At the annual meeting of central bankers in Jackson Hole, Wyoming, Federal Reserve Chair, Jerome Powell, summed up the uncertain environment rather well with the ornate “navigating by the stars in a cloudy sky”. This relates, among other things, to the uncertainty about the level of the neutral interest rate, the lagged effect of key-lending rate hikes on economic growth and inflation, and the drivers of inflation.
Generally speaking, the quality of models for forecasting economic growth and inflation has declined. Last but not least, negative economic news about China has led to rising worries of a long period of deflation similar to Japan in the 1990s, but the data is opaque.
Weak Purchasing Managers’ indices
The preliminary estimates of the Purchasing Managers’ indices (PMI) for the month of August in the developed economies (Australia, Japan, Eurozone, United Kingdom, United States) showed a disappointingly weak growth environment. The indicator for the manufacturing sector remained locked in its downward trend.
The report points to continued stagnation with downside risks. The service sector, which has been the pillar of gross domestic product (GDP) growth to date, also shows a falling trend but remains in growth territory – but only just. Overall, the report points to stagnation in real GDP growth.
In contrast, many official growth estimates for the developed economies are around trend (above in the US, below in the Eurozone). The big difference in the USA between the estimates for strong growth and the weak US Purchasing Managers’ index is raising eyebrows though. The Federal Reserve Bank of Atlanta’s model estimate for the third quarter holds at 5.9% (quarter-on-quarter growth, annualised). However, indicators for Europe were particularly weak. They point to the risk of GDP contraction.
Conclusion: the correlation between Purchasing Managers’ indices and economic growth has weakened since the pandemic. This also applies to those models that have been pointing to an increased risk of recession for several months. Nevertheless, one should not ignore the weak growth signals. At the very least, there are downside risks to the economic growth forecast, even if one were to opt for a so-called “soft” landing scenario of the economy.
Weak growth in China
The negative growth news flow in China is mounting: declining exports, weak private consumption, sharply falling investment in the construction sector, weak investment across the private sector, falling consumer and producer prices and GDP deflator, disappointingly weak credit growth, and news of defaults by real estate developers and companies in the shadow banking sector.
The growth target of 5% for 2023 is now unlikely to be achieved. This is because falling construction activity is removing an essential growth driver for the Chinese economy. At the same time, the structural risk is increasing with falling property prices and the falling prices of goods and services, because both companies and consumers are exposed to pressure to reduce debt and increase the savings rate, i.e. to consume and invest less.
Several scenarios for future development in China are conceivable:
- a) The economic support measures are sufficient to stay on a growth path in terms of GDP per capita. The shift from a model initially driven by exports, then by investment and later, i.e. in the future, by private consumption is naturally bumpy. The downside risks are mitigated by targeted economic policy measures.
- b) A slow adjustment similar to Japan after 1990, in which case prices stagnate and debt is slowly reduced.
- c) A quick adjustment via a recession.
Scenario a) – a bumpy adjustment – is the most likely scenario. However, poor data quality makes it difficult to assess the situation.
Conclusion: cautious approach
Chairman Powell’s speech in Jackson Hole was short on news but highlighted the heightened uncertainty that the monetary policy also faces. While inflation is falling, it is still too high. The focus here is on core inflation in the service sector (excluding food, energy, and real estate). This is because this sector in particular is influenced by the labour market, which remains very tight (low unemployment rate).
Given that the environment is uncertain, Powell says the central bank will proceed cautiously in deciding whether to tighten the monetary policy further or instead hold the Fed funds rate constant and wait for further data. In other words: unless the reports on inflation and the labour market surprise with strong data, the central bank will not raise the Fed funds rate, at least not in September. The Fed wants to wait and see and weigh the risks of tightening too much (recession) against too little (inflation). Powell, however, clearly indicated his willingness to raise the Fed funds rate further if necessary.
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Prognoses are no reliable indicator for future performance.