Week of September 9, 2024
- US job market softens, which may be good news
- The inversion of the US yield curve is ending. What does this mean?
- Office property woes
- China gets advice
US job market softens, which may be good news
- Is the US job market becoming dangerously weak, or is it simply reverting to normalcy? The answer to this question has implications for the path of the US economy in the coming year. Here’s what’s happening.
First, the US government recently released its Job Openings and Labor Turnover Survey (JOLTS) for July. It found that the job openings rate (the share of available jobs that are unfilled) fell to 4.6% in July, the lowest level since December 2020. Moreover, it’s the same as the level seen in the months just prior to the pandemic. In other words, we are back to a pre-pandemic normal.
On the other hand, the job openings rate just prior to the pandemic was the highest it had been since data collection began in 2002. Thus, the job openings rate now remains historically high. Still, the sharp decline in the job openings rate over the past two years signals that the tightness of the job market has eased considerably (likely due to rising participation, high immigration, and possibly a weakening of demand for labor). This bodes well for further easing of wage pressure, thereby allowing inflation to decline to the target level of 2%. Indeed, the 10-year breakeven rate, which is a measure of bond investor expectations for inflation in the coming 10 years, was 2.07% as of recently.
As always, the job openings rate varies by industry. In July, the highest job openings rates were in health care (7.7%); accommodation and food service (6.9%); transportation, warehousing, and utilities (6.1%); and arts, recreation, and entertainment (5.8%). Our own professional services industry had a job openings rate of 5.5%. The lowest rates were in state and local schools (2.3%), manufacturing (4%), wholesale trade (4.1%), and construction (4.2%).
Another important indicator is job growth. Employment in the United States grew more slowly in August than investors had expected, but faster than the long-term ability of the economy to produce jobs. In addition, the unemployment rate fell. Investors reacted to the report by pushing down equity prices, bond yields, and oil prices. The value of the US dollar, however, increased against the euro and the British pound while it fell against the Japanese yen. The US government conducts two surveys to understand labor market conditions: One a survey of households, the other a survey of establishments. Let’s begin with the establishment survey.
In August, the US economy produced 142,000 new jobs, less than expected but still the fastest employment growth since May. Job growth in July was downwardly revised to 89,000. Job growth in the United States was concentrated in just four industries. If job growth in construction, health care and social assistance, leisure and hospitality, and local government are combined, it adds up to 146,000 new jobs, more than the total job growth for the United States.
Meanwhile, employment in manufacturing fell by 24,000. Half of that decline was due to declining employment in transportation equipment. In addition, employment fell by 11,000 in retailing. In most other industries, job growth was small. For example, in our own professional services industry employment increased by only 8,000. Thus, although the headline job growth number was relatively strong, the lack of broad-based employment growth was likely a concern to investors.
The establishment survey also provided data on wages. It found that average hourly earnings were up 3.8% in August versus a year earlier, the same as in June and slightly higher than in July. Wage growth has decelerated significantly since earlier in the year, likely reflecting the impact of declining inflation and an easing of the tightness in the job market.
Also, the separate household survey, which includes the impact of self-employment, found that employment grew slightly faster in August than the size of the labor force. The result was that the unemployment rate fell from 4.3% in July to 4.2% in August. In addition, the number of people unemployed because they lost jobs fell sharply in August. As such, the household survey suggested that, at the least, labor market conditions did not worsen in August.
The latest report confirmed that the US job market is slowing. This contributed to the decline in equity prices and the slight drop in bond yields. However, as was true a month ago, investors could be overreacting. Rather than being headed for recession, the US economy appears to be reverting to a more normal and sustainable rate of growth. Recall that the US economy grew at an annualized rate of 3% in the second quarter. This cannot be sustained in a tight labor market without generating increased inflation.
Finally, the US government reported last week on the number of initial claims for unemployment insurance. The report said that there were 227,000 initial claims for unemployment insurance in the most recent week, down from 232,000 in the previous week. The four-week moving average was 230,000, down from 231, 750 in the previous week. The four-week moving average was the lowest since June of this year. In other words, the number of people initially claiming unemployment insurance remains relatively low, suggesting that businesses are not engaged in mass dismissals.
