The global economy is facing several negative events. The dominant issue is high inflation, which is holding back economic growth. Derived from this, the rapid increases in key interest rates and the tighter financial environment are also having a dampening effect on growth. In addition, the massive increase in gas prices represents a particularly negative external shock for Europe. Volume restrictions would have an additional significant negative impact on economic activity. Furthermore, in China the real estate crisis and the zero-tolerance policy toward covid are dampening growth. On the geopolitical front, the visit of US House Speaker Nancy Pelosi to Taiwan has now also caused the relationship between the US and China to deteriorate further.
Falling economic indicators
The majority of economic indicators point to a significant slowdown in economic momentum as well as rising recession risks. Last week, the global Purchasing Managers’ Index for the month of July fell to the lowest level in the recovery period following the spring 2020 contraction. At 50.8, it points to global growth below potential. Of particular concern is the decline in new orders (weaker demand) and the expectations component (poor sentiment). The employment component has also fallen. This provides an indication of a weakening of very tight labor markets. On the positive side, both selling prices and delivery times fell. One important source of inflation seems to be losing steam: Supply bottlenecks. After all, in the global purchasing managers’ report for the manufacturing sector, the ratio of new orders to inventories continued to fall significantly. Unfortunately, this also means increased risks of recession.
Strong employment growth in the USA
At the same time, two economic reports in the US came as a positive surprise last week. First, the ISM Non-Manufacturing Index for July surprisingly rose to a high level (56.7). This is at odds with the deterioration of other indicators. The S&P Global’s Services PMI also fell significantly (47.3). Second, employment growth was particularly strong in July (Nonfarm Payrolls: actual +528,000 vs. expectation: +250,000). In addition, the unemployment rate fell further to a very low level (from 3.6% to 3.5%).
Very tight labor market
In line with the very tight labor market, average hourly wage growth remained high (0.5% month-on-month to 5.2% year-on-year). There again seems to be an inverse relationship between the unemployment rate and wage inflation. Until recently, there were some articles that could not find a correlation for the past few years (death of the Phillips curve). At the same time, the ratio of job vacancies to unemployment is very still (Beveridge curve). Both curves indicate a very tight labor market.
Aftermath of the pandemic
The labor market remains damaged by the pandemic. At 60%, the ratio of employed persons to the employable population (employment rate) is still well below the pre-pandemic level of 61.2%. The same is true for the ratio of the total labor market (employed and unemployed) to the employable population (participation rate: 62.1% vs. 63.4%).
How can inflationary pressures be alleviated?
A good outcome would be for job vacancies to fall sufficiently (because aggregate demand is weakening) and for more people to participate in the labor market (because wage growth has risen and savings rates are falling). After all, the latest JOLTS report showed a slight decline in job vacancies (March: 11.9 million, June: 10.7 million). A soft landing of the economy, i.e. a cooling on the labor market and falling inflation without a recession, is at least theoretically possible.
However, a bad outcome, i.e. an increase in the unemployment rate (= recession) triggered by a restrictive central bank policy, is seen as more likely by some prominent economists (Blanchard / Domash / Summers).
Adaptive inflation expectations
The problem of an excessively tight labor market described by the Phillips curve and the Beveridge curve has an additional component. As an explanation for current inflation, the Phillips curve uses not only the unemployment rate (the lower, the higher the inflation), but also inflation expectations. To estimate the latter, past inflation trends are sometimes also used. In a phase in which inflation does not particularly concern the population because it is low, the correlation between past and current inflation is low (low persistence). In a phase in which inflation is the focus of interest because it has already been high for a certain period, the correlation increases (high persistence implies an inflation spiral).
Restrictive Fed policy
So the Fed faces the Herculean task of preventing (or breaking) an inflationary spiral by weakening demand. If, in the process, the number of job openings falls enough (and more people participate in the labor market), a recession can be prevented. However, past experience suggests that due to the restrictive central bank policy, the unemployment rate will also rise (= recession).
Energetic Bank of England
Last week, the Bank of England raised its key interest rate by 0.5 percentage points to 1.75%. This was already the sixth hike since December 2021. In the published statement, the central bank was forceful in its fight against inflation. If inflationary pressures remain high, it would raise the key interest rate even in the event of a recession.
High employment growth has mitigated the immediate risks of recession in the USA. However, because inflationary pressures remain high as a result, the probability of more key rate hikes than those priced into the market has increased (end-2022: just under 3.6%, end-2023: 3.0%). This in turn implies increased recession risks for next year. This will also be the case if consumer price inflation in the USA falls this week, as expected, from 1.3% pm / 9.1% pa in June to 0.2% pm / 8.7% pa.
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