Viet Hustler's weekend macroeconomics column will start a 4-part article series on Global Macroeconomic Perspective. In which, Viet Hustler will analyze the interactions between the economic policies of major central banks, at a time when the global economy is facing risks of inflation/deflation and recession.
This week, Episode 1 of the series will focus on the synchronization and divergence of inflation cycles and monetary interest rate policies in the Eurozone and the US - two regions long considered longstanding economic allies.
In June, when Fed paused rate hikes to monitor the market, ECB continued to steadily increase rates. This slight divergence could mark the beginning of larger differences in policy direction between ECB and Fed.
So what causes ECB to start diverging from the policy path with Fed?
What impact does the asynchrony in interest rate policy between these two traditional economic allies have on the US economy?
This is the main content of the first article in the Global Economic Perspective series that Viet Hustler has prepared for readers.
Economic and inflation situation in Europe: ECB's direction
Europe seems to have been left behind in the global disinflation trend.
Eurozone inflation remains at +5.3% y/y in August 2023, unchanged from the July figure and higher than the +5.1% forecast for August.
Core inflation fell to 5.3% in August (from 5.5% in July) but remains too high and quite sticky (not much reduced from the peak).
Both the US, Eurozone and UK in later stages faced structural inflation issues due to wage-price spiral, where nominal wage growth is too high while labor productivity remains unchanged.
But the US is gradually emerging from this situation, while Eurozone and UK are still struggling to adjust the inflation structure.
For example in Germany, real wage growth continued to return above 0% in August (nominal wage +6.6% y/y): meaning wages are rising faster than inflation!
This will create pressure from wage-price spiral keeping inflation sustained at high levels.
Europe is standing at the threshold of recession
2 out of 6 largest European economies (Germany and Netherlands) have entered recession!
In the Netherlands:
Official recession began in the Netherlands as GDP fell -0.3% consecutively in the first two quarters.
The main reason is the weakness in domestic consumer spending (down to -1.6%) and exports (down -0.7%).
In Germany: the economy is in recession due to the burden of weakening global economy.
Germany's economy continued to stagnate in Q2/2023, mainly due to exports falling to -1.1% (net exports -0.6%).
Germany's economy depends heavily on exports, especially heavy industry exports. However, declining global demand for goods has greatly affected the industrial production of Europe's big brother.
Germany's DAX 30 stock index fell -0.6% last Friday, led by the decline in automotive industry value (Germany's spearhead manufacturing sector).
This is a consequence of the survey results from Germany's Ifo Institute showing ~50% of automakers lack orders, causing production activities to stall.
Germany's economy is forecasted to continue stagnating in Q3/2023, following the situation in the first two quarters of this year.
According to forecasts, Germany could be the only major European economy to contract in 2023 (GDP down -0.3% y/y, according to Bundesbank forecast).
In addition, Germany is also gradually facing a weakening labor market:
The number of unemployed in Germany increased by nearly +30,000 in August 2023, a large number compared to Germany's population and territory size.
Germany's unemployment rate has been rising sharply in the past 3 months, reaching 5.8%. In the following months, if the unemployment rate continues to rise, Germany will sink deeper into recession.
Despite the recession, German Chancellor Olaf Scholz refuses calls to increase federal spending (financed by government borrowing) to boost economic growth, due to concerns about public debt burden and the current fiscal deficit situation.
This is a correct decision according to Viet Hustler, because ECB's interest rate policy is having less and less impact on Germany and Spain…
…when inflation in these 2 countries is still quite sluggish (even continuing to rise in Spain).
If Germany continues economic bailout through fiscal policy increasing government spending, it will reverse the impact of monetary policy from the ECB.
But if there is no adjustment from fiscal policy to stimulate growth, Germany may bog down in a long-term recession.
Unemployment is showing signs of rising, inflation is stubborn and staying high, economic output is declining and the possibility of long-term stagnation in recession…
=> The German economy is showing signs of Stagflation!
The economic environment in Europe is gradually cooling down
Although the overall EU economy still has growth (due to some countries with hot growth like Poland - GDP up +4.8%), the trade environment in Europe's major economies is gradually cooling down:
Two indicators providing signals about future business activity (similar to manufacturing PMI): Ifo index in Germany and INSEE survey in France both show that Europe's two largest economies are on a cooling trajectory:
Germany's Ifo index falls to disappointing figure 85.7 in August (lower than expected 86.7) - the lowest since October 2022 (peak of last year's energy crisis).
INSEE's business climate index also falls below the 100 threshold, ~ business activities in France are slowing down just like previous EU crisis and recession periods.
Industrial production in Europe's three largest economies: Germany, France, and Italy has been stagnant in recent years after the 2008 financial crisis and has not recovered to 2007 levels.