What can we infer from the three sets of data discussed above? First, the job market has weakened. Yet the data also suggests that the job market is now operating in a manner typical of the pre-pandemic era. That is, it is reverting to normal. So far, at least, the data from the job market is not signaling a deterioration sufficient to produce an economic downturn. Rather, it suggests a job market that may generate a normal level of economic growth, likely slower in the coming months than in the past year.
The fact that the economy is slowing is good news from an inflation perspective and allows the Federal Reserve to cut rates later this month with confidence. On the other hand, investors are evidently so worried that the economy might decelerate too quickly that they are now pricing in a likelihood that the Fed will cut rates by more than 100 basis points before the end of the year. Still, one might reasonably ask why the Fed should cut rates dramatically when the unemployment rate is falling while job growth is in excess of 100,000 per month.
The inversion of the US yield curve is ending. What does this mean?
- In the United States, the yield curve is no longer inverted. In the past, when inversion ended, a recession soon started. Will that happen this time? First, however, let’s define things. The yield curve to which I’m referring is the gap between the yields on the 10-year and two-year bonds. For the first time in 26 months, this gap is no longer negative. However, another commonly observed yield curve is the gap between the 10-year yield and the three-month yield. That gap remains inverted. Traditionally, an inverted yield curve has been a good predictor of recession. In most instances in which there was an inversion, a recession followed the end of inversion, although the timing varied.
Yet it is important to note that inversion does not cause recession. Rather, it can reflect factors that might cause a recession. For example, inversion often means that there has been a tightening of monetary policy, which involves an increase in short-term interest rates. That happens because the Federal Reserve attempts to quell inflation by restricting credit market conditions. The reversal of inversion comes when investors expect a Fed easing, thereby suppressing shorter-term rates. That is evidently what has happened lately. Moreover, each time there is news about job market weakening, investors appear to boost their implied probability of a rate cut.
Monetary policy acts with a lag. Thus, the negative impact on the economy might not begin until the policy begins to ease. The argument can be made that, in the current situation, the negative impact of monetary tightening is only now beginning, as evidenced by a weakening of the job market. Thus, even as the Fed soon begins to ease policy, the negative impact of months of high interest rates might continue to unfold. This could mean recession, or it might simply mean a slowdown in growth.
On the other hand, the economy has been remarkably resilient in the face of monetary tightening. There are a couple of reasons for this. First, the huge fiscal stimulus during the pandemic led to a surge in household savings. Spending that excess savings allowed consumer spending to continue growing for a long time. However, the excess savings is largely depleted. Now, households are cutting back on saving to sustain spending. In addition, fiscal stimulus continues, already having a positive impact on investment in manufacturing due to subsidies. Third, it could be that the private sector is less vulnerable to high interest rates than previously, due in part to strong household and business balance sheets.
If the Fed believes that the economy is at risk of imminent recession, it is likely to accelerate the process of interest-rate reductions. That explains why many investors now expect a 50-basis-point cut later this month. My own view is that recession will likely be avoided in the coming year, but that the economy may significantly decelerate from the gangbuster growth we have recently seen.
Office property woes
- In the United States, the delinquency rate on commercial property loans by banks has risen to the highest level since the fourth quarter of 2014. On the other hand, at 1.42%, the delinquency rate is far lower than the 8.75% rate seen at the end of 2010. Thus, delinquencies do not appear to be a problem. Still, some observers believe that the commercial property market in the United States is a ticking time bomb. Moreover, the delinquency rate on office property has now risen above 8% for the first time since 2013. Office property accounts for about 16% of commercial property debt.
It has been more than four years since the pandemic led to a mass movement of workers from offices to homes. And while many workers have returned to the office, many have not. This, in turn, has led many companies to reassess their office needs. Given that most companies lease office space with multi-year leases, it takes time for a change of sentiment to influence the market. That change is happening, with many companies either not renewing leases or negotiating much lower leasing costs.
Meanwhile, with much higher interest rates than two years ago, many office building owners are struggling to re-finance their mortgages. It has been reported that nearly one trillion dollars of commercial mortgage loans are coming due this year. In addition, valuations of office buildings have fallen sharply, leading to difficulty in selling properties. Many distressed sales are taking place, leaving owners facing cashflow challenges. For the small- and medium-sized US banks that account for about 70% of commercial mortgages, this situation is causing financial stress.
