comments from Fed Chair Powell, reinforced the view that the Fed will indeed cut the rate in September.

The Federal Open Market Committee (FOMC) said that there is “somewhat elevated” inflation, a more moderate description than in the previous meeting when it simply said “elevated” inflation. More importantly, the FOMC is evidently pivoting from a focus solely on inflation to a focus on both inflation and employment. Remember, the US Congress has mandated that the Fed target both. The recent statement said that “the committee is attentive to both sides of its dual mandate,” whereas over the past two years it has described policy as “highly attentive” to inflation. Also, Fed Chair Powell said, “We have made no decisions on future meetings,” adding that “the economy is moving closer to the point where it will be appropriate to reduce our policy rate.” Investors can reasonably interpret these statements as boosting the likelihood of a rate cut in September. 

The newly stated focus on employment comes at a time when the unemployment rate is up and job growth has receded. Plus, there are reports of rising financial stress for households, consumers trading down, and consumer-oriented companies facing weaker revenue and earnings. On the other hand, economic growth was strong in the second quarter, consumer spending was strong in June, and business investment has been strong despite high interest rates. Regarding inflation, the numbers have been favorable, but service inflation remains far too high.

Productivity growth offers hope for lower inflation

• In the United States, the principal reason to worry about persistent inflation is that the labor market has been tight, which has been driving up wages. Yet if labor productivity (output per hour worked) rises, it can offset the impact of higher wages. That is, in an environment where productivity is rising, businesses can boost wages without necessarily raising their prices. That is because they are getting more output from workers, commensurate with the increase in wages. An important indicator is unit labor costs (ULCs), which is measured as the ratio of hourly compensation to labor productivity. If productivity grows commensurately with hourly compensation, then ULC doesn’t change. This implies no inflationary pressure from the labor market. Thus, for the Federal Reserve, the holy grail of monetary policy is an increase in productivity. 

Recall that, in 2023, there was a significant rise in labor productivity, even as wages were rising. This likely contributed to an easing of inflation. Then, in the first quarter of 2024, productivity barely grew. This raised fears that inflationary pressure will not abate. However, we have recently learned that productivity rose strongly in the second quarter, boding well for further progress on inflation. Here are the details.

In the second quarter, non-farm business output was up at an annualized rate of 3.2% from the previous quarter. The number of hours worked was up at a rate of 1.1%. Consequently, labor productivity was up 2.1%—a strong number. In the first quarter, productivity had been up at a rate of 0.5% from the previous quarter. Thus, productivity has accelerated significantly. Also, the second-quarter growth of productivity was largely due to services rather than manufacturing. Indeed, manufacturing productivity was up at a rate of only 1.1% from the previous quarter, implying even faster growth of productivity for services. This is very important given that the remaining inflation problem is in services.

Meanwhile, the government reports that, in the second quarter, hourly compensation was up at a rate of 3.2% from the previous quarter. This means that ULCs were up at an annualized rate of only 1.1% from the previous quarter. Recall that ULC increased 3.7% in the first quarter. Also, manufacturing ULC was up at a rate of 3.2% in the second quarter, implying that services ULC was up even slower than 1.1%. This is very good news from an inflation perspective. The Federal Reserve has been explicit in saying that strong productivity growth could lead to an easing monetary policy sooner and faster than otherwise. 

Separately, the government reported on employment costs, including both wages and benefits. The employment cost index (ECI) is published every three months and offers insight into the tightness of the job market. The latest ECI for June was up 4.1% from a year earlier. In March, the ECI had been up 4% and in June of last year it was up 4.5%. Thus, pressure on employment costs has eased. Still, employment costs are rising faster than inflation. The government estimates that real (inflation-adjusted) employment costs were up 1.1% in June versus a year earlier. However, given that productivity was rising in the second quarter, this doesn’t necessarily imply more inflationary pressure. In any event, the fact that real wages are rising implies that the labor market is relatively tight. 

However, one indication that the tightness in the US labor market is easing is that initial claims for unemployment insurance have been rising. It is reported that, two weeks ago, the number of initial claims hit 247,000, up 14,000 from the previous week and the highest level since August 2023. If this continues, it will likely remove pressure on wages. 

