Weekly global economic update

Real business fixed investment increased at a rate of 2.9%. This included a 2.1% increase for business equipment (the first increase in three quarters, fueled by investment in information technology and offset by a sharp drop in investment in transportation equipment), a 0.1% decline for structures, and a 5.4% increase for intellectual property (which includes software and R&D). Real investment in residential property was up at a rate of 13.9%. On the other hand, a decline in business inventories reduced real GDP growth by 0.35 percentage points. The rise in investment in information technology was the strongest since the first quarter of 2022. This bodes well for demand for consulting services. 

Meanwhile, although real exports of goods and services were up 0.9%, imports were up 7.2%. This means that net exports made a negative contribution to GDP growth. In addition, while state and local government purchases were up at a rate of 2%, real Federal purchases were down 0.2%. 

Although real GDP grew more slowly than expected in the first quarter, the core components did very well. Final sales to private domestic purchasers (which excludes the impact of trade, government, and inventories) were up at a rate of 3.1%. This was the second-fastest rate of growth since the fourth quarter of 2021 when the economy was bouncing back from the pandemic downturn. Thus, the news on economic growth remains relatively good. Moreover, the news suggests that the United States remains a prime engine for global economic growth. Still, the weak headline number evidently spooked investors. 

• The US government also published data on household income, consumer spending, and the Federal Reserve’s favorite measure of inflation. Although the news on household spending was good, investors mainly focused on the inflation numbers. 

Specifically, it was reported that the personal consumption expenditure deflator (PCE-deflator) was up 2.7% in March from a year earlier, up from 2.5% in February. This was the first acceleration in the index since September 2023. However, when volatile food and energy prices are excluded, the core PCE-deflator was up 2.8% in March versus a year earlier, the same as in February. Core inflation has been relatively steady for four months, suggesting that the previous deceleration has halted. 

The inflation problem remains one of services, which are labor intensive. Thus, the problem is the tight labor market, which is generating significant wage gains. Specifically, prices of durable goods were down 1.9% from a year earlier while prices of non-durables were up only 1.3%. This included food, which was up just 1.5%. Yet prices of services were up 4% from a year earlier, roughly unchanged over the past five months. 

As such, it is not surprising that futures prices are implying a 60% probability that the Fed will start cutting rates in September. Plus, they imply only a 50% chance of a second rate cut in 2024. This is a sea change from just a few months ago when investors expected the Fed to start in June and undertake three to four cuts in 2024. The shift in investor expectations reflects the persistent tightness of the labor market and strong underlying demand in the economy. Investors evidently believe that the Fed will not loosen monetary policy while the economy is so strong and underlying inflation is stuck. 

Meanwhile, the US government also reported that, while real disposable personal income was up 0.2% from February to March (the fastest growth since December), real personal consumer spending was up 0.5%, the same as in the previous month. Thus, households continue to reduce savings to enable strong increases in spending. The personal savings rate fell from 3.6% in February to 3.2% in March. 

• The Federal Reserve intends to keep interest rates high for longer, largely because the US labor market has remained unusually tight, thereby generating wage gains that propel inflation in services. Thus, any indication that the labor market is loosening would be welcome news for the Fed. The latest data suggested that labor market tightness is easing. The government reported a sharp slowdown in employment growth in April, although it remains higher than the expected long-term trend. Plus, wage growth in April receded. Let’s look at the data.

The US government report on employment includes results from two surveys: one is a survey of households, and the other is a survey of establishments. The establishment survey found that, in April, 175,000 new jobs were created. This was the slowest job growth since October 2023. On the other hand, the growth for March was upwardly revised to 315,000, an unusually strong number. One month does not make a trend. However, if the slower growth seen in April persists in the months to come, it will likely signal an easing of labor market tightness. That, in turn, might influence the decisions of the Federal Reserve.

By industry, there was very modest job growth in goods-producing industries (mining, construction, manufacturing). There was a decline in employment in information as well as professional and business services and there was very modest growth in financial services, leisure and hospitality, and government. Moderately strong growth took place in wholesale trade, retail trade, and transportation. But the strongest growth took place in health care and social assistance. Overall, April was a relatively poor month for job growth. 