To address this situation, there is growing and bipartisan support in the US Congress to provide tax incentives to convert office space to housing. This is considered not only a way to address stress in the financial community, but also to address a shortage of housing in the United States. Still, most office buildings are not built in a way that is conducive to such conversions.
China gets advice
- Former central bank chiefs in both China and Japan have expressed concern about China’s deflationary pressure. Moreover, the former head of the Bank of Japan (BOJ) worried that China might be experiencing the problems that Japan faced in the 1990s and first decade of this century. Both leaders expressed concern that China is plagued by insufficient domestic demand and excess capacity. At a time when other major economies are struggling to bring inflation under 3%, China is struggling to keep inflation modestly positive.
The former Governor of the People’s Bank of China (PBOC), Yi Gang, said: “I think right now we should focus on fighting deflationary pressure. The immediate task is to turn the GDP deflator positive in the short term. I know there are doubts and some people don’t agree, but we must try our best.” Yi’s proposed solution to the problem of deflation involves more fiscal stimulus, a more aggressive easing of monetary policy, addressing the property market disequilibrium, and dealing with excessive local government debt.
Meanwhile, the former head of the BOJ, Haruhiko Kuroda, said that China’s combination of property market troubles, deflationary pressure, and demographic challenges are similar to what Japan experienced in the period from 1998 to 2012. Although Kuroda said that China’s deflation problem is not yet as severe as Japan’s earlier problem, it nonetheless requires action.
The statements by these two former central bankers will likely carry weight given the esteem in which they are held. Meanwhile, the problem of excess capacity in China is exacerbated by the difficulty in shutting down loss-making businesses, many of which are invested by local governments. These local governments are reluctant to close companies that provide plenty of jobs. In Japan in the 1990s and early 2000s, a similar problem emerged. Many “zombie” companies in Japan were partly owned by banks that would rather roll over bad loans than force companies to shut down. This type of situation exacerbates excess capacity and deflationary pressure.
Week of September 2, 2024
- Central bankers see a soft landing coming
- Is US monetary policy tight or not?
- US household data is consistent with expectations for a rate cut
- Eurozone inflation data is consistent with a September rate cut
- Usage of Chinese renminbi is rising
Central bankers see a soft landing coming
- Recently, the world’s leading central bankers gathered for their annual meeting in Jackson Hole, Wyoming, an idyllic landscape for discussing such mundane topics as interest rates and inflation. What made the gathering notable was that it represented a pivot away from the pessimism of the last few years. No longer was fear expressed about imminent recession. Nor was there any discussion this time about troubling trade-offs between inflation and employment. Rather, the gathering exhibited general confidence that the major economies can experience a soft landing. Let’s look at what the leading central bankers had to say, beginning with Jay Powell of the US Federal Reserve.
Powell was surprisingly explicit that “the time has come for policy to adjust.” Investors were not surprised at the content of his comments, just by the fact that he said it. Thus, asset prices did not respond sharply, although bond yields fell while the value of the US dollar fell. Moreover, Powell noted that “the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks.”
Powell’s statement that interest-rate cuts are appropriate came after he reviewed the recent history of inflation in which he noted that the rise of inflation had largely to do with pandemic-related supply issues. He then asked the question: “How did inflation fall without a sharp rise in unemployment?” His answer was that “pandemic-related distortions to supply and demand, as well as severe shocks to energy and commodity markets, were important drivers of high inflation, and their reversal has been a key part of the story of its decline.” He added that “our restrictive monetary policy contributed to a moderation in aggregate demand.” Plus, he said that this moderation eased demand for labor while rising labor supply brought “the labor market to a state where it is no longer a source of inflationary pressures.” He concluded that expectations of inflation are well anchored, thereby allowing the Fed to cut rates.
The Fed has a dual mandate from the US Congress to minimize inflation and maximize employment. Until recently, it was largely focused on inflation, especially at a time when the labor market was very tight and likely contributing to inflation. Now, things have changed, with job growth having eased in recent months. Powell said that the Fed does not “seek or welcome further cooling in labor market conditions.” While he appeared confident that the economy will experience a soft landing, he said that the Fed has “ample room to respond to any risks we may face, including the risk of unwelcome further weakening in labor market conditions.”
