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Political paralysis in the United States likely – also a problem for Europe?

After the midterm elections in the U.S., there is hardly any time to take a deep breath on the political level. For now speculation will begin as to which of the Democrats and Republicans will enter the race for what will probably be another controversial presidential election in two years’ time. Although the midterm elections may strengthen the more moderate forces in both parties somewhat, society remains divided on many issues. This means political uncertainty at a time when the U.S. economy is likely to slip into recession or at least a slowdown in growth with rising unemployment. With inflation still high and only slowly declining, the Fed has little choice but to continue to raise interest rates sharply. If inflation does not come down faster than generally expected, interest rates will probably rise from today’s four percent to around five percent. The more restrictive monetary policy will slow down the U.S. economy until the presidential elections in November 2024, which is likely to hurt the Democrats in particular as the party of the incumbent.

Fiscal policy, on the other hand, is likely to be much more passive. The opportunity for Biden to boost the cooling economy by increasing spending will probably be limited. The Republicans will probably try to put the brakes on Joe Biden’s plans, which is likely to paralyze political activity to some extent. In view of the arguably too extensive and inflation-driving fiscal packages during the pandemic, a more passive fiscal policy can certainly be viewed positively from a macroeconomic perspective. However, there is also a downside: a recession without a simultaneous fiscal stimulus will make the economic situation more difficult for many people and the election campaign even more heated than is already to be expected. There is also a risk that the regularly scheduled increases in the debt ceiling for the federal budget will once again become the plaything of party interests, increasing the risk of default.

The political paralysis and the two years until the uncertain outcome of the U.S. presidential election come at an inopportune time for the European economies. They are already being jolted by the energy crisis, dramatically high inflation and the cooled global economy. All in all, the U.S. economy is less affected by these factors, and it has also digested the pandemic-related economic slump better than the euro zone. For example, U.S. economic output returned to the pre-crisis level of late 2019 as early as the early summer of 2021, whereas this was not the case in the euro area until the end of 2021 and in Germany, for example, until the summer of 2022.

In addition to all the other burdens on the European economies, there is now uncertainty about the political course of the United States after the upcoming presidential elections – for example, with regard to the future of transatlantic trade relations, support for climate policy goals or the military umbrella for Europe. Such uncertainties could, for example, reduce companies’ propensity to invest and further dampen the already gloomy economic outlook. However, the threat of weak economic development makes it more difficult in Europe to finance the energy turnaround or infrastructure renewal. In the USA, too, investment is needed in the energy turnaround and infrastructure; under Joe Biden, the US government has already made substantial financial resources available for this in the coming years. Against this backdrop, the looming political paralysis until the presidential elections is manageable for the USA in terms of economic policy. Or to paraphrase an old saying of former U.S. Treasury Secretary John Connally from 1971: While the upcoming presidential elections are extremely important, especially for the U.S. itself, they will also be a major problem for Europe because of their great significance and the uncertainties surrounding the outcome.

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Economic slowdown hits euro zone in worse shape than the USA

The global economy is severely impacted by various factors in the summer of 2022. Many countries are on the brink of recession. The Corona lockdowns in China and, from a European perspective, the war in Ukraine in particular, are reducing growth in many places, fueling inflation and bringing the euro zone in particular, but also the United States, to the brink of recession. The Chinese economy is also likely to show low growth rates this year and will not be able to act as an economic locomotive. After the financial crisis, Chinese stimulus programs were stimulating the global economy.

In the first half of 2022, economic output in many countries was already only moderate or even declining. The US economy, for example, contracted by 1.6 and 0.9 percent in the first two quarters of 2022 (annualized). The purchasing managers’ indices and consumer sentiment also point to subdued growth in the summer half-year. In addition, monetary policy is rapidly becoming more restrictive in view of high inflation on both sides of the Atlantic.