The establishment survey also includes data on wages. The report says that, in April, average hourly earnings of all workers were up only 3.9% from a year earlier, the smallest increase since March 2021. Thus, wage pressure is evidently easing. However, it remains too high given the Fed’s goal of 2% inflation. If productivity were rising rapidly, then businesses could increase wages without increasing prices as they would be getting more out of each worker. Yet as indicated below, productivity growth stalled in the first quarter. 

Finally, the household survey indicated that, in April, employment grew more slowly than the labor force, thereby leading to an increase in the unemployment rate to 3.9%, still a very low level. 

• The US government also reported on labor productivity in the first quarter. Recall that, in the three most recent quarters, labor productivity (output per hour worked) increased rapidly. This was helpful in reducing inflation. It also contributed to strong economic growth. The rise in productivity in 2023 was likely related to business investments in labor-saving and labor-augmenting technologies, a response to the tight labor market. 

Yet, in the first quarter of 2024, labor productivity nearly stalled. Productivity increased only 0.3% from the fourth quarter of 2023 to the first quarter of 2024. This followed strong growth of 3.5% in the previous quarter. The result was that, with wages continuing to rise, unit labor costs (ULCs) accelerated sharply in the first quarter. ULC denotes the labor cost of producing a unit of output. It is calculated as real (inflation-adjusted) hourly compensation divided by productivity. Thus, if productivity rises at the same rate as real wages, then ULCs are unchanged. That implies that companies needn’t raise prices in line with wage increases. 

In the second half of 2023, ULCs were basically unchanged as productivity gains offset real wage gains. Yet in the first quarter, ULC was up 4.7% from the previous quarter. Moreover, ULC was up faster for services than for manufacturing. This is not good news for suppressing inflation, especially given that most of the remaining inflation is the services sector.  

Federal Reserve indicates that rates will remain high for longer

• As expected, the US Federal Reserve left its benchmark interest rate unchanged for now. However, Fed Chair Powell indicated that inflation has been more persistent than anticipated. He said: “It’s likely to take longer for us to gain confidence that we are on a sustainable path to 2% inflation. I don’t know how long it will take.” Consequently, he said that rates will remain high for longer. On the other hand, he said that the Fed will soon start to lighten its program of quantitative tightening. That is, it will slow the pace of asset sales. Doing so will put downward pressure on bond yields. Moreover, he said that an increase in interest rates is “unlikely.” 

Investors were evidently not surprised by this announcement. Bond yields and equity prices moved very little. Investors had already shifted their expectations based on the latest data on inflation and economic growth. 

Although Powell said that rates will remain high for longer, it is not clear if the current level of rates is having the necessary dampening effect on labor markets. As I note below, the job openings rate has been declining, indicating an easing of the tight labor market. Yet that might not be the result of Fed policy. There are likely other factors at work. Still, given the surprising strength of the US economy and US labor market, and given that core inflation has stabilized at a rate too high for comfort, it would likely not make sense for the Fed to cut rates at this time.  

One result of the new trajectory of Fed policy will likely be higher bond yields in the coming year than would otherwise be the case. Indeed, bond yields have risen in the last few months due to changing expectations about Fed policy. Higher yields will likely have a negative impact on merger and acquisition transactions. Moreover, the longer the yields remain high, the bigger the impact as businesses face the need to roll over debts. 

Eurozone economy accelerates while inflation recedes

• The Eurozone economy finally accelerated in the first quarter of 2024 after a prolonged period of stagnation. In the first quarter of 2024, real GDP was up 0.3% from the previous quarter, the strongest rate of growth since the third quarter of 2022. Real GDP was up 0.4% from a year earlier. 

By country, the quarter-to-quarter growth of real GDP was 0.2% for Germany and France, 0.3% for Italy, and 0.7% for Spain. Most notable was the sharp rebound of the German economy, which had seen real GDP decline 0.5% in the previous quarter. German GDP growth in the first quarter of 2024 was the strongest in since the first quarter of 2023. Germany’s government attributed the rebound to strong business investment and exports. These offset weakness in consumer spending. In addition, Italy’s relatively favorable performance was, in part, related to strong exports. 