Industrial production in Germany and France even declined after the Covid pandemic.
ECB is betting economic growth on the price stability target
At last week's Jackson Hole conference, ECB President Christine Lagarde emphasized 3 main issues of the Eurozone (and EU) currently:
Labor market: wage growth continuously “chasing” prices (as mentioned above).
Energy transition process: Europe affirms it will pursue the green energy process.
Global geopolitical divisions: could cause global import volumes to decrease by 30% (ECB estimate) …
Most importantly, Lagarde presented a quite hawkish stance of the ECB (compared to the Fed) on interest rates, possibly due to the stubbornly high inflation situation in Europe currently:
The ECB may keep high interest rate policy for a long time so that inflation can return to 2% quickly.
Full speech of Lagarde here.
ECB member P. Wunsch also said that the ECB may need to raise interest rates a bit higher.
It should be emphasized that: The ECB has raised interest rates 11 consecutive times in this cycle, with cumulative increase of +4.25%.
This is the most hawkish rate-hiking cycle in the history of the Eurozone.
In addition, The ECB continues strong monetary tightening (QT), in which the balance sheet has decreased from EUR 8,835 billion to EUR 7,153 billion in just over a year.
The ECB's total assets currently equivalent to 53% of Eurozone GDP (compared to Fed: 30% US GDP, BOE: 33% UK GDP and BoJ: 126% Japan GDP).
The ECB's high interest rate policy is gradually being transmitted across Europe through the financial channel (as the ECB has difficulty controlling bloc consumer spending demand due to different fiscal policies in countries).
Borrowing costs, consumer loans are rising due to higher policy rates.
In addition, deposit interest rates are also rising high, encouraging people to reduce current consumption to save (smoothing consumption).
But the downside of the policy transmission channel through the financial market is:
... the burden on people and businesses needing to refinance capital during this time with borrowing rates gradually reaching higher peaks.
..the steps in the monetary tightening process in the Eurozone are also gradually pushing this area into recession:
Eurozone M2 money supply is decreasing at an increasingly rapid rate: down -1.4% in July 2023 (the largest decline in history).
This is a positive sign for reducing inflation but a negative sign leading to recession due to credit crunch.
And the fact is that Germany and the Netherlands have already entered recession!
Credit crunch: Business lending and home purchase activities in the Eurozone are returning to the “ugly” state of the sovereign debt crisis period in 2012-2015.
=> This is the trade-off that the ECB anticipated when they faced the dilemma: the economy must weaken in exchange for the price stability target.
In reality, due to fragmentation risk, ECB does not have much room for soft-landing like Fed!
Therefore, Viet Hustler believes that in the meeting on 09/14 upcoming, ECB will continue to raise interest rates even though Fed may stop raising rates in September.
This could be the ECB's last rate hike, but ECB may keep rates high for a long time. This will worsen the capital markets in the Eurozone.
US Macroeconomy: Impact of labor report on September FOMC
Two important pieces of information that could lead to the Fed stopping rate hikes in this September meeting:
Inflation is already on a downward trend according to deflationary effect, , the decline in free-market rental prices will also ensure that housing inflation is no longer the main concern in the near future (and Fed/Powell are fully aware of this).
Related articles:
The labor market has shown many signs of “normalization”, creating less pressure on inflation through wage-price spiral.
Weekly highlights on labor report by Viet Hustler:
Notably, the unemployment rate surged to 3.8% in August (from 3.5% in July), the highest since February 2022.
Wage growth has slowed month by month: down from +0.4% m/m in July to +0.2% m/m August 2023.
Hourly wage growth rate increased +4.29% y/y in August, still high but the slowest growth rate since July 2021.
Total employment increased +2.0% y/y, the lowest growth rate since March 2021. This confirms that the labor market continues to loosen and gradually normalize.
Most importantly, the labor market may not be as tight as we previously thought,
In the first 6 months of 2023, the labor report via payroll numbers (NFP) has been revised down by a total of -325,000 jobs:
January: revised from +517,000 => +472,000 jobs (down -45,000)
February: +311,000 => +248,000 (down -63,000 jobs)
March: +236,000 => +217,000 (down -19,000 jobs)
April: +253,000 => +217,000 (down -36,000 jobs)
May: +339,000 => +281,000 (down -58,000 jobs)
June: +209,000 => +105,000 (down -104,000 jobs)
Such large downward revisions are currently only seen in the recessions of 1980, 1981-82, 1990-91, the 2008 financial crisis, and COVID.
=> This confirms that the US job market is not as tight as we thought.