Eurozone growth recovers

• The Eurozone economy is not strong, but it is clearly rebounding from a near recession last year. That is the inference to be drawn from last week’s release of second-quarter GDP numbers. The European Union (EU) reported that real GDP in the 20-member Eurozone increased 0.3% from the first to the second quarter, the same as in the previous quarter. Real GDP was up 0.6% from a year earlier. Recall that, in the third and fourth quarters of 2023, real GDP was unchanged on a quarterly basis. 

Second-quarter growth in the Eurozone was held back by Germany where real GDP declined 0.1% from the first to the second quarter. In two of the last three quarters, German real GDP declined. The German government said that the weakness was due to a drop in business investment in equipment and structures. Investment in Germany has been hurt by several factors including relatively high energy costs, weak demand in China, weak domestic demand, and intense competition from China and the United States. 

Meanwhile, other Eurozone economies performed better. In Spain, real GDP was up 0.8% from the first to the second quarter. This followed growth of 0.8% in the first quarter and 0.7% in the fourth quarter of 2023. In other words, Spain’s economy is on fire. The Spanish government reported that all major components were up strongly including consumer spending (up 0.3%), investment (up 0.9%), and exports (up 1.2%). It reported that the unemployment rate in Spain has dropped to the lowest level since 2008. Meanwhile, Spanish inflation has decelerated, largely due to declining electricity prices. That, in turn, likely helped consumer spending. 

In the rest of the Eurozone, growth was mostly moderate. In France, real GDP was up 0.3% in the second quarter versus the first quarter while real GDP was up 0.2% in Italy. The better-than-expected growth in France was largely due to strong export growth. On the other hand, the current political climate in France threatens to undermine business confidence and, consequently, investment. 

The big question on the minds of investors is what the European Central Bank (ECB) will do in September. There is a widespread expectation that the ECB will continue to cut interest rates. The latest GDP numbers do not likely change the trajectory of monetary policy. They indicate modest GDP growth, with strength in Spain and weakness in Germany offsetting one another. This, combined with recent data showing favorable inflation trends will likely allow the ECB to feel comfortable in cutting rates. However, the future trajectory of rates will depend on whether inflation continues to decelerate.

Eurozone inflation might be stuck

• Until very recently, there had been a strong expectation that the European Central Bank (ECB) would cut interest rates in September. Yet after the release of inflation data for July, it is a bit less certain. Rather, the modest acceleration in headline inflation suggests a possibility that the ECB will wait a bit longer. Let’s look at the data.

The EU reported that, in July, consumer prices in the 20-member Eurozone were up 2.6% from a year earlier, an increase from 2.5% in June. Moreover, headline inflation appears to have gotten stuck. It was 2.6% in February and as low as 2.4% last November. Still, prices were unchanged from June to July, which bodes well for a reduction in annual inflation in the months to come. 

When volatile food and energy prices are excluded, core prices were up 2.9% in July from a year earlier. This is the same rate of increase as in March, May, and June. As such, inflation appears to have stabilized higher than the ECB’s target of 2%. Still, core prices fell 0.2% from June to July, indicating shorter-term progress. 

Looking at the details, goods prices are tame while service prices continue to rise. The prices of non-energy industrial goods were up only 0.8% in July from a year earlier. Moreover, they fell 2.6% from June to July. Energy prices accelerated in July while food price inflation remained tame. Meanwhile, prices of services were up 4% from a year earlier and were up 1.2% from June to July. The service price situation is the principal conundrum facing the ECB. Services inflation has not decelerated, having been 4% as far back as November. Real wages are rising while productivity is falling. That is likely why service prices continue to rise faster than desired.  

By country, annual inflation in July was 2.6% in Germany, 2.6% in France, 1.7% in Italy, 2.9% in Spain, 3.5% in the Netherlands, and 5.5% in Belgium. On a monthly basis, prices fell in Italy, Spain, and Belgium, suggesting that annual inflation is likely to recede further in these countries. 

All of this leads to the decision-making of the ECB. On the one hand, headline inflation is at a desirable level while Europe’s largest economy (Germany) remains very weak. Plus, monthly inflation data in July was quite favorable. On the other hand, service inflation is stable and too high, while some European economies exhibit considerable strength. Thus, the ECB must undertake a balancing act. It does not want to keep interest rates high for too long lest it weaken a fragile recovery. Yet it doesn’t want to cut rates too soon lest it fail to get inflation under control. Finally, until recently futures markets were pricing in an 80% probability of a rate cut in September. That is now down to 65%. After the ECB undertook the initial rate cut in June, it said that the path of interest rates in the months to come would be bumpy.  