In the euro zone, the economy grew by 0.6 percent in the first quarter. However, this was primarily due to still strong export growth and a high inventory build-up. However, private consumption and investment have already declined somewhat. In the euro zone, too, in view of the depressed assessment of the economic situation and outlook among both companies and consumers, only stagnation is to be expected in the summer half-year. The global economy continues to be severely impacted by the war in Ukraine and the Chinese corona crisis. Recently, in particular, concerns about an impending gas shortage and even higher energy prices have increased noticeably again. These developments are also contributing to inflation remaining high. In addition, the export industry is suffering from the weak global economy. At present, the order backlog is still high. However, it can only be processed slowly because global supply chains are still disrupted and the shortage of starting products remains serious in many places. Although there are signs of a gradual easing in supply chains, the war in Ukraine and the lockdowns in China will probably continue to contribute to increased problems in the coming months. Supporting the economy, at least for the time being, are still the services, which are benefiting from the easing of the Corona protection measures. Tourism and the food service industry in particular are enjoying a good start to the summer. However, this recovery process is now gradually coming to an end. In addition, high inflation is significantly reducing household purchasing power, which is contributing to a marked deterioration in consumer sentiment.

Somewhat later than the U.S. Federal Reserve, the European Central Bank (ECB) raised its key interest rates in July to counter high inflation and dampen inflation expectations. In addition, the securities purchase program was ended in June. The increasingly restrictive monetary policy will further dampen the already weak economic growth and, together with the consequences of the war in Ukraine and the corona crisis in China, will probably lead to a slight decline in economic output in some euro area countries.

Looming recession hits euro area at an inopportune time

The growth freeze is hitting the euro area economies in worse shape than that of the United States. The U.S. economy digested the pandemic-induced slump in spring 2020 more quickly than the euro area. For example, the U.S. economy regained its pre-crisis GDP level of late 2019 as early as early summer 2021, whereas this was not the case for the euro area until about a year later.

An important reason for the rapid recovery in the United States is probably the extremely expansionary fiscal policy during the pandemic. In total, three fiscal packages amounting to nearly 15 percent of U.S. gross domestic product were passed in 2020 and 2021 under Presidents Trump and Biden. These fiscal packages have stimulated private consumption. In the euro area, by contrast, private consumption has not yet reached pre-crisis levels even at the beginning of 2022.

Even from the last major economic crisis – the financial crisis which originated in 2007/2008 – the US economy recovered more quickly than the euro zone. This is also due to the debt crisis that started in several euro area countries at the beginning of the last decade. As a result, economic output in the United States increased by around 25 percent between 2008 and 2021, while gross domestic product in the euro area increased by only 12 percent. In particular, the debt crisis in some euro area countries has widened the growth gap between the two economic areas.

Not only has economic output and private consumption developed significantly better in the USA than in the euro area, but so has investment in equipment – in other words, those key investments that are of great importance for long-term economic development. Looking at the entire period since 2008, equipment investment in the euro area has increased only marginally, while in the USA it has risen by more than 50 percent. Equipment investment in the euro area has also not yet fully recovered from the pandemic, while in the USA it was already well above pre-crisis levels by the beginning of 2021. The subdued investment trend is reducing growth prospects in the euro zone. At the same time, there is a high need for investment in Europe, particularly to successfully shape the energy transition and digitization. At least there is reason to hope that the “Next Generation EU” instrument will provide some impetus for investment in the euro area in the coming years.

Also important for long-term economic development are investments in research and development as well as software, which are part of intellectual property products in the national accounts. However, the data should be interpreted with some caution, as these are difficult to determine due to their intangible nature, among other things. After all, the development in the euro area was for a long time similarly dynamic as in the USA. In both economic areas, these investments have increased by around 70 percent since the financial crisis. Since the pandemic, however, a clear gap seems to have opened up between the United States and the euro area, according to the official figures. While the United States appears to be experiencing a boom in these intangible investments, they have plummeted noticeably in the euro area.