….with regard to the revisions in the labor report, the current interest rate level is already “completely sufficient” to curb inflation: inflation will gradually decline in the coming time due to policy lag!
Even, the labor market may weaken unexpectedly in the next year, as the impact of credit crunch gradually materializes leading to mass layoffs by businesses.
In reality, the new hiring rate has decreased particularly sharply in the past two months, dropping from 4.0% in May to 3.7% in July/2023:
What will the September FOMC bring?
The September FOMC may turn out just as the market expects: Fed will pause the rate hike cycle based on the above labor, inflation, and housing rent data.
The market has raised the odds of the Fed holding rates steady in the September FOMC to 94%.
The market still believes that the Fed may continue to hike rates in the November-December/2023 meetings before cutting rates early next year.
However, given the labor market and inflation situation, Viet Hustler believes the Fed is highly likely not to continue raising rates in the last 4 months of the year!
The reason is that a US economic recession may arrive in the next six months once consumption and retail collapse:
The US savings rate has dropped from 4.3% to just 3.5% in July/2023,
… explaining why US consumer spending is still increasing in the summer months despite the pressure of credit crunch.
Asynchronous interest rate policies between ECB and Fed: what could happen to the US?
From the above analyses, it is clear that ECB is becoming more hawkish than Fed:
because ECB is lagging behind Fed in this inflation and interest rate policy cycle: ECB will extend the tightening cycle beyond Fed's cycle because inflation in the US is falling faster than in Europe.
Likely in September, ECB will continue to hike rates while Fed pauses this rate hike cycle.
So, what impact will the asynchrony in interest rate policy between these two superpowers and economic allies have on the US?
Forex market: The value of EURO will continue to rise against USD
With base interest rates in the Eurozone rising while base rates in the US stay steady, the EUR will become stronger.
Because interest rates are the cost of borrowing, also the value for “exchanging” currencies, high interest rates in Eurozone mean the value of EUR increases (relative to USD).
However, the increase in EUR value due to interest rates may disappear in the long term if Eurozone sinks deep into recession.
The trade balance in September-October will shift favorably for US exports and unfavorably for US imports, as USD weakens relatively against EUR.
This could reduce the US trade deficit with Europe, benefiting US economic growth and soft-landing prospects (though not too much since US GDP largely depends on domestic consumption).
Impact on private investment (FDI) between the two regions: (impact not very clear)
Net direct investment flows (net FDI) from the US to EU are in surplus, meaning capital flows from the US to EU exceed those received by the US from EU.
Once yields in EU rise relatively higher than in the US, capital flows may continue to pour into EU. But this is not entirely certain due to the higher recession risk in the Eurozone compared to the US.
CONCLUSION
In comparison to the US macroeconomic situation, at present, Europe is facing a more stubborn and prolonged inflation cycle, accompanied by an impending recession.
Europe's leading economy Germany is showing signs of stagflation: with unemployment starting to rise sharply, the economy entering a recession phase while inflation remains above 6%. Notably, the German chancellor has temporarily refused to use fiscal measures to stimulate growth, which could prolong economic stagnation.
ECB's interest rate and monetary policy can only be transmitted through the capital markets channel due to fiscal policy asynchrony and public debt situations of member states. Therefore, the trade-off between economic stagnation to ensure price stability targets is unavoidable for ECB.
Meanwhile, in the US, the job market has shown positive shifts and is less tight.
Wage growth is gradually normalizing, the unemployment rate is trending upward again indicating that wage/labor demand pressures have eased in businesses and wage pressure on inflation has diminished. Even, the labor market tightness in the first half of 2023 was not as severe as we thought after job numbers were revised down by up to -325,000 jobs in the first 6 months.
With inflation having declined and expected to return to 2% after housing rents are adjusted in the CPI basket, a loosening job market is likely to prompt Fed to pause rate hikes in the September meeting.
From here, we can clearly see the policy mismatch (policy asynchrony) between the two long-time economic allies ECB and Fed: as ECB is becoming even more hawkish while Fed begins to pivot.
The first impact could be on the EUR-USD exchange rate, directly altering the trade balance between the US and Europe. Additionally, differing policy moves between the two regions could also affect FDI between the two sides; however, this impact will be further adjusted if Europe slips deeper into recession. Nevertheless, ultimately, the Fed and ECB always stand on the same frontline regarding interest rate and monetary policies.
Perhaps only the policies of the PBOC (People's Bank of China) and, especially, the BoJ (Bank of Japan), which are going against the policies of Western countries, have the potential to create many ripples for the US and Europe.
Next week, Viet Hustler will deliver to readers an analysis of the impact of BOJ policy on the current financial markets in the US and Europe, revealed through the famous meme at Jackson Hole below (image source: Nakamura).
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