Article 30 May 2023

Weekly global economic update

What’s happening this week in economics? Deloitte’s team of economists
examines news and trends from around the world.

Ira Kalish
United States

Week of May 29, 2023

United States—a resilient economy with persistent inflation

Federal Reserve indicates uncertainty about future path

Potential constraints on Chinese growth

The latest trends in global trade

Europe reverts to price controls

United States—a resilient economy with persistent inflation

In April, US households increased their spending considerably, even as income
growth was stagnant. Moreover, new orders for core capital goods increased
sharply. These indicators point to continued resilience of the US economy.
However, the Federal Reserve’s favorite measure of inflation showed an acceleration
in price increases in April. Thus, the Fed faces difficult choices. Let’s look at the
numbers.

1/34
 First, real (inflation-adjusted) disposable personal income was unchanged from
March to April. Although nominal income increased 0.4%, this was entirely
offset by rising prices. However, due to a decline in the personal savings rate, real
household spending increased 0.5% from March to April, the first and biggest
increase since January. Notably, this involved a 1.4% increase in real spending
on durable goods. In addition, real spending on nondurables increased 0.4%
while real spending on services increased 0.3%.

In addition, the government reported that new orders for nondefense,

nonaircraft capital goods increased 1.4% from March to April. New orders for
computers were up 1.8% while new orders for transportation equipment were
up 3.7%. These numbers indicate robust intentions for business investment. The
data on household spending and capital goods orders suggest that the US
economy remains relatively vibrant.

Meanwhile, the bad news is that inflation appears to be settling at an elevated

level after having decelerated sharply. The Fed’s favorite measure of inflation, the
personal consumption expenditure deflator, or PCE-deflator, increased 4.4% in
April versus a year earlier. This was up from 4.2% in March. Moreover, when
volatile food and energy prices are excluded, the core PCE-deflator was up 4.7%
in April versus a year earlier. This was up from 4.6% in March. Since November,
the core measure has moved within a narrow band between 4.6% and 4.8%. As
such, it appears that underlying inflation is stuck. This is expected to be
worrisome for the Federal Reserve as it contemplates either continuing to tighten
monetary policy or taking a pause.

Interestingly, the lion’s share of inflation was attributable to services. Prices of

services were up 5.5% from a year earlier. Prices of durable goods, however,
were up only 0.8% while prices of nondurables were up 2.9%. The latter
includes food which continues to see big price increases.

Federal Reserve indicates uncertainty about future path

Many investors believe that the Federal Reserve is likely to halt interest-rate
increases in the coming months, especially given that the banking crisis has led to
weaker credit market conditions. Now, with the release of the minutes of the Fed’s

2/34
 last meeting, it is affirmed that the Fed is thinking about this. That is, the members
of the Federal Open Market Committee (FOMC) indicated “uncertainty” about the
proper path of interest rates going forward.
The minutes indicate that FOMC members believe “recent developments in the
banking sector had contributed to some tightening of lending standards beyond
that which had occurred during previous quarters, especially among small and
mid-sized banks.” Moreover, they noted that “small businesses tend to rely on
small and mid-sized banks as primary sources of credit and therefore may
disproportionally bear the effects of tighter lending conditions.” They also said
that “stress in the banking sector would, in coming quarters, likely induce banks
to tighten lending standards by more than they would have in response to higher
interest rates alone.”

On the other hand, the minutes noted that inflation remains unacceptably high,
indicating “tighter credit conditions may not put much downward pressure on
inflation in part because lower credit availability could restrain aggregate supply
as well as aggregate demand.” As such, this leaves the Fed facing uncertainty
about the appropriate path forward. The members noted “the possibility that the
cumulative tightening of monetary policy could affect economic activity more
than expected, and that further strains in the banking sector could prove more
substantial than anticipated.” Consequently, the participants said that “in light
of the lagged effects of cumulative tightening in monetary policy and the
potential effects on the economy of a further tightening in credit conditions, the
extent to which additional increases in the target range may be appropriate after
this meeting had become less certain.” The committee agreed that it will carefully
monitor economic data in the months ahead to find the right balance.

Potential constraints on Chinese growth

In a relatively short time, China moved from poverty to middle-income affluence,
sending hundreds of millions into the middle class, and hundreds of millions from
farms to cities. Its footprint on the global economy went from trivial to the second
largest in the world. I remember first traveling to China in 1996. There were very
few cars, mostly bicycles. There were no major Chinese companies that were known
outside of China. The lion’s share of the population remained rural. Fast forward to

3/34
today. China has, by far, the world’s largest market for cars. It is the world’s biggest
exporter of cars. There are numerous world class companies based in China. And
the lion’s share of the population is now urban. When I was a graduate student in
economics, before China’s rise, one of the big questions was what set of policies
would be needed to move large numbers of people from poverty to comfort. China
figured it out, and its experience will be studied for decades to come.
But enough about the past. Let’s consider the future. Now that China’s economy
is so massive, the path that China takes in the next decade and beyond will have
global implications. Can China continue to grow rapidly, thereby matching the
G7 in per capita income? Or will it grow slowly, maintaining its position as a
middle-income country? The answer to these questions will matter not only for
China, but for the world. The path that China takes will influence global growth,
global commodity markets, climate change, and geopolitics.

A debate is now underway about how fast China can grow. Michael Pettis, a
well-known expert on China’s economy, says that China’s growth in the coming
decade will be constrained and that the best-case scenario has China growing no
more than 4% per year. His medium scenario has China growing between 1.5%
and 2% per year, no more than the more mature economy of the United States.
In the latter scenario, China never catches up to displace the United States as the
world’s largest economy.

Why does Pettis believe that China is constrained? In part, it has to do with the
nature of economic growth in the last two decades. China grew rapidly, in part,
because of a massive wave of investment. This involved investment in property,
infrastructure, and businesses—especially state-owned businesses. This
investment was largely fueled by debt. Indeed, debt as a share of GDP, at nearly
300%, is now at a very high level relative to other emerging economies.
Consumer debt has risen dramatically and is now about 30% of disposable
income, an unusually large number. Pettis argues this cannot go on indefinitely,
and that further increases in debt will be unsustainable.

Investment is a good thing. It boosts productivity and productive capacity,

allowing future increases in output. Yet China invested too much. In the last two
decades, investment averaged well more than 40% of GDP, hitting a peak of

4/34
 47% in 2010. For the world economy, investment is about 25% of GDP. Many
emerging economies have investment at 30%–35% of GDP while advanced
economies invest around 20% of GDP. Yet China is in a class by itself. Too much
investment renders excess capacity and makes it appear that the economy is
growing faster than is sustainable. In China, we see this especially in the property
market but also in heavy industry. In China, the return on investment in terms of
incremental economic growth per renminbi invested has declined for the last few
decades and is low relative to other emerging countries. This means that
incremental investment has been highly inefficient, perhaps wasteful.

Pettis argues that China’s economy not only needs to rebalance away from
investment but is bound to do so as the alternative is not feasible. That is,
investment as a share of GDP will decline while consumption will increase. To
avoid a sharp slowdown in growth due to declining investment, two things must
happen. First, investment must become more efficient, with less property
investment and more investment in technology in the private sector. Second, and
more importantly, consumption must grow more rapidly. This will entail
transferring a larger share of income to households. Pettis suggests that even if
these things happen, growth will be modest, perhaps 4%. If they don’t happen
sufficiently then growth will be under 2%. The path that China takes will be
heavily influenced by the mix of policies implemented by the government.