So even before the outbreak of the war in Ukraine, the euro area had already fallen further behind in growth during the pandemic. In this respect, it is also helpful to compare the forecasts for 2020 and 2021 made by the International Monetary Fund at the end of the year with actual developments. This comparison suggests that economic output in the United States in 2021 was only slightly more than one percent below the level assumed at the end of 2019. In the case of the euro area, on the other hand, there was still a gap of more than four percent.

Various scenarios conceivable for the coming economic development

Before the outbreak of the war in Ukraine, it could be assumed that the U.S. economy would achieve the growth path assumed by the International Monetary Fund at the end of 2019 in the current year. For the euro area, on the other hand, the International Monetary Fund assumed in January 2022 that the growth trend expected before the pandemic would still not be achieved in 2024 and that a prosperity gap of just over one percent of gross domestic product would probably remain. 

The war in Ukraine, which is a tragedy for the people affected, is now leading the global economy into a second crisis shortly after the pandemic. Similar to the debt crisis after the financial crisis, the war is now likely to put the brakes on economic recovery. In the further course, only low positive or even negative growth rates are to be expected in the developed economies. The headwinds are blowing too hard: Inflation, war in Ukraine and lockdowns in China all continue to weigh on economic development. Added to this is a monetary policy that is rapidly becoming more restrictive in the face of inflation. The US Federal Reserve and the ECB will continue to raise interest rates rapidly and make their monetary policies more restrictive.

As with the debt crisis ten years ago, the euro area is economically more affected by the war in Ukraine than the United States for obvious reasons. The growth gap with the United States is thus likely to widen further. An important difference to the debt crisis in the euro area today, however, is that the German economy is no longer the driving force in economic growth, but is one of the laggards, mainly due to its high energy dependence on Russia to date.

Two scenarios illustrate an approximate order of magnitude for the widening growth gap between the USA and Europe up to 2024, assuming further developments in GDP up to 2024 for the USA and the euro zone by means of a positive and a negative scenario for each (Fig. 4). These scenarios are not to be understood as complete forecasts, but are intended to illustrate how economic output could develop under the respective scenario. In the positive scenario, it is assumed that the central banks of the USA and the euro area succeed in controlling inflation with a more restrictive monetary policy in such a way that no recession occurs. In addition, it is assumed that the conflict in Ukraine will continue but that there will be no sudden halt in gas supplies to Europe. The negative scenario, on the other hand, assumes that the central banks will have to tighten the monetary reins to such an extent that a recession with a weak recovery will result. In addition, there will be a halt to gas supplies to Europe in the fall of 2022.

Even in a positive scenario, the GDP growth assumed at the end of 2019 will still not be achieved in the USA in 2024, leaving a gap of around one percent of GDP (Fig. 4). In the case of the euro zone, on the other hand, gaps of almost three percent will remain even in the positive scenario. A gap of a similar size would only arise for the United States in the negative scenario. By contrast, in this negative scenario, gaps of almost five percent will remain in the euro area in 2024. The pandemic and the ensuing war would then result in long-lasting losses in prosperity – also due to the triggered high inflation and monetary tightening.

I published an earlier version of this text on June 30.

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U.S. Economy: Inflation remains worryingly high

The US economy contracted by 0.4 percent in the first quarter of 2022 compared with the previous quarter (annualized 1.4 percent). However, this was mainly due to the fact that exports declined significantly as a result of the low momentum of the global economy. Public sector consumption was also down. In addition, companies were somewhat more reluctant to build up inventories than in the final quarter of 2021, when they had replenished their stocks exceptionally strongly. Encouragingly, however, both private consumption and investment increased at solid rates.

Positive growth rates can be expected again in the further course of the year. However, the US economy will not grow strongly. The headwinds are too strong: Inflation, war in Ukraine and lockdowns in China are weighing on further development. In addition, monetary policy is becoming more restrictive. The U.S. Federal Reserve will continue to raise interest rates and also start to shrink its balance sheet. However, despite continuing interest rate increases, inflation will remain elevated and will probably only gradually decrease. In May, inflation increased by 1.0 percent compared to April. Within one year, inflation increased by 8.6 percent, which is worryingly high.

