Central banks are raising policy rates to reduce aggregate demand and bring it back in line with the productive capacity of the economy. We are seeing more signs that this is happening, though given the still high levels of inflation currently, it is clear to us that more needs to be done.
The most recent sign was the fall in Chinese export growth, something we have not seen since 2020. Exports to the US have been negative for several months, while exports to Europe have now dropped as well (see Exhibit 1). The figures for the US are all the more surprising given the strength of the US dollar. It has appreciated by 14% against the Chinese yuan, which would normally increase US imports.
Faster in Europe than in the US
Purchasing Manager Indices (PMI) for October paint a similar picture for Europe: all the readings were below 50 (indicating contraction), with the exception of the index for the French services sector. Most figures for the US were still in expansionary territory.
Europe’s economy is weakening ahead of that of the US as the region is facing not only higher interest rates (the change in 10-year bond yields has been about the same for both areas), but also an energy shock. Europe is likely already in a recession that will continue into the first quarter of 2023.
Contrasting data has come from the US, where the labour market remains robust. Consensus estimates were for the creation of 200 000 new jobs in October, when the actually figure came in at 233 000. September’s number was revised upward. The unemployment rate dropped to 3.6%.
Such a strong labour market, and the high wage growth that goes along with it, pose a dilemma for the US Federal Reserve. As it thinks about how much and how quickly it needs to raise policy rates, wage growth is crucial as the key driver for services inflation. Without a deceleration in wage growth, it is hard to see services inflation reverting from its current 7.4% year-on-year gain to the 2.7% it averaged in 2019.
‘Excessive’ wage growth is not just a US problem, however. Wages are rising rapidly in Europe as well, which underscores that the ECB’s problem is not only adapting policy rates to account for higher energy prices, but also moderating demand (see Exhibit 2).
The most recent US CPI figure – 7.7% for headline inflation in October versus forecasts for 8.0% and after 8.2% in the previous month – has nonetheless provided some welcome relief to risk assets. The data will support the market’s view that the Fed will be able to begin lowering rates by next spring, even though the central bank has communicated that it plans to keep rates higher for longer.
We are more sceptical that inflation will decelerate as quickly as the market would like, even if growth does.
The week’s other key event, of course, was the US mid-term elections. At the time of writing the results are still unclear, but it appears that the Republican Party will gain control of the House of Representatives, but perhaps not the Senate.
As far as market impact is concerned, it probably does not matter that much whether the Republicans gain control of the Senate, too. Either way, the US faces divided government with the same result of policy gridlock.
On the other hand, if the Democrats do manage to retain control, investors might anticipate further spending. This might lead to higher inflation expectations, but commensurately a higher anticipated path of policy rates from the Fed to offset it.