Meanwhile, China’s economy already shows signs of weakness. Household

spending has not rebounded as rapidly as expected, youth unemployment is up
sharply, private sector investment is weak, and exports are being hurt by the
slowing global economy. The troubled property sector has contracted while,
with lower property prices, household wealth has been hurt. Given this
weakness, as well as continued low inflation, many observers had expected the
central bank to ease monetary policy. However, recently the People’s Bank of
China (PBOC) left the benchmark interest rate unchanged for the ninth
consecutive month, evidently concerned about further downward pressure on the
currency stemming from tightening US monetary policy.

The latest trends in global trade

5/34
The weakening of global trade, due to the weakening global economy, is evident in
the latest data on containers. It is reported that global production of containers in
the first quarter of 2023 was down 71% from a year earlier. Sales of containers
declined 77%. The cost of shipping containers has dropped sharply. The decline in
production is indicative of a considerable excess supply. This stems from the surge
in demand for durable goods during the pandemic, which was disproportionately
driven by the US consumer. That surge created shortages and delays and compelled
companies to boost capacity to produce and distribute goods. Now, however, with
the pandemic fading, consumer demand has shifted away from goods and toward
services. In addition, tight monetary policies are likely weakening key economies.
The results is declining demand for goods.

In the United States, there is strong bipartisan support for constraining economic
relations with China. In the US Congress, there is concern about China’s growing
military capabilities, its investment in military facilities in the South China Seas, its
treatment of ethnic minorities, and its attitude toward intellectual property.
Already, the US imposed tariffs on some Chinese goods in 2018–19. In addition, the
current US government has imposed export restrictions. Now, there is growing
support in Congress for repealing Permanent Normal Trade Relations (PNTR) with
China. This is also known as most favored nation (MFN) status. 

The US granted MFN status to China a generation ago, which played a major
role in China’s integration into the global economy. Repeal would mean a
significant increase in tariffs on almost all imports from China. Critics warn that
this could have a devastating impact on US industry, which relies on Chinese
inputs, drive up consumer prices and thereby reduce US consumer purchasing
power, and ultimately lead to retaliation by China. Repeal of MFN would go far
beyond the impact of President Trump’s tariffs on China. There is likely sufficient
support for repeal to pass in the US Congress. However, there might not be
sufficient support to override a presidential veto.

In the first four months of 2023, German exports to China were down 11.3% from
a year earlier. In part this reflects the impact of high energy costs and a rising euro.
The German automotive sector is having difficulty competing with rising Chinese

6/34
 production of electric vehicles. In addition, the weakness of demand in China is a
headwind for German carmakers and other heavy industry.

There is increasing evidence that global supply chain disruption is largely over. One
indicator is the global supply chain volatility index produced by IHS Markit, which
is also the publisher of the leading purchasing manager’s index data. The latest
reading of the index found that it fell to the lowest level since 2020. After early
2020, the index soared as supply chains were hugely disrupted by the pandemic and
by changing consumer demand patterns. Markit reports that, during that time, the
biggest contributor to supply chain volatility was “business stockpiling due to
supply or price concerns.” In other words, precautionary hoarding played the
dominant role in disrupting global supply chains. This, in turn, contributed strongly
to the surge in inflation in Europe and North America. The good news now is that
the index has fallen sharply, thereby releasing stress and reducing inflationary
pressure.
Europe reverts to price controls
In the 1970s, governments in North America and Europe used price controls to
fight inflation and to relieve households from the impact of onerous price increases.
That experience was not a happy one. It led to shortages and inefficiencies and
failed to suppress underlying inflation. Rather, inflation was only broken when
central banks used especially tight monetary policies to weaken economies and
undermine inflationary pressure. By the 1980s, there was a consensus that price
controls are foolhardy and that the best thing governments can do is to let markets
determine prices.

Not anymore. Price controls are back. In several European countries,

governments have imposed controls on the retail price of food. In other
countries, value-added taxes on food and other household goods have been cut.
Food, especially, is of great concern. The European Union (EU) reports that, in
April, while overall consumer prices were up 8.1% from a year earlier, food
prices were up 16.6%, with prices of some key food items up much more
sharply. For lower-income households, this is a big burden, especially given that
wages are rising far more slowly than prices.

7/34
 Price controls impose a burden on retailers, damaging their profit margins. This
can result in shortages. The World Bank has urged European governments to use
more targeted approaches to assist troubled households. This can involve
government payments to low-income households. Yet many EU governments,
having accumulated considerable debt during the pandemic, are not in a fiscal
position to boost spending.

Week of May 22, 2023

Global supply chain stress declines dramatically

Chinese economic data offers a mixed picture

Chinese trade patterns are shifting

US retail sales and industrial production data offer contradictory trends

Japan’s economy grew modestly while inflation remains high

Russian oil revenue falls following oil price cap

Global supply chain stress declines dramatically

During the pandemic, global supply chains were under tremendous stress. This was
due to constraints on production and distribution, especially in China, as well as a
dramatic shift in consumer demand toward durable goods. The latter contributed to
shortages, delays, and ultimately higher costs. In fact, the supply chain crisis was
the initial contributor to the surge in inflation seen in North America and Europe.
The good news is that supply chain stress has fallen sharply.

During the pandemic, the Federal Reserve Bank of New York created an index
meant to measure global supply chain stress. The index incorporates measures of
transportation costs (such as the Baltic dry index) as well as indicators of
manufacturing stress (such as purchasing managers’ indices and their
components). During the pandemic, the index increased dramatically. Its peak, in
December 2021, was at a level four standard deviations above the average for
the period 1997 to 2020. Since then, the index has declined. The New York Fed
8/34
 now reports that, in April of this year, the index fell to 1.3 standard deviations
below the historic average. This was the lowest level since late 2008. 

What are the implications of this? First, it is likely that the reduction in supply
chain stress is mostly due to the weakening of the global economy. Tighter
monetary policy in North America and Europe has caused a slowdown in
consumer demand. Second, as the pandemic has ended, consumers have been
shifting away from durable goods toward services. Third, the improvement in
supply chain efficiency has likely contributed to the reduction in inflation,
especially in the United States. Today, durable goods prices are actually falling.
The remaining inflation mainly has to do with services.

Finally, the New York Fed reports that the lion’s share of the improvement in the
index was due to “Euro Area delivery times, Euro Area stocks of purchases, and
Korean delivery times.” The New York Fed said that this was partly offset by “a
notable upward contribution from Taiwan stocks of purchases.”

Chinese economic data offers a mixed picture

Data released last week by China’s government paints a mixed picture. Retail sales
increased sharply, but not as fast as analysts had anticipated. Industrial production
and fixed asset investment grew at a modest pace, but investment in the property
sector fell sharply. The unemployment rate fell, but youth unemployment hit a
record high. However, slack in the labor market implies weak inflationary pressure.
Indeed, inflation has remained low. Deloitte China’s chief economist, Xu Sitao,
continues to expect China’s central bank to cut interest rates due to economic
weakness and low inflation. However, Xu says the fact that this has not yet
happened “suggests that policymakers do not think it is time to push the panic
button yet.”