For 2022 as a whole, I expect economic growth of only 1.7 percent followed by 1.9 percent in 2023. Inflation will remain high this year with an annual average of more than 7.0 percent. In 2023 however, I expect inflation of somewhat less than three percent.

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Basic income – an interesting idea, but its macroeconomic impact is still largely unknown

The idea of an unconditional basic income has gained renewed momentum since the outbreak of the corona pandemic. It is quite possible that various forms of unconditional transfers will become a reality more often than was thought before the pandemic. However, truly unconditional and living wage basic incomes, as they are often discussed, are unlikely and probably also not goal-oriented. Above all, too little is known about the macroeconomic effects of an unconditional basic income and the risks involved.

During the corona pandemic, transfer payments with few and simple conditions were adopted in various countries in order to be able to distribute funds to people quickly and without bureaucracy. Such low-condition transfer payments are similar to an unconditional basic income, but are tied to certain conditions – such as the amount of income or the way it is used – and are usually insufficient in amount to cover living expenses.  The best-known example is the total of $3200 that low- and middle-income individuals in the United States have received in three installments since March 2020. 

It has been argued in various quarters that such low-condition transfer payments or even an unconditional basic income could also play a more important role in the future – for example, to cushion the consequences of technological change. Job profiles are changing, partly because the pandemic is currently acting as a kind of catalyst, accelerating technological and social change. Forms of home-based work, digital education, or telemedicine will remain in part even after the pandemic hopefully subsides permanently. In addition, there are repeated warnings that robots or artificial intelligence could take more and more work away from people and cause higher unemployment among some population groups, at least temporarily. 

Structural change as a challenge for people

Such structural change is a challenge for people and the welfare state. Existing knowledge and skills acquired in the past may be rapidly devalued. To be sure, as with past technological changes, many new jobs will probably be created, which should more than compensate for the loss of other jobs.  However, at least temporarily, unemployment may rise in some sectors and social tensions may arise in society. In addition, flexible forms of employment such as on-call work and project-based work are on the rise. For these forms of employment, however, social security is usually worse than for permanent employees.

It is therefore important that social systems are restructured not so much with a view to possible job losses due to automation, but above all with a view to structural change that alters job profiles. In a broader sense, a social system is part of a country’s infrastructure and should be continuously renewed. Low-condition transfers could be an instrument for this and mean not only economic security but also more freedom for people. For example, by enabling them to pursue further education more flexibly. The individualization of life circumstances could be another reason for more low-condition transfers. People are increasingly taking time off from work or part-time work in very different ways in order to do unpaid work in the form of childcare or caring for relatives.

Unconditional basic income unlikely in the near future

These different work and life models make it difficult to adapt conventional social benefits to individual needs. Forms of unconditional transfers have several advantages because they quickly and easily reach many of the people who need them. However, it is unlikely that countries will introduce comprehensive and living wage forms of basic income. A rapid and radical transformation of social security systems would be too complex and risky. Ambitious ideas for an unconditional basic income – such as the 2016 popular initiative in Switzerland – have repeatedly failed because they would have led to drastic changes in the welfare state and society that were difficult for people to assess. In particular, questions of financing and incentives to work were not clarified convincingly enough. Most importantly, it is also largely unknown what the macroeconomic effects of an unconditional basic income would be. It is conceivable that unintended side effects could occur. For example, aid payments in the U.S. have – quite intentionally – stimulated aggregate demand. At the same time, however, inflation has probably also risen significantly as a result of these aid payments, which is now prompting the U.S. Federal Reserve to become much more restrictive in its monetary policy than was recently expected.

It is quite possible, however, that more and more forms of low-condition transfers will emerge. For example, low-condition support for training could become more popular, since in a world with uncertain future and employment prospects, investment in training is associated with high uncertainty and existing skills could quickly lose their value. For example, it could be determined that each person can draw a certain amount that covers continuing education costs. It is also conceivable that people with low incomes could receive a certain amount without conditions, for which they would not have to account. Higher levels of support would still be conditional.