Going forward, there is reason to expect continued modest growth of the Eurozone economy. Real (inflation-adjusted) wages are rising, thereby creating the conditions for a boost to consumer spending. In addition, an expected easing of monetary policy by the European Central Bank (ECB) will likely have a positive impact on investment and interest-sensitive consumer spending. Meanwhile, a strong US economy and better-than-expected economic performance in China can help to stimulate exports. 

• Inflation in the Eurozone is getting better. Although headline inflation in March was unchanged from the previous month, core inflation continued to decelerate. This potentially sets the stage for an easing of monetary policy by the ECB. However, investors are increasingly expecting the ECB to wait a bit longer before acting. Here are the details.

In March, consumer prices in the 20-member Eurozone were up 2.4% from a year earlier, the same as in February. However, when volatile food and energy prices are excluded, core prices were up 2.7% in March versus a year earlier. This was the lowest core inflation since February 2022. Recall that core inflation peaked at 5.7% in March 2023. Thus, significant progress has been made. 

As in the United States, the main inflation problem is in services. While prices of non-energy industry products in the Eurozone were up only 0.9% from a year earlier, prices of services were up 3.7%. Europe’s labor market remains tight, generating wage gains greater than the rate of inflation, especially when it comes to labor-intensive services. This is the principal concern of the ECB. Still, given that underlying inflation continues to decline, and given that economic growth remains sub-par, it seems reasonable to expect the ECB to start cutting interest rates sometime this year. 

By country, annual inflation in March was 2.4% in Germany and France, 1% in Italy, 3.4% in Spain, 2.6% in the Netherlands, 4.9% in Belgium, and 0.6% in Finland. The numbers for Germany and Spain were higher than in the previous month. This raised questions as to whether inflation is becoming sticky. For the ECB, this implies that the last mile toward the 2% target could be difficult and might require tighter policy for longer. In response to the inflation news, bond yields in Europe were up as investors reassessed the timing of a rate cut.  

Mexico-China trade tensions increase

• Geopolitical tensions and uncertainty have led to a decline in foreign direct investment in China, especially on the part of US-based companies. Global companies are diversifying supply chains with resilience and redundancy in mind. One country that has attracted attention is Mexico. That is because it has relatively low labor costs (lower than in China), low costs of transporting goods to the United States, free trade with the United States, and relatively good political relations with the United States. 

Consequently, some Chinese companies are investing in Mexico, importing components from China to be assembled in Mexico for export to the United States. The US Mexico Canada Agreement on trade requires that a certain amount of value added be created in Mexico for goods to qualify for tariff-free entry into the United States. Still, the United States has pressured Mexico about the surge in Chinese exports to Mexico. Notably, Chinese exports to Mexico were up 34.8% from 2022 to 2023. From China’s perspective, trade with Mexico serves two purposes. First, it contributes to the production of goods in Mexico that are exported to the United States. Second, Mexico is seen as a valuable market in its own right. 

Mexico, however, is concerned lest the United States clamp down on trade with Chinese entities based in Mexico. Already, Mexican-US trade has increased significantly, with Mexico now the largest trading partner for the United States. As such, Mexico is now imposing tariffs on imports from countries that do not have free trade agreements with Mexico. Mostly, that means China. The tariffs, ranging from 5% to 50% will affect 544 product categories including steel, aluminum, textiles, and apparel. 

Mexican tariffs come as other countries consider restrictions on trade with China. In many countries, there is concern that China is dumping cheap products on global markets due to excess capacity and weak domestic demand. For China, tariffs will likely damage the ability to boost exports as a source of economic growth.

Meanwhile, although the United States has expressed concern about Chinese investment in Mexico, the reality is that the numbers remain relatively small. In the first quarter of 2024, the United States accounted for 57% inbound foreign direct investment in Mexico, with Germany accounting for 17%. China, on the other hand, only accounted for 6%.