Here is the data: Retail sales were up 18.4 percent in April versus a year earlier,
up from 10.6 percent growth in March but still lower than analysts expected.
The surge was due, in part, to a low base in April 2022. Despite the strong
growth, some categories were weak. Auto sales were up only 5.4 percent. Sales
of home appliances, communications equipment, office supplies, and building

9/34
 materials were all down from a year earlier. This likely reflected the troubles in
the property sector.

Industrial production was up 5.6% in April versus a year earlier. In addition,

fixed asset investment in the first four months of the year was up 4.7% from a
year earlier. Investment in manufacturing increased 6.4% while investment in
real estate fell 6.2%. 

As for China’s labor market, the unemployment rate fell to a 16-month low of
5.2%. The rate for those aged 25 to 59 fell to 4.2%. On the other hand, the
unemployment rate for those 16 to 24 years old rose to 20.4%, a record high. As
recently as late 2021, the youth unemployment rate was a bit over 14%. With
over 11 million university graduates set to enter the labor force this year, the
high youth unemployment rate could be an impediment to absorbing those
young workers. 

Overall, the latest batch of data is consistent with other recent data indicating
weakness in China’s economy. Xu Sitao expects an easing of monetary policy in
response but does not expect the government to engage in a more expansive
fiscal policy. Rather, he expects that the government will ease restrictive policies
regarding home purchases. 

Chinese trade patterns are shifting

As China faces constraints on exporting to the United States and Europe, both due
to weakening economies and trade restrictions, China’s export profile is shifting.
Exports to Southeast Asia and other emerging areas of the global economy are
increasing rapidly. For example, in the first four months of 2023, China’s overall
exports were up 10.6% from a year earlier. Yet exports to the 10 nations of ASEAN
(Southeast Asia) were up 24.1%. Exports to Africa were up 36.9 percent while
exports to Latin America were up 11.2%. China has taken steps to boost its
relationships in the Middle East and this is evident in the 51.3% increase in exports
to Saudi Arabia. 

Notably, this shift in the geographic destination of China’s exports coincides

with a shift in the composition of exports. There has been a sizable increase in

10/34
 shipments of intermediate rather than final goods. Many of the products
exported to Southeast Asia are intermediate goods used to assemble final goods,
either for export or for the domestic market. In part, this is likely due to global
companies diversifying their supply chains and relying less on final assembly in
China. In addition, as China has moved up the value chain, it has shed much low
value-added final assembly in favor of more sophisticated production of high-
tech inputs. Given that China’s wages have surged in the last two decades, basic
assembly no longer makes as much sense as in the past.

The geographic shift in China’s exports has led to a sharp increase in shipping
lanes running from China to Southeast Asia, Middle East, and Africa. The cost
of shipping containers to these locations has increased commensurately.
Meanwhile, shipping capacity between China and North America has fallen
sharply. 

US retail sales and industrial production data offer contradictory

trends
US retail sales were less than expected in April. Following declining sales in
February and March, many observers anticipated a strong increase in April.
Instead, retail sales increased at a modest pace. What explains the weakness of
retail spending? There are several possibilities. First, real incomes continue to
decline as wages fail to keep pace with inflation. Second, US households saw a
sharp increase in credit card debt in the first quarter of 2023. This means that debt
servicing costs in April were up significantly, thereby diminishing the volume of
discretionary funds. Lastly, retail sales mostly entail expenditures on goods rather
than services. In recent months, spending on goods has stagnated while spending on
services has accelerated—a sharp reversal from the pattern seen during the
pandemic. In any event, the weakness of retail spending could presage a further
slowing of the US economy.

Let’s look at the details. In April, retail sales (not adjusted for inflation) were up
0.4% from the previous month. Spending at automotive dealerships was also up
0.4%. However, some categories saw a decline in April. These included furniture
(down 0.7%), electronics stores (down 0.5%), grocery stores (down 0.4%),

11/34
 department stores (down 1.1%), apparel stores (down 0.3%), and gasoline
stations (down 0.8%). The latter was surprising given that gasoline prices
increased. This suggests a decline in driving in April. 

Meanwhile, spending at nonstore retailers (mainly online shopping) was up

1.2% for the month and up 8% from a year earlier. The longer-term shift away
from store-based shopping continues apace. In addition, spending at restaurants
and bars was up 0.6%. 

Although retail sales disappointed in April, US industrial production grew at a

healthy pace. Thus, investors were faced with contradictory data about the state of
the US economy. Industrial production increased 0.5% from March to April. This
included a 1.2% increase in production business equipment, boding well for
increased business investment. Within the category of business equipment,
production of transport equipment increased 3.6% while production of information
processing equipment increased 2.2%. 

In addition, the manufacturing component of industrial production was up 1%

from March to April. This included a 9.3% increase in motor vehicle production
and a 2.1% increase in output of computers and electronic products. Thus, it
appears that the automotive and information technology sectors played a key
role in the strength of the US industrial sector. As for autos, although sales were
modest in April, the industry had a low level of inventories, thus requiring a
strong increase in output to prepare for future consumer demand. 

Japan’s economy grew modestly while inflation remains high

The Japanese economy grew in the first quarter of this year after not growing in the
previous two quarters. Thus, commentators are saying that Japan has emerged from
recession. In the first quarter, real GDP was up 0.4% from the previous quarter, or
increased at an annualized rate of 1.6%. Growth was fueled by consumer spending,
which increased 0.6% from the previous quarter, and business investment, which
increased 0.9% from the previous quarter. Meanwhile, government spending
stagnated while trade made a negative contribution to GDP growth. This was
because exports fell more rapidly than imports.

12/34
 Most investors reacted positively to the news, driving up equity prices to close to
their highest level in more than 30 years. Domestic demand has been helped by
the end of COVID-19–related restrictions. In addition, wages are rising at a
relatively rapid pace, thereby boost consumer purchasing power. The strength of
business investment likely reflects confidence that the recovery will continue,
thereby necessitating an increase in capacity. Japan’s principal headwind is a
weakened global economy as well as fraught relations with China. These factors
contribute to poor export performance.

Although inflation is now at a relatively high level, it is widely expected to

diminish this year, thereby reducing the need for the Bank of Japan (BOJ) to
severely tighten monetary policy. Indeed, the new leadership of the BOJ has
maintained the unusually easy monetary policy that has characterized the last
decade. 

Inflation in Japan remains above the central bank’s target of 2%. The government
reports that, in April, core prices (which excludes the impact of fresh food) were up
3.4% from a year earlier. This was up from 3.1% in March. When volatile food
and energy prices are excluded, so-called “core-core” prices were up 4.1% from a
year earlier. This was the highest rate of core-core inflation since September 1981. 

The rise in underlying inflation was mainly due to an acceleration in inflation in

services. This had much to do with supply and demand conditions. Since the
government removed pandemic-related restrictions, there has been an increase in
consumer demand, including demand by tourists. In fact, hotel prices were up
8.1% in April versus a year earlier.

Meanwhile, the price of food (excluding fresh foods) was up 9% in April, the
highest in 47 years. The price of meals eaten away from home were up 6.6%, the
highest in several decades. This surge in food prices could eat into the ability of
consumers to purchase other goods and services.