Be open to experimentation

At present, there is still too often a belief that changes in the welfare state do not even need to be discussed in detail. This is dangerous. It is possible that our working world will not change as much as we think, but we should be better prepared for possible developments in the future. We should discuss it more. However, because of the unclear macroeconomic effects, it is better to experiment with limited low-condition transfers at the local level.

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U.S. economy remains robust, but recession likely next year

Recession, yes or no. Many economists argued about this after gross domestic product in the United States contracted somewhat in the first half of this year. It was rightly pointed out that the labor market was robust and domestic demand was solid. The decline in economic output in the first half of 2022 was mainly due to the fact that business inventory accumulation was much less dynamic than towards the end of 2021 and residential investment had recently declined.

In the third quarter, the U.S. economy has now grown significantly by an annualized 2.6 percent. But again, we have to ask the question: Recession, yes or no? This time, the question is whether the U.S. economy will be able to avoid a recession in 2023. The U.S. economy suffers from high inflation, subdued growth in the global economy and rising interest rates. Purchasing managers’ indices have fallen sharply and, above all, consumer sentiment is poor – mainly because of inflation. However, despite the many headwinds, the economy is still developing remarkably robustly. I expect a mild recession, but only a sluggish recovery thereafter at the end of 2023 and in 2024.

The high level of savings accumulated in the wake of the pandemic is now being drawn down, and consumer demand will be less and less able to play its role as the main growth driver of the U.S. economy in the way it has in the past. In the course of 2023, growth in private consumer spending will gradually weaken further. Against this background, business investment will also develop weakly in 2023. In addition, higher interest rates are worsening corporate financing conditions.

The impending slowdown in growth or even recession in the U.S. will also worsen the situation on the labor market. Most recently, the unemployment rate was only 3.7 percent in October, compared with 4.7 percent in September 2021 and as high as 14.7 percent in April 2020. However, in the wake of the pandemic, many people have withdrawn from the labor market, at least temporarily; the labor force participation rate in October was still more than one percentage point lower than before the pandemic in February 2020. Initially, the still high number of job vacancies will probably decrease. For the moment, there is no reason to fear a significant rise in unemployment. However, wage increases are now falling ever lower and will lead to losses in inflation-adjusted wages for many people.

Monetary policy is now rapidly becoming more restrictive in the face of still dramatically high inflation. In July, the consumer price index published by the Bureau of Labor Statistics was 8.2 percent higher than in the same month a year earlier. While much of the higher inflation in 2021 was still attributable to temporary factors such as higher oil prices as well as supply bottlenecks and associated price increases for various goods – semiconductors and raw materials, for example – higher price increases are now evident across a much broader range of goods. Inflation is still likely to be noticeably above three percent in the coming year. I do not expect inflation to be near two percent until 2024.

The index of personal consumption expenditures published by the Bureau of Economic Analysis, which the U.S. Federal Reserve primarily uses for its monetary policy decisions, will also remain very significantly above the central bank’s average inflation target of two percent in 2023, following a year-on-year increase of 6.2 percent in September. Only in 2024 do I expect a decline to two percent. After all, many commodity prices seem to have come down sustainably and the problems in global supply chains are increasingly dissipating. And consumer demand in the U.S., which was strong until recently, is gradually becoming less dynamic, further reducing inflationary pressures. Interest rate hikes by the U.S. Federal Reserve are also likely to dampen inflation significantly in the coming months.

The U.S. Federal Reserve will probably raise its interest rates again significantly by the end of the year. Overall, I expect another increase of 0.75 percent. After that, I expect the central bank to raise interest rates twice more in the first quarter of 2023 (by 0.5 and 0.25 percent) and then leave them at a high level of five and a half percent until the end of 2023. I then expect slight interest rate cuts in 2024.

All in all, the U.S. economy will probably grow by only 1.9 percent in the current year compared with 2021. In 2023, the U.S. economy will go through a mild recession in my base scenario and stagnate on average for the year. Growth will also be low in 2024 in my baseline scenario, at 0.8 percent.

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German economy in recession: not deep, but the worst is yet to come

The German economy continues to face fierce headwinds from the energy crisis, high inflation rates, and the cooling global economy. Germany is likely to have slipped into recession as early as the third quarter of 2022 and this is unlikely to end before the summer of 2023. Provided there is no gas shortage, the recession is likely to be less deep than during the pandemic or the financial crisis, but the probably permanently higher energy prices are also likely to dampen economic development in the medium term and lead to structural changes in industry.

In the wake of the weakening global economy, new orders for German industry are declining not only from the domestic market but also from abroad. At least the hitherto stubborn bottlenecks in international supply chains appear to be gradually easing, allowing the still high order backlog to be processed more efficiently. However, the main problem for German industry is the energy crisis, even though prices for gas and electricity have recently retreated from their highs in August. In addition, the planned gas price cap will now prevent the worst from happening.

Services are also now in a downturn after an interim high in the spring. High inflation is severely dampening household purchasing power. In addition, the savings built up during the pandemic have now been used up. At least the planned gas price cap is easing the worries of many people, even though the financial burden will still be considerable, especially for low- and middle-income households. Another bright spot is that the situation on the labor market is still robust, which is providing some support for private consumption.

All in all, I expect the German economy to grow by 1.4 percent this year and contract by 0.6 percent next year. From today’s perspective, things could then pick up again in 2024, although this is of course still quite uncertain. However, high growth rates are not to be expected. At the moment, I expect GDP to grow by 1.2 percent in 2024. Inflation will remain high for the time being, but in my view it will approach the central bank’s two percent target again by 2024. However, I expect inflation to come down more quickly than many think. Most underestimate how much the recession, the easing in supply chains, and the absence of dramatic energy price increases will depress inflation. Next year, I still expect inflation to average just under four percent.

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What caught my eye: The US-China trade conflict, workers and commuting, climate scenarios for central banks, and much more…

As always when Chad Bown publishes a piece, I can only recommend it! “Four years into the trade war, are the US and China decoupling?” by Chad P. Bown

https://www.piie.com/blogs/realtime-economics/four-years-trade-war-are-us-and-china-decoupling

Natural Gas Futures Plunge

“What Have Workers Done with the Time Freed up by Commuting Less?” by David Dam, Davide Melcangi, Laura Pilossoph, and Aidan Toner-Rodgers

“Climate Scenarios for central banks and supervisors”:

https://www.ngfs.net/en/ngfs-climate-scenarios-central-banks-and-supervisors-september-2022

“Big Techs vs Banks” by Leonardo Gambacorta, Fahad Khalil and Bruno Maria Parigi

https://www.bis.org/publ/work1037.htm

How Much Did Supply Constraints Boost U.S. Inflation? By Julian di Giovanni

https://libertystreeteconomics.newyorkfed.org/

The future of investment treaties:

https://www.oecd.org/investment/investment-policy/investment-treaties.htm

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U.S. economy: Surprisingly robust development with inflation still high

Recession, yes or no? Many economists have been pondering this after GDP in the United States shrank somewhat in the first half of the year. It was rightly pointed out that the labor market was robust and domestic demand was solid. The decline in economic output in the first half of 2022 was mainly due to the fact that business inventory building was much less dynamic than towards the end of 2021 and residential investment had recently declined.

The U.S. economy contracted by 0.4 and 0.1 percent quarter-on-quarter in the first and second quarters of 2022, respectively (annualized 1.6 and 0.6 percent). Thus, the economic recovery following the pandemic-related slump in the first half of 2020 did not continue. By the summer of 2021, U.S. economic output had already returned to the level of the final quarter of 2019 before the pandemic – earlier than in most countries in Europe, for example. Most recently, private consumption was still growing at a surprisingly robust pace in the second quarter of 2022, and business investment had not yet declined either.

