Economists are not known for their optimism, but today their good mood is palpable. Not so long ago, it seemed like a US recession was inevitable, as the Federal Reserve kept raising interest rates to fight inflation. Other central banks have followed suit, their inflation problems compounded by the rising dollar – a particular problem for emerging markets that borrow and trade using US currency. Still, news that the headline annual inflation rate in the United States fell to 3% in June has fueled hopes that the Fed’s next rate hike, scheduled for July 26, will be its last and that other central banks may also relax. Stocks are up, bond yields are down and the greenback is near its weakest level since the Fed started raising rates.
The surge of hope is all the more unusual as the global economy is slowing. On July 17, China announced that its economy grew just 0.8% in the second quarter from the previous three months, although many expected a boom after the government scrapped its zero-covid policy in December. Global manufacturing suffered as consumers emerged from lockdowns and started eating more and buying less home office equipment. And, although America experienced strong growth in the first half of the year, most forecasters expect the economy to slow soon.
Increasingly, however, they do not expect it to diminish. And slowing growth just enough to bring inflation down without a recession is the best case scenario for overheated economies like the United States. Even the disappointing reopening of China, which has no inflation problem of its own, has prevented the dreaded spike in global commodity prices. This helped Europe, which replaced piped Russian gas with liquefied-type shipments.
Still, it would be a mistake to assume that the global economy is now on track for a so-called soft landing, for three reasons. The first is that inflation, although lower, remains well above the central bank’s 2% targets. The drop in the US key rate was driven by a one-off drop in energy prices: excluding food and energy, and prices are 4.8% higher than a year ago. In the Eurozone, the figure is 5.5%, and in both economies wages continue to grow well in excess of productivity growth.
In other words, the rich world still has a long way to go before it is completely deflated – and many economists expect the last mile to be the hardest. Although stubborn inflation of, say, 3-4% might not grab the headlines as much as recent alarming price rises, it would still be a problem for central bankers. They may have to choose between tightening more than currently expected or tacitly abandoning their 2% target. Either would be disruptive to asset markets and potentially to the real economy as well.
The second risk is that while the world is now seeing the benefits of cooling, the costs may not be visible for some time. So far, the US labor market has rebalanced quite easily by shrinking vacancies rather than jobs. Hiring is still strong and layoffs are rare. With fewer job openings, wage growth has slowed. Still, no one knows how long the job market can shed fat rather than muscle – and in recent months job vacancies have come to a worrying halt. Across the rich world, there is evidence that companies, scarred by the memory of labor shortages, are hoarding workers they don’t need; in several countries, the average number of hours worked has fallen. If companies decide it’s too costly to hang on to workers who may or may not be needed in the future, then layoffs could spike.
The third danger is that the divergence among the world’s major economies means that even if the pressure on the Fed eases, policymakers elsewhere remain worried. Britain celebrates a bigger-than-expected fall in annual inflation in June, but with underlying price and wage growth of around 7%, it remains a troubling outlier (see Britain section). Japan has barely started its monetary tightening; with rising inflation, the Bank of Japan may again adjust its ceiling on long-term bond yields at the end of July. China could face a structural slowdown in growth where the economy is weighed down by bad debts, like that of Japan in the early 1990s, and where inflation is permanently too low.
In other words, wherever you look, there remains immense uncertainty as to where inflation and interest rates will eventually stabilize. By all means, celebrate the good news. But the global economy has not yet emerged unscathed.
© 2023, The Economist Newspaper Limited. All rights reserved. From The Economist, published under licence. Original content can be found at www.economist.com
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