The evident persistence of underlying inflation raises questions about the future
path of the BOJ. It has retained the relatively easy monetary policy of the past
decade. In its last meeting, it did not change the yield curve control policy. The
new Governor of the BOJ has said that any change will come only if there is

13/34
 evidence that inflation is becoming embedded and is driven by excess demand
rather than supply chain problems. 

Russian oil revenue falls following oil price cap

Last year, on the advice of the US government, the G7 adopted a plan to cap the
price paid to Russia for oil. The goal was to reduce the revenue received by Russia
while enabling Russian oil to flow. The goal was also to minimize the impact on oil
consumers from the war in Ukraine. Immediately following the Russian invasion of
Ukraine, the global price of oil surged. It has since come down sharply, thereby
reducing the damage to Western economies. And the price cap has been effective in
reducing Russian revenue. 

Specifically, the International Energy Agency (IEA) and others report that
Russia’s oil revenue was down 43% in March from a year earlier. This was
despite the fact that the volume of oil sold had increased, hitting a record level in
April. One result is that Russia’s government has changed the way it taxes oil
production in order to claw back some of the lost revenue. Yet this might have
the effect of limiting investment in new capacity. Moreover, the net loss of
revenue to the Russian government likely damages its ability to wage war.

Aside from the price cap, the West has imposed sanctions that limit Russian
access to global shipping and insurance services. Consequently, it is reported that
Russia is spending money to build its own network of ships and insurance
companies. It has significantly boosted the sale of oil to China and India, which
together now account for 80% of Russian oil sales. The Deputy US Treasury
Secretary recently said that “the Russian price cap is working and working
extremely well. The money that they’re spending on building up this ecosystem
to support their energy trade is money they can’t spend on building missiles or
buying tanks. And what we’re going to continue to do is force Russia to have
these types of hard choices.”

Week of May 15, 2023

US financial market conditions are a source of concern

14/34
 US inflation heads in the right direction

The latest on China

Russia’s evolving economic situation

US financial market conditions are a source of concern
While the Federal Reserve and the US Treasury have successfully stabilized financial
markets following the collapse of a handful of medium-sized banks, the Fed is
worried that the crisis will create enough of a credit crunch to slow the US
economy. This is according to the Fed’s latest report on financial stability. In
addition, the Fed’s survey of banks indicated that they intend to tighten lending
standards, in part due to fears of deposit flight.

The Fed’s report on financial stability found that despite “decisive actions” by
authorities, the bank crisis could undermine the “economic outlook, credit
quality, and funding liquidity” and could cause “banks and other financial
institutions to further contract the supply of credit to the economy.” It also said
that “a sharp contraction in the availability of credit would drive up the cost of
funding for businesses and households, potentially resulting in a slowdown in
economic activity.” 

Meanwhile, the Federal Reserve’s survey of bank loan officers found that the
share of banks that are tightening lending standards increased moderately from
January to March. However, the latest survey was taken only shortly after the
collapse of Silicon Valley Bank. It is likely that the next survey, which will be
released in July, will indicate the degree to which the crisis has affected bank-
lending intentions. 

The irony of all this is that the crisis in the banking system is mostly in the minds
of investors and depositors. There is no systemic problem in the banking system,
at least not one that should lead to a seizing up of credit activity. It is very
different from 2008 when excessive leverage led to a near collapse of the banking
system. This time, a handful of medium-sized banks, with roughly half a trillion
dollars in assets (in a system with US$23 trillion in assets), failed, in part when
depositors got scared and moved their money elsewhere. This, in turn, led to a

15/34
 larger exodus of deposits from smaller banks. The shrinkage of smaller banks
means less ability to deliver credit to small and medium-sized businesses, thereby
hurting the economy. Sheila Bair, a former US bank regulator, said that the
turmoil is “overblown” and that “there is no crisis, unless media hype and short
selling pressure undermine confidence so that depositors flee otherwise health
banks.”

Although the banking system remains relatively safe, there is a problem involving
the balance sheets of some medium-sized banks. Many face troubles due to
excessive exposure to commercial property, especially the market for office
buildings as well as nongrocery shopping centers. This is exacerbated by higher
interest rates. Following the pandemic, many office workers continue to work
remotely, leaving many office buildings only partially occupied. Many companies
are gradually reducing their office footprint. Consumer online shopping
accelerated rapidly during the pandemic, a trend that has not reversed. This has
rendered many retail properties troubled. The result will likely be a decline in
office building and shopping center revenue and greater difficulty in servicing
bank loans for office and retail construction. There will also likely be a
tightening of lending conditions for office space and shopping center space on the
part of banks. 

Two possibilities emerge. First, some banks may face problems, potentially
requiring rescue by authorities. This could have a further negative impact on
credit conditions. Second, troubles in the property market can have a negative
impact on construction activity and the range of industries that supply the
construction industry. Still, there might also be opportunities to acquire property
inexpensively and repurpose it. 

US inflation heads in the right direction

Investors were likely relieved when the US government reported that inflation
continued to decelerate in April. There had been concern that the progress seen
since last June might be reversed. That fear was exacerbated by the fact that
progress was, indeed, reversed in the Eurozone. Instead, US inflation did continue
to ease. On the other hand, core inflation (which excludes the impact of volatile
food and energy prices), although falling slightly, appears to be more persistent. 
16/34
Let’s look at the numbers. The government reported that consumer prices were
up 4.9% in April versus a year earlier, the lowest rate since April 2021. Inflation
had peaked in June at 9.1% and has been declining ever since. Consumer prices
were up 0.4% from the previous month. Core prices were up 5.5% from a year
earlier, down from 5.6% in March and the same as in February. This was the
lowest rate of core inflation since late 2021. Still, core inflation has been in the
range of 5.5%–6% since November, receding much more slowly than headline
inflation. Meanwhile, energy prices were down 5.1% while food prices were up
7.7%.

Inflation appears to be sustained by the sharp rise in the price of shelter, up 8.1%
from a year earlier. This reflects the lagged impact of last year’s sharp rise in
home prices. However, April’s shelter inflation was slightly lower than in March.
Thus, shelter inflation appears to have peaked. Now that home prices have
declined, it is expected that the shelter component of the consumer price index
will continue to recede throughout this year, thereby helping to further reduce
inflation. In any event, if shelter is excluded, consumer prices were up a modest
3.4% in April versus a year earlier.

Consumers purchase three types of categories: durables, nondurables, and

services. Prices of durables were down 0.2% in April versus a year earlier. This
reflects weak demand for durable goods combined with improvements in supply
chains that deliver such goods. Prices of nondurables less food were down 1.3%
in April. Prices of services less shelter, however, were up 5.2% in April. Thus, the
persistence of inflation is largely related to trends in the service sector.

Finally, some categories saw sharp price declines in April. These included the
following: car rentals (down 11.2%), used cars (down 6.6%), health insurance
(down 15.8%), and airline tickets (down 0.9%). 

The bottom line is that goods inflation has largely disappeared. To the extent
that inflation remains persistent, it mostly has to do with shelter and other
services. This likely reflects consumer demand shifting sharply away from goods
and toward services now that the pandemic is over. Going forward, given that
the economy is weakening due to Fed tightening, it seems likely that inflation
will continue to decelerate. From the perspectives of the Federal Reserve, the

17/34
 inflation report is favorable news and increases the likelihood that interest rates
will be kept steady. This expectation explains the rise in equity prices following
release of the inflation report. However, the Fed has indicated that its decisions
will be data-driven. Thus, future decisions will depend, in part, on future
inflation data. 

The latest on China

In recent months, much has been written about the tense relationship between
China and the United States, especially given US export controls and China’s threats
of retaliation. Now it appears that the relationship between China and the
European Union (EU) is becoming more fraught. 

The EU is proposing sanctions on specific Chinese companies that are said to

support Russia’s war effort. This would be the first such measure by the EU to
sanction China. In response, China is threatening to retaliate. A Chinese official
said that China is not supplying any weapons to Russia and that economic
relations between China and Russia are normal. Moreover, he said that “we are
against states introducing extraterritorial or one-sided sanctions on China or any
other country according to their own domestic laws. And, if that were to
happen, we would react strictly and firmly. We will defend the legitimate
interests of our country and our companies.” 

Two Chinese companies that the EU might target are already sanctioned by the
United States. German Foreign Minister Baerbock said that it is important that
sanctions on Russia not be undermined by actions of third parties. She said that
China is not being targeted, but only those companies that sell sanctioned goods
to Russia. 

Meanwhile, Chinese investment in Europe has fallen sharply. In 2022, Chinese

investment in Europe was 22% below the year earlier level, hitting the lowest
level in nearly a decade. In part, the decline reflects more stringent governmental
rules in Europe about Chinese inbound investment. For example, a study by the
Rhodium Group found that, in 10 of 16 infrastructure and technology projects
sought by Chinese firms, governments stopped the projects from taking place.
The governments were the United Kingdom, Germany, Italy, and Denmark. In

18/34
 many instances, governments rejected deals in which Chinese companies would
acquire companies that make products with potential military applications. 

There are signs that China’s recovery is weaker than previously anticipated. At the
Canton Fair, there have been far fewer orders than expected. The Canton Fair is
one of China’s biggest trade shows. Activity at the Fair has often provided an
indication of global demand for Chinese goods. This year the Fair returned to full
operations after the pandemic. The volume of orders, however, was down roughly
one-third from 2019, the last year of full operations. This is an indication of weak
global demand for Chinese products.

In addition, it is reported that US and European companies are pointing to

weaker-than-expected sales in China as an explanation for weaker-than-expected
profits. Many had anticipated that, after China dropped COVID-19–related
restrictions, and after the initial wave of infections dissipated, Chinese demand
for goods and services would soar. Some analysts even worried that an
overheated Chinese economy would lead to a surge in oil prices, thereby fueling
a rebound in global inflation. Instead, China’s economy has recovered only
modestly. 

Why is China’s growth subpar? One explanation is that Chinese consumers are
holding back. They are being cautious, in part, because they have been
pummeled by volatility in the property market, which is an important source of
their wealth. In addition, global demand for China’s exports is weakening due to
the weakened global economy. Also, trade tensions between China and the
United States and other Western countries have a negative impact not only on
trade of goods but also on cross-border investment. 

China’s weakness is important to the global economy. A weaker Chinese

economy has negative implications for export growth for other major economies.
It likely implies somewhat slower global economic growth this year than
previously anticipated. However, weaker growth in China could help to suppress
energy prices, thereby further enabling inflation in the West to decelerate. 

There is more evidence of China’s economic weakness. First, iron ore prices have
fallen sharply, reflecting a decline in Chinese demand. The price of iron ore
19/34
 delivered to Chinese ports is down 23% from early March. When China ended
pandemic-related sanctions and reopened, there was optimism that China’s growth
would soar. It did not. Instead, steel production (in which iron ore is the key input)
fell sharply in April as demand waned. Given China’s property market problems,
this is not entirely surprising. The weakness in demand for steel is emblematic of
the overall weakness of the Chinese economy.
In addition, after a surge in March, China’s trade with the rest of the world is
easing. In April, imports fell at a record pace while exports grew at a more
modest pace. Imports were down 7.9% in April from a year earlier. Exports were
up 8.5%, far slower than the March numbers. Moreover, April’s numbers were
distorted by very weak performance in April 2022. 

The weakness of imports likely reflects both weak domestic demand as well as
weak external demand. The latter implies fewer imports of inputs used in
producing exportable goods. The weakness of external demand reflects the
weakening of the economies of the United States, Europe, and many emerging
markets. Notably, South Korean exports to China were down 26.5% in April
versus a year earlier. South Korea supplies China with inputs used to produce
exportable goods. In addition, China’s imports of coal, copper, and natural gas
were all down in April, likely due to weak domestic demand. 

Xu Sitao, chief economist of Deloitte China, offers his thoughts on the latest inflation
report for China:

It is becoming increasingly clear that disinflation warrants more potent monetary

easing in China. April consumer price inflation came in at just 0.1% year over year
(YoY), compared to 0.7% YoY in March. Such disinflation is likely to persist due to
severe slack in the Chinese labor market. In addition, there was a sharp decline in
producer price inflation in China (–3.6% YoY), down from a fall of 2.5% in
March, suggesting that downstream sectors lack pricing power.

Even before the US Federal Reserve was approaching the end of its tightening
cycle, it made sense for Chinese monetary policy to take precedence over fiscal
stimulus because the latter tends to skew to large infrastructure projects. In light
of decelerating headline inflation in the United States, a compelling case can be

20/34
 made for the PBOC (China’s central bank) to lower interest rates. Today, all
Chinese banks were asked to lower the ceiling on the rates of “agreement” and
“call” deposits starting on May 15. This can be seen as a prelude to the
reduction of interest rates. Meanwhile, given that interest differentials between
the RMB and the USD are likely to widen with expected easing in China, some
minor weakening of the RMB is necessary for the PBOC’s monetary easing to
gain traction.

Russia’s evolving economic situation

There is growing evidence that the Western sanctions on Russia are being violated.
This is important because many of the sanctions were meant to weaken Russia’s
economy and, consequently, its ability to wage war. Moreover, some sanctions were
meant to keep sophisticated technology away from Russia, thereby limiting its
ability to produce sophisticated weapons. 

The Institute of International Finance (IIF) says that there has been a surge in
exports from key countries to Russia’s neighbors. Specifically, it found that
exports from China, Germany, Japan, and the United States to Belarus,
Kazakhstan, Turkey, and Georgia have increased sharply in the past year.
Particularly noteworthy was the tripling of Chinese exports to Belarus in the past
year. The IIF says that it does not know what products were shipped, but it
suggests the possibility that such exports are undertaken to avert sanctions on
Russia. 

Meanwhile, Nikkei found that US-made semiconductors are flooding Hong

Kong and then being sent to Russia. The G7 group of industrial nations is
discussing ways to limit this flow. The G7 is also concerned that, although G7
trade with Russia has fallen sharply, Russian trade has increased sharply with
China, India, and Turkey. Specifically, G7 exports to Russia were down 50% in
2022 versus a year earlier and imports were down 10%. That represented a
US$52 billion decline in trade. Yet that was more than offset by a US$103 billion
increase in Russian trade with China, India, and Turkey. Although the West shut
off Russia from US dollar denominated transactions, Russia has substantially
increased transactions in Chinese renminbi. 

21/34
 When the war in Ukraine began, the surge in oil prices led to an increase in tax
revenue for the Russian government. This enabled Russia to fund its war effort
despite onerous sanctions from the West. Yet late in 2022, the G7 initiated a price
cap on oil of US$60 per barrel, meant to hurt Russia’s ability to wage war. The
result is that, in the first quarter of 2023, oil and gas tax revenue for the Russian
government was down 45% from the same period one year earlier. 

In response, Russia has increased taxes on oil producers. However, this will have
an onerous impact on the ability of energy producers to invest in new capacity.
Thus, Russia is attempting to boost short-term revenue to wage war, even at the
expense of a longer-term loss of energy capacity. Moreover, as European
governments take steps to obtain alternative sources of oil and gas, and as they
accelerate investment in clean energy, Russia’s long-term prospects diminish.

In any event, the mix of sanctions and the oil price cap have already wreaked
havoc with the Russian economy. This is despite Russia’s efforts to boost sales of
energy to India, China, and elsewhere. In three of the four quarter of 2022, real
GDP fell from a year earlier. It was down 2.7% in the fourth quarter. Retail sales
were down 5.1% in March versus a year earlier and have been declining ever
since the start of the war.

Week of May 8, 2023

Financial markets survive yet another bank failure

US Fed tightens against backdrop of strong job growth

Eurozone inflation persists while ECB acts

Financial markets survive yet another bank failure

Three of the four largest bank failures in US history took place in the last two
months. And yet the banking system remains stable. The latest event was the failure
of First Republic Bank, based in Northern California. There was a massive outflow
of US$100 billion in deposits (the bank has US$229 billion in assets) as customers

22/34
worried that the bank’s large portfolio of mortgages for wealthy homeowners
would become troubled due to rising interest rates. Moreover, depositors were
likely influenced by the failure of neighboring Silicon Valley Bank two months ago,
which set off a brief period of contagion. Markets had reacted negatively to fears
that First Republic would fail while the government worked hard to find a buyer. In
the end, JPMorgan acquired the bank’s loans. Depositors will be protected while
shareholders will be wiped out. The Federal Deposit Insurance Corporation
participated in the rescue. JPMorgan CEO Jamie Dimon said that “this part of the
crisis is over. This is how the system is meant to work. You're never going to have
no bank failures.”
This transaction has evidently been welcomed by investors who feared that a
more disruptive failure of the bank would have serious repercussions, potentially
causing yet a new banking crisis. Equity prices are stable as are yields on
government bonds. Risk spreads are also stable, having surged when Silicon
Valley Bank failed and then reverting to a lower level when authorities quickly
intervened. Although there are other mid-sized banks known to be problematic,
the good news is that, so far, fears about the stability of those banks are not
having a negative impact on the stability of financial markets.

Still, there is reason to be concerned. Many mid-sized banks are heavily exposed
to loans for office buildings and shopping centers, many of which could become
troubled as people increasingly work and shop remotely. The result could be a
substantial write-down of those loans, thereby putting pressure on banks that
have already seen a big exodus of deposits. Moreover, as mid-sized banks shrink,
the availability of credit to small and medium-sized businesses could be
disrupted. 

The exposure of troubled banks began after the Federal Reserve raised interest
rates. This has often been the case historically and should not be a surprise. Yet
the contagion that followed the failure of Silicon Valley Bank, and which resulted
in a decline in bank lending, had the same effect on credit markets that a further
Fed tightening would have. From the Fed’s perspective, further tightening might
not be necessary if markets are already doing their job. Thus, it is reasonable to
expect that the Fed may soon halt the process of raising interest rates. Once this
happens, troubled banks will be in a better position to become stable, possibly
23/34
 through being acquired or obtaining injections of capital. Either way, the Fed’s
likely trajectory implies less likelihood of a further crisis in the banking system.  

US Fed tightens against backdrop of strong job growth

It was not a surprise on May 3 when the US Federal Reserve raised the Federal
Funds rate by 25 basis points (bps) to a range of 5%–5.25%. This means that the
Fed has increased the rate by 500 bps since the start of monetary tightening. The
latest action had been widely expected, although there were voices in the market
urging the Fed to refrain from any action given the failure of First Republic Bank
earlier this week. Yet Fed Chair Powell said that banking conditions have improved
since early March when the failure of Silicon Valley Bank set off the turmoil in the
banking market. On the other hand, Powell acknowledged that overall credit
conditions have worsened, mainly due to the tightening of monetary policy, but
also due to the banking crisis. This is expected to continue weighing on economic
activity.

The continuing tightening of monetary policy is meant to stifle inflationary

pressure. Powell said that inflation expectations remain well anchored. This is
important because anchoring expectations is one of the main goals of monetary
policy. Meanwhile, inflation has decelerated due to improved supply chains,
lower commodity prices, and the impact of Fed tightening. Whether and to what
degree the Fed tightens more will be data driven, as Powell indicated. However,
most observers now expect the Fed to pause for a while. After all, the banking
crisis is weakening credit market conditions. Moreover, Fed policy acts with a
lag. The Fed needs to determine if it has already done enough.

Although Powell has suggested that rates will need to remain elevated for a
while, many investors evidently think otherwise. The path of the Federal Funds
rate implied by futures markets suggests that the Fed will start to cut the rate in
July, pushing the rate down to 3.5% by January. Why do investors think this?
Perhaps they expect the banking crisis to worsen, thereby pushing the economy
into recession and forcing the Fed to ease monetary policy to stabilize the
banking system. Perhaps they expect inflation to fall quickly, thereby enabling
the Fed to ease policy. 

24/34
 What is unusual is that, after raising the Fed Funds rate by 500 bps,
unemployment remains historically low. What is also unusual is that, although
the number of job openings has fallen, unemployment remains very low. Powell
noted that the labor market remains surprisingly tight even after monetary policy
has weakened credit markets. He suggested the possibility that the Fed will
succeed in significantly reducing inflation without engineering a sharp rise in
unemployment. However, he left open the possibility of a big increase in
unemployment and signaled that his primary focus is on suppressing inflation.
Either way, he said, there is a good likelihood that a recession can be avoided. 

Job growth in the United States continued in April at a healthy pace while the
unemployment rate fell slightly to 3.4%. Employment grew at a moderate pace in
many sectors. Job growth was not excessively dependent on the leisure and
hospitality sector, which had been the case during much of the postpandemic
period. Thus, the economy appears to be moving back toward normalcy.
Meanwhile, average hourly wage growth, having decelerated from March 2022 to
January 2023, appears to have stabilized in the past three months. This will likely
be a concern for the Federal Reserve.

Let’s look at the details. The government releases two employment reports: one
based on a survey of establishments; the other based on a survey of households.
The establishment survey indicated that, in April, 253,000 new jobs were
created. This was the strongest growth since January. The strength of job
growth, to which Chair Powell alluded in his press conference this week, is
unusual in the context of a significant tightening of monetary policy. On the one
hand, it could signal a need to further tighten in order to suppress inflationary
pressure. On the other hand, it could indicate a new normal in which the
economy is weakened while the job market remains relatively tight. Time will
tell.