Meanwhile, the European Central Bank (ECB) sent its chief economist, Philip Lane, to the gathering in Jackson Hole. Lane expressed some hesitation about further rate cuts. He said that “the return to target is not yet secure. The monetary stance will have to remain in restrictive territory for as long as needed to shepherd the disinflation process towards a timely return to the target.”
Recall that the ECB became the first large central bank to cut rates back in June. Moreover, investors are pricing in a likelihood of two more rate cuts this year. Still, services inflation in the Eurozone has been persistent while the labor market has remained relatively tight. Hence the hesitation. On the other hand, Lane said that “a rate path that is too high for too long would deliver chronically below-target inflation over the medium term and would be inefficient in terms of minimizing the side effects on output and employment.” Thus, he appeared to suggest that rate cuts are coming.
Finally, Bank of England (BOE) Governor Andrew Bailey said that he is “cautiously optimistic” about inflation. The BOE has already cut rates one time and investors are pricing in further rate cuts. The United Kingdom has made significant progress on inflation while the economy continues to grow. Bailey said, however, that it is “too early to declare victory” over inflation. Notably, Bailey appeared to embrace a soft-landing scenario, saying that “the economic costs of bringing down persistent inflation—costs in terms of lower output and higher unemployment—could be less than in the past.”
Overall, the Jackson Hole meeting exuded a sanguine attitude toward the major economies. However, one participant offered a note of caution. The president of the Federal Reserve Bank of Chicago, Austan Goolsbee, said that monetary policy tends to act with a long and variable lag. This raises “the question of how long are the lags in monetary policy, and the longer you think the lag is, the more concerned we should be about whether the Fed could make a rapid pivot.” In other words, we might not yet have experienced the negative consequences of the recent tightening of monetary policy. Moreover, it is unclear if the negative effects can be offset by a quick easing of policy. Time will tell.
Is US monetary policy tight or not?
- Recently, it has been said that the US Federal Reserve needs to cut interest rates because monetary policy has become tighter in the past year. That is because, with declining inflation, real (inflation-adjusted) interest rates have risen, thereby having a more negative impact on economic activity. It could be argued that, absent an imminent easing of monetary policy, the Fed risks allowing recessionary conditions to develop. And indeed, the Fed has been explicit in its intention to start cutting rates in September.
But there is another point of view. Adam Posen, president of the Peterson Institute and a former member of BOE’s policy committee, says that Fed policy is not tight. His reasoning is that financial market conditions remain relatively favorable. Thus, he says, the tightness or looseness of monetary policy should not be judged by the level of interest rates. Rather, it should be judged by the impact on financial market conditions. Moreover, he notes that the evident resilience of the US economy, due in part to productivity gains and strong immigration, also demonstrates that monetary policy has been relatively easy rather than tight. A tight policy would have led to a sharp deceleration in output.
Still, Posen does not argue that the Fed should leave interest rates in place. He supports a cut, especially given that inflation is down considerably and that the labor market is clearly weakening. However, he thinks that, ultimately, interest rates will land significantly higher than previously.
As for financial market conditions, there are several favorable indicators. Risk spreads remain historically low, equity valuations are historically high, and a Federal Reserve Index of Corporate Bond Market distress is historically low. In addition, consumer finances are in good shape. Although levels of debt, debt service payments, and delinquencies have risen, they remain relatively low by historical standards. Plus, the creditworthiness of most household borrowers is far better than before the global financial crisis. Thus, Fed policy has not had the effect of weakening credit market conditions or suppressing asset prices.
US household data is consistent with expectations for a rate cut
- In July, real (inflation-adjusted) disposable income grew modestly while real consumer spending grew rapidly. That divergence cannot go on indefinitely, but for now it is leading to strong economic performance. Meanwhile, the Federal Reserve’s favorite measure of inflation remained steady in July. Let’s look at the details.
The US government reported that, in July, real disposable personal income (household income after inflation and taxes) was up a modest 0.1% from the previous month. This reflected continued growth of employment and rising real wages. Meanwhile, real consumer expenditures were up 0.4% from June to July. This difference was possible because the personal savings rate continued to decline, falling from 3.1% in June to 2.9% in July. Recall that the savings rate had been as high as 4% in January, falling steadily ever since. It should be noted that the savings rate falls when the debt/income ratio rises.