Bank of Japan action leads to a sharp rise in the value of the yen

• In the past year, much ink has spilled as pundits attempted to predict when the Bank of Japan (BOJ) would start to meaningfully tighten monetary policy, especially as Japanese inflation has been at or near a 40-year high in recent years. Now, the time has come. The BOJ increased the benchmark interest rate from 0.10% to 0.25%. This followed an increase in March from –0.1% to 0.1%. In addition, the BOJ announced that it will slow the pace of asset purchases by half. 

While investors had expected a shift in asset purchases, they did not expect the rise in the benchmark interest rate, according to a survey of investors. As such, they reacted strongly by pushing up the value of the yen. In recent days it reached close to 148 yen per US dollar, having bottomed just a few weeks earlier at 161 yen per dollar. This is a significant change. 

In his comments following the announcement, BOJ Governor Ueda said: “The policy rate is still very low even after a hike to 0.25. It is still negative after inflation is taken into consideration. We do not view this as a strong brake on the economy.” This sets the stage for further rate hikes. Ueda said that “I do not necessarily view 0.5% as a barrier.” He said that the BOJ would continue to raise the rate depending on the inflation data. 

For now, there is likely a broad expectation of further rate hikes by the BOJ. There is also a widespread expectation that the US Federal Reserve will start to gradually cut rates in September. Unless actions by either central bank turn out to differ from current expectations, there is no reason for a further sharp appreciation of the yen. Of course, unexpected events could disrupt currency values. 

What will be the impact of the higher valued yen? First, a rising currency can be disinflationary, which is precisely what the BOJ desires. In fact, Ueda said that the exchange rate was a factor in the BOJ’s decision. Second, a higher yen will cut prices of imported commodities, potentially boosting the purchasing power of Japanese households. Third, a higher yen could reduce the competitiveness of exports. Fourth, if investors expect a further rise in interest rates and/or a rise in the value of the yen, this will likely suppress the carry trade. Indeed, it has been reported that investors have been unwinding carry trade positions.

China’s currency is becoming more international, but not by much

• China aspires to internationalize its currency, the renminbi. Internationalization means that the renminbi would be used often as a transaction currency, as a store of wealth for foreign nationals, and as a reserve asset for major central banks. For China, the benefit of internationalization is that it reduces currency risk for Chinese exporters and importers. In addition, it gives China soft power in dealing with other countries. For the United States, the dominance of the dollar has been called “an exorbitant privilege” that lowers the cost of borrowing money for the US government and US nationals. It also allows the US government to restrict access to the dollar as a weapon in international relations. China is keen to avert this tactic of the US government.

Lately, there is evidence that the global role of the renminbi is rising, although it remains low. Renmin University in China releases a yuan (renminbi) internationalization index, which is meant to measure how the Chinese currency performs globally. The index is based on measures of renminbi usage in trade settlement, financial transactions, and use as a reserve currency by central banks. In 2023, the index was up 22.9% from a year earlier, indicating a sharp increase in usage. On the other hand, the internationalization score in 2023 was 6.7. In comparison, the score was 51.5 for the US dollar and 25.0 for the euro. However, China’s score exceeded that of the British pound (3.8) and the Japanese yen (4.4). 

The government in Beijing has taken various steps to boost usage of the renminbi. A professor in China said that “cross-border financial settlement platforms established by various provinces have effectively attracted many financial institutions, improving the efficiency of corporate payments and receipts, expanding investment and financing channels, and advancing the internationalization of the yuan.”

Going forward, China’s government is expected to continue to promote the renminbi, including through the negotiation of currency-swap arrangements with emerging country governments. However, it seems unlikely the renminbi can challenge the role of the US dollar anytime soon. That is because China continues to retain capital controls. This enables China to target the currency value and to maintain interest rates at a rate lower than a free market rate. This is sometimes known as financial repression, undertaken to enable favored companies to borrow cheaply, even at the cost of low returns for holders for renminbi-denominated assets. Unless China is willing to remove capital controls, the role of the renminbi is likely to be suppressed.