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Economists aren't known for their optimism, but today their exuberance is palpable. Not so long ago, an American recession seemed inevitable as the Federal Reserve continued to raise interest rates to combat inflation. Other central banks followed suit, and the inflation problem was exacerbated by a strong dollar, which was especially problematic for emerging markets that borrowed and traded using the U.S. currency. However, news that the headline US annual inflation rate fell to 3% in June raises concerns that the Fed's next interest rate hike, expected on July 26th, will be the last and that other central banks may also ease. Expectations are rising. Stocks are rising, bond yields are falling and the dollar is near its lowest level since the Fed began raising interest rates.
The rise in hope is even more unusual as the global economy is slowing. July 17: China's economic growth in the second quarter slowed compared to the previous three months, despite many expecting a boom after the government abandoned its “zero coronavirus” policy in December. reported that it was only 0.8%. Global manufacturing has taken a hit as consumers emerge from lockdown, eating out more and buying less home office equipment. And although America experienced strong growth in the first half of this year, most forecasters expect the economy to slow soon.
But they don't expect it to shrink in size. And the best-case scenario for an overheated economy like the United States is for growth to cool enough to rein in inflation without triggering a recession. Even if the restart of economic activity in China, which does not suffer from inflation per se, has been disappointing, it also means that the feared rise in global commodity prices has not materialized. This helped Europe replace Russian piped gas with liquefied gas transportation.
However, it would be a mistake to think that the global economy is currently on a so-called soft landing trajectory for three reasons. First, although inflation has fallen, it remains well above the central bank's 2% target. The decline in headline U.S. interest rates is driven by a temporary decline in energy prices, which are 4.8% higher than a year ago, excluding food and energy. In the euro area, the figure is 5.5%, with wage growth still far outpacing productivity growth in both countries.
In other words, the rich world still has a way to go to completely eliminate inflation, and many economists expect the last mile to be the most difficult. Stubborn inflation of, say, 3% to 4% may not be as talked about as the recent alarming price increases, but it will still be a problem for central bankers. The Fed may have to choose between tightening more than currently expected or implicitly abandoning the 2% target. Both would be disruptive to asset markets and potentially destructive to the real economy as well.
The second risk is that although the world is now realizing the benefits of cooling, the costs may not be visible for some time. So far, the U.S. labor market has rebalanced fairly painlessly by reducing vacancies rather than hiring. Employment remains strong and layoffs are rare. Wage growth is slowing because there are fewer jobs available. But no one knows how long the job market will be able to lose fat instead of muscle. And in recent months, the decline in job openings has been eerily stagnant. Across the rich world, there is evidence that companies are buying up unnecessary workers, scarred by the memory of labor shortages. Average working hours are decreasing in some countries. Layoffs could surge if companies decide it's too costly to hire workers who may or may not be needed in the future.
A third danger is that disagreements among the world's economic powers mean that even as pressure on the Fed eases, national policymakers remain concerned. Although the UK celebrated a stronger-than-expected decline in annual inflation in June, it remains a worrying outlier given that real price and wage growth is around 7% (UK section). Japan has only just begun monetary tightening. The Bank of Japan may readjust the cap on long-term bond yields at the end of July as inflation rises. China, like Japan in the early 1990s, may be facing a structural growth slowdown with bad debts weighing down the economy and inflation too low.
So no matter where you look, there remains a great deal of uncertainty about where inflation and interest rates will end up. Let's celebrate the good news. However, the global economy is not yet intact. â–