The details of the establishment survey are interesting. There was a loss of
employment in the banking sector, possibly related to the troubles at some mid-
sized banks. Yet job growth was positive in other financial services areas
including insurance and real estate. In addition, there was strong growth in the
construction sector, especially in specialty contractors. Manufacturing saw

25/34
 moderate growth of employment, with roughly half that growth coming from
the automotive sector. The strongest growth came in professional and business
services (even after a sharp decline in employment at temporary services). In
addition, there was strong growth in health care and moderate growth at
restaurants. 

The establishment survey also looked at compensation. Average hourly wages

were up 4.4% from a year earlier, not much changed in the past four months.
Prior to January, wage inflation had been steadily decelerating from a peak of
5.9% last March. The question, then, is whether the labor market is getting
stuck. If productivity accelerates, then it would not be inflationary for wage
gains to exceed inflation. Yet that is not the case. Rather, the Fed likely fears that,
so long as the labor market is tight, wage inflation will not decelerate further,
thereby making it more difficult to bring inflation down from the current 5%. If
that is the Fed’s thinking, it might consider further monetary tightening, even if
this means boosting the unemployment rate.

The separate survey of households indicated that participation in the labor

market was steady in April. However, participation among prime-aged workers
(25 to 54) continued to rise, with participation among prime-aged women
reaching a record high. Thus, the shock to participation from the pandemic
appears to be easing. Rising participation will help to loosen the tightness in the
labor market and to cause a further deceleration in wages.

Eurozone inflation persists while ECB acts

Inflation in the 20-member Eurozone is not decelerating. The data for April
indicates that inflation is stabilizing at an elevated level after having fallen rapidly.
If inflation is stuck, this implies that the European Central Bank (ECB) will have to
tighten substantially further to break the back of inflation. That, in turn, nearly
assures an economic downturn sometime later this year. 

Let’s look at the numbers. In April, consumer prices in the Eurozone were up 7%
from a year earlier, higher than the 6.9% in March. However, inflation had
steadily declined previously each month from a peak of 10.1% in November.

26/34
 One month of reversal does not make a trend. Prices were up 0.7% from the
previous month, down from an increase of 0.9% in March. 

The important thing is to look at underlying inflation. When volatile food and
energy prices are excluded, core prices were up 5.6% in April versus a year
earlier, down from 5.7% in March and the same as the 5.6% seen in February.
Thus, core annual inflation does appear to be stuck. Core prices were up 1%
from the previous month, an alarmingly high number. Thus, there is reason to be
concerned.

By country, inflation varied considerably in April. In Germany, the Eurozone’s

largest economy, consumer prices were up 7.6% in April versus a year earlier,
down from a peak of 11.3% in November, and down from 7.8% in March. In
Spain, however, inflation accelerated from 3.1% in March to 3.8% in April. In
Italy, inflation accelerated from 8.1% to 8.8%. In France, inflation accelerated
more modestly from 6.7% to 6.9%.

For the ECB, the challenge now is to get inflation under control while, at the
same time, avoiding a financial crisis stemming from the troubled banks in the
United States. The ECB recently reported that credit conditions for both
households and businesses worsened in the first quarter. This fact will likely
influence their deliberations. The goal of monetary-policy tightening is to worsen
credit conditions in order to weaken inflationary pressure. So far, the ECB has
been successful at worsening credit conditions, but questions remain about the
persistence of inflation. The ECB must decide if April’s numbers are the start of a
trend or merely an aberration. It must also decide to what degree weak credit
conditions are sufficient to further suppress inflation. After all, monetary policy
acts with a lag. It is difficult to know if what the ECB has already done is
sufficient. In a sense, implementing monetary policy is like navigating a car on a
highway while facing backwards.

A day after the US Federal Reserve raised its benchmark rate, the ECB followed
suit, raising its rate by a similar 25 bps. This is a smaller increase than previously
expected. The new benchmark rate is now 3.25%, still well below that of the
United States. Meanwhile, Eurozone inflation remains higher than in the United
States. Although Eurozone inflation has decelerated, core inflation has not.
27/34
 ECB President Lagarde said that “we have more ground to cover and we are not
pausing, that is extremely clear.” She said that the cost of borrowing is now in
“restrictive territory.” She also added that the slower pace of interest-rate
normalization this month reflects concerns about the banking crisis that began in
the United States and its potential impact of European capital markets.

If the ECB continues monthly increases of 25 bps, it will reach a rate of 3.75%
in July. This would match the highest level in ECB history, which happened in
2001. Meanwhile, the ECB said that it will slow the pace of purchasing bonds to
replace those that mature. The idea is to shrink the ECB’s balance sheet at a
faster pace. It is a form of quantitative tightening meant to boost longer-term
borrowing costs.

Week of May 1, 2023

Will companies diversify supply chains rapidly or gradually?

The US economy continues to grow

US consumer spending is stable as income rises

Europe’s economy barely grows

Japan struggles with demographics

Will companies diversify supply chains rapidly or gradually?

Major unexpected shocks to the global economy in recent years have led to new
debate about the future of globalization and the design of global supply chains.
These events included trade wars, pandemic, war in Ukraine, and lockdowns in
China. The fear of further unexpected shocks, especially with respect to China, has
led many to expect global companies to rapidly diversify their supply chains away
from China. There is anecdotal evidence of companies reducing exposure to China
and boosting investment in such places as Southeast Asia, India, Mexico, and
Central Europe. Indeed, a recent report indicates that China’s share of US imports

28/34
 of manufactured goods has gradually declined in the last few years. The Asian
countries that gained at China’s expense were Vietnam, Thailand, Taiwan, and
India. This shift was likely due to concerns about geopolitical risk, especially at a
time of heightened tension between the United States and China.
Still, there is also a view that a large-scale shift of production from China to
other countries is not possible, at least in the short to medium term. The
ecosystem that developed in the last 40 years around Chinese manufacturing is
too deep and vast to be quickly disrupted. China is so much bigger than such
countries as Vietnam and other Southeast Asian nations that it is not possible to
move the lion’s share of Chinese capacity to these countries. Thus, even as global
companies effectively purchase insurance against political risk in China by
moving assets to other countries, they are likely to be left with considerable
exposure to China in the coming years. 

On the other hand, there is some evidence of rapid change. For example, the
Chinese share of US container import volume dropped from 42% last year to
roughly 32% now. The share attributable to other Asian countries increased
commensurately. Moreover, although Vietnam cannot absorb a massive shift of
capacity from China, a combination of Southeast Asia and India might be large
enough to facilitate a considerable adjustment over time. Within Southeast Asia,
Indonesia is a massive economy with tremendous potential. Thus, debate will
continue about the speed at which globalization moves away from dependence
on China. Yet there is no debate that a change is taking place. 

The US economy continues to grow

First quarter GDP data signaled a slowing of the US economy and increased risk of
recession. At least that is the story much of the press carried in recent times. Real
(inflation-adjusted) GDP grew from the last quarter of 2022 to the first quarter of
2023 at an annualized rate of only 1.1%. This was significantly slower than the
growth rate of 2.6% in the previous quarter. Notably, however, most components
of GDP, including consumer spending, exports, and government purchases, grew at
a healthy pace. Business investment in equipment and investment in residential
property both fell slightly. 

29/34
Yet the main reason that real GDP grew slowly was a sharp decline in business
inventories. The change in inventories is a component of GDP. If that component
is excluded, real GDP grew at a rate of 3.4%—a very healthy rate of expansion.
The decline in inventories meant that businesses sold off existing inventories
rather than produce enough to satisfy rising demand. This bodes well for GDP
growth in the current quarter if one assumes that businesses will have to
replenish their inventories to meet demand. It assumes that demand will be
sustained. Thus, the outlook for the current (second quarter) is not necessarily
bad, especially given the favorable purchasing managers’ indices (PMIs) reported
earlier this week. They signal strong underlying demand. 

Let’s look at some details of GDP growth in the first quarter of 2023. First, real
personal consumption expenditures grew at a rate of 3.7%. This included
growth of 16.9% for durable goods, 0.9% for nondurable goods, and 2.3% for
services. The lion’s share of durable goods growth was due to strong demand in
the automotive sector. The strength of consumer spending was related to the
rapid growth of consumer income. Real disposable personal income increased at
an annualized rate of 8.0 in the first quarter. This reflected strong job growth as
well as the impact of a sizable cost of living increase for recipients of Social
Security. Given that the increase was a one-off event, it is likely that consumer
spending growth will recede somewhat in the current quarter.

Meanwhile, nonresidential fixed investment only grew at a rate of 0.7%. This

included an 11.2% gain for investment in structures, a 7.3% decline in
investment in equipment (computers, telephony, transport), and a 3.8% increase
in investment in intellectual property (software, R&D, branding). Investment in
residential property fell at a rate of 4.2% after having fallen far faster in the
three most recent quarters. Thus, one could argue that the housing sector is
starting to stabilize.

Exports of goods and services were up at a rate of 4.8% while imports were up
2.9%. Finally, real government purchases increased at a rate of 4.7%. This
included a 10.3% increase in nondefense purchases by the Federal government,
5.9% for defense purchases, and 2.9% for state and local government. 

30/34
 Overall, the GDP report was not as bad as was reported in the press. That is not
to say that there are no headwinds. The Federal Reserve is expected to further
tighten monetary policy, likely in the coming week. It will do this at a time when
the US banking system is modestly reeling from the impact of recent bank
failures. Thus, a combination of tighter monetary policy and weakened credit
markets could curtail growth in the coming months, thereby boosting the
possibility of a recession. 

US consumer spending is stable as income rises

After declining from January to February, real (inflation-adjusted) consumer
spending was unchanged in March. This was despite an increase in real disposable
personal income. That was because households increased their saving from 4.8% of
disposable income in February to 5.1% in March. This was the highest savings rate
since December 2021. 

The stability of real consumer spending was entirely due to an increase in

spending on services. Spending on both durable and nondurable goods declined
in March from the previous month. Durables were down 0.8% while
nondurables were down 0.1%. This was offset by a 0.1% increase in spending
on services. 

This pattern is consistent with the reversion to normal consumer behavior

following the pandemic-period surge in spending on durable goods. Moreover,
you will recall that the inflation of the last two years was initially generated
because of that surge in durables spending. Now, with spending on durables
falling, inflation is abating, especially inflation for goods. 

Indeed, the government’s report on income and spending included data on the
Federal Reserve’s favorite measure of inflation: the personal consumption
expenditure deflator, or PCE-deflator. This measure was up 4.2% in March from
a year earlier, the lowest since May 2021. Notably, prices of durable goods were
up only 0.8% from a year earlier while prices of nondurables were up 2.1% and
prices of services were up 5.5%. This is a complete reversal of what transpired
early in the pandemic. Meanwhile, when volatile food and energy prices are

31/34
 excluded, core prices were up 4.6% in March from a year earlier, the lowest
since December 2022. 

The latest report suggests that household income continues to grow modestly
while spending is stagnant but not declining. It also indicates that inflation is
decelerating but that core inflation is a bit more stubborn that overall inflation.
This situation does not provide the Federal Reserve with an unambiguous road
map, which is why debate remains about what the Fed will do and what it
should do. 

Europe’s economy barely grows

The economies of the European Union (EU) and the smaller 20-member Eurozone
both grew in the first quarter of 2023, but only modestly. Compared to the
previous quarter, real GDP was up 0.1% in the Eurozone and up 0.3% in the larger
EU. Compared to a year earlier, real GDP was up 1.3% in both the EU and
Eurozone. This performance was significantly slower than in the United States,
which just published its GDP data last week. Still, it is an improvement since the
previous quarter. At that time, real GDP fell in the EU from the previous quarter
and was unchanged in the Eurozone. Thus, it appears that the economy is
rebounding slightly. However, the first-quarter numbers were worse than many
observers anticipated. This led some investors to expect the European Central Bank
(ECB) to be cautious about further tightening—despite persistent high inflation.

By country, there was divergence. Italy and Spain both grew at a moderately
healthy pace with real GDP rising 0.5% from the previous quarter. Spain’s real
GDP was up 3.8% from a year earlier while that of Italy was up 1.8%. France’s
economy grew more modestly, up 0.2% from the previous quarter and up 0.8%
from a year earlier.

The worst performer in the region was Germany, with real GDP unchanged from
the previous quarter and down 0.1% from a year earlier. Still, this was better
than the decline in real GDP in the fourth quarter. Germany has been especially
vulnerable to the energy shock given its significant dependence on Russian
energy. 

32/34
Japan struggles with demographics
It has long been known that Japan faces some onerous demographic trends due to
low birth rates and very little immigration. The government now says that, by
2050, Japan’s population will fall below 100 million. Moreover, the population is
expected to reach 87 million by 2070. Keep in mind that the population is currently
roughly 126 million. The population peaked at 128 million in 2010 and has been
steadily declining. 

Not only is the population falling. The working-age population is falling even
faster as the population ages. Thus, the ratio of workers to retirees will fall
rapidly. This implies onerous costs for pension and health care. This can be
funded through higher taxes (which has already begun with periodic increases in
the national sales tax), lower pension benefits, a higher retirement age, and/or
more immigration. As for the latter, immigration has, indeed, accelerated. Still, it
remains at a level much lower than is found in most advanced economies. 

Ultimately, the best solution to this dilemma would be a surge in productivity

growth, which, in turn, would lead to faster economic growth. That would mean
that the pie would increase in size, thereby enabling retirees to have an adequate
share of the pie without forcing workers to take a much smaller amount of
income. Boosting productivity will require innovation, driven by strong
investment in human capital, a vital market for financial capital, free flow of
information and ideas, and openness to foreign investment. Also, the experience
of other countries suggests that immigration can contribute to innovation. 

Meanwhile, the government has taken steps to encourage people to have more
children. It has also taken steps to encourage more female participation in the
labor force. In addition, it has encouraged more older people to remain in the
labor force. The goal is to prevent a sharp decline in the number of workers.

 Acknowledgments

33/34
 Cover image by: Sofia Sergi

Deloitte Global Economist Network

The Deloitte Global Economist Network is a diverse group of economists that
produce relevant, interesting and thought-provoking content for external and internal
audiences. The Network’s industry and economics expertise allows us to bring
sophisticated analysis to complex industry-based questions. Publications range from
in-depth reports and thought leadership examining critical issues to executive briefs
aimed at keeping Deloitte’s top management and partners abreast of topical issues.

Ira Kalish
Chief Global Economist, Deloitte Touche Tohmatsu
ikalish@deloitte.com

34/34