In the second half of the year, the U.S. economy will continue to face various headwinds from high inflation, subdued growth in the global economy, and rising interest rates. However, the economy is still developing surprisingly robustly despite these many headwinds. I expect only a mild recession, but then only a sluggish recovery in 2023. Purchasing managers’ indices have fallen and, above all, consumer sentiment has plummeted – mainly because of inflation.

The high level of savings accumulated during the pandemic is now being reduced and consumer demand will now no longer be able to play its role as the most important growth driver of the U.S. economy as it has in the past. Over the course of 2022 and 2023, growth in private consumer spending will gradually weaken further. Against this background, business investment will also develop weakly in the second half of 2022. Higher interest rates are also rapidly worsening corporate financing conditions.

The dynamic recovery of the U.S. economy has also steadily improved the situation on the labor market. The unemployment rate in July was only 3.5 percent and 3.7 percent in August (due to higher labor force participation), down from 4.7 percent in September 2021 and 14.7 percent in April 2020. However, in the wake of the pandemic, many people withdrew from the labor market, at least temporarily; the labor force participation rate in August was still around one percentage point lower than before the pandemic in February 2020. The labor market situation is now unlikely to improve further. Initially, the number of job vacancies will probably decrease. For the moment, there is no reason to fear a significant rise in unemployment. Wage increases will now probably be lower and lead to losses in inflation-adjusted wages for many people.

Monetary policy is now rapidly becoming more restrictive in view of the still dramatically high inflation. In July, the consumer price index published by the Bureau of Labor Statistics was 8.5 percent higher than in the same month a year earlier. While much of the higher inflation in 2021 was still attributable to temporary factors such as higher oil prices, as well as supply shortages and associated price increases for various goods – such as semiconductors and raw materials – higher price increases are now evident across a broader range of goods.

I think that inflation will decrease somewhat faster than others. However, inflation will probably remain above two percent in the coming year. The personal consumption expenditures price index published by the Bureau of Economic Analysis, which the Federal Reserve primarily uses in making monetary policy decisions, is also expected to be very significantly above the central bank’s average inflation target of two percent in 2022, following a 6.8 percent year-over-year increase in July. Even in 2023, I still do not expect a decline to two percent. However, many commodity prices seem to have reduced sustainably and the problems in global supply chains are gradually dissipating. Thus, inflation pressures will gradually decrease. In addition, consumer demand in the U.S., which was strong until recently, is gradually becoming less dynamic, further reducing inflationary pressures. Interest rate hikes by the U.S. Federal Reserve are also likely to dampen inflation significantly in the coming months.

Against this background, the Federal Reserve is likely to raise interest rates significantly by the end of the year. I expect an overall increase of 1.5 percent. After that, I expect the central bank to leave interest rates at a high level until the end of 2023. I then expect slight interest rate cuts in 2024. In one scenario, however, I assume that the central bank will even overshoot in its fight against inflation at present and will reduce its interest rates again as early as the summer of 2023.

All in all, the U.S. economy is likely to grow by only 1.5 percent in the current year compared with 2021. In 2023, the growth rate will decline further to 0.5 percent before a recovery sets in in 2024 and the economy will grow by 2.1 percent, albeit still at a subdued pace. 

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German economy already in recession

The energy crisis, high inflation and the cooling global economy are fierce headwinds for the German economy. Germany is in recession and unfortunately there is no light at the end of the tunnel at the moment. The war in Ukraine instigated by the Russian president is likely to lead to growth losses of at least five percent of gross domestic product in 2022 and 2023.

The enormous increases in energy prices are leading to dramatic losses in purchasing power and threaten to make production unprofitable in many companies. The gloomy global economy is also placing an increasing burden on export-oriented German industry. For example, the war in Ukraine is not only leading to an energy crisis and high inflation rates in most developed economies, but also to recessions or significantly lower growth rates. In addition, the Chinese economy is being held back by corona lockdowns and the smoldering real estate crisis.

In the wake of these developments, new orders for German industry are declining. There are increasing signs of