As for the details of consumer expenditures, real spending on durable goods was up 1.7% from June to July, spending on non-durables was up 0.2%, and spending on services was up 0.2%. The considerable strength of spending on durables is notable, especially at a time when activity in the housing market remains stagnant. Housing often fuels purchases of home-related durable goods.
The report also included data on the personal consumption expenditure deflator (PCE-deflator), which the Federal Reserve favors over the better-known consumer price index (CPI) as a measure of inflation. The PCE-deflator was up 2.5% in July versus a year earlier, the same as in June, but also the same as in January and February. Thus, headline inflation appears to have stabilize slightly above the Fed’s 2% target. When volatile food and energy prices are excluded, the core PCE-deflator was up 2.6% in July versus a year earlier, the same as in May and June. However, core inflation decelerated from earlier in the year, having been 2.9% in January.
The data indicates that the prices of durable goods fell 2.5% in July versus a year earlier, prices of non-durables were up 1.3%, and prices for services were up 3.7%. Regarding services, prices have decelerated from April when they were up 4%. Still, services inflation remains too high, driven by a tight labor market. This has been the principal concern of the Fed. However, the labor market has clearly eased in recent months. Consequently, the Fed has signaled a strong intention to start cutting interest rates in September. The latest data do nothing to change that expectation. Indeed, equity prices and bond yields moved very little in response.
Eurozone inflation data is consistent with a September rate cut
- Inflation in the 20-member Eurozone was very low in August, boding well for the ECB to renew rate cuts in September. Specifically, the CPI was up only 2.2% in August versus a year earlier, down from 2.6% in the previous month and the lowest rate since July 2021. Prices were up 0.2% from the previous month. The low level was due, in part, to a sharp decline in energy prices.
When volatile food and energy prices are excluded core prices were up 2.8% in August versus a year earlier, down from 2.9% in July. However, core inflation has been steady throughout this year. Notably, service inflation increased to 4.2% in August, the highest since last October. That is likely the most worrisome aspect of the latest inflation report. On the other hand, the surge in services inflation could have been a temporary reaction to the Olympic games in France.
By country, annual inflation was 2% in Germany, 2.2% in France, 1.3% in Italy, 2.4% in Spain, 3.3% in the Netherlands, and 4.5% in Belgium. Financial market reaction to today’s report was relatively muted. Investors were evidently not surprised.
Now that there is a high anticipation that the US Federal Reserve will start cutting interest rates in September, and with many investors expecting the Fed to implement a 50-basis-point rate cut, the environment is now more favorable for the ECB to engage in a second rate cut (the first took place in June).
Usage of Chinese renminbi is rising
- China wants to reduce dependence on the use of US dollars in trade. Doing so would reduce currency risk and would increase the influence of China in dealing with its trading partners. Now it is reported that usage of the Chinese renminbi in China’s bilateral trade has grown significantly. The Chinese government reported that, in July, the renminbi accounted for 53% of China’s inbound and outbound transactions, up from 40% three years ago.
Partly, the increase reflects the surge in Chinese trade with Russia. Russians are restricted from using US dollars due to sanctions imposed following Ukraine-Russia war. Russia is eager to engage in renminbi-based transactions as it helps to offset the negative impact of Western sanctions.
In addition, the rise of renminbi transactions reflects an increase in the number of currency swap agreements that China has with several other countries. These include Saudi Arabia, Argentina, Mongolia, and Brazil, among others. In the case of Saudi Arabia, China has become the biggest purchaser of oil and prefers to transact in renminbi. Saudi Arabia has a trade surplus with China, which means that the kingdom is accumulating renminbi, which are not easy to invest outside of China. Thus, the Saudis are likely selling renminbi in exchange for dollars and euros.
Moreover, China has intervened in currency markets to stabilize the exchange rate between the US dollar and the renminbi. This helps to encourage others to transact in renminbi as it enables them to sell their renminbi in exchange for dollars at a reliable rate. If China were to remove existing capital controls, then it would become less risky for others to invest renminbi in China, thereby making renminbi transactions more attractive. Yet there is no indication that this will happen anytime soon.
Despite the rise in renminbi usage, the renminbi still only accounts for less than 5% of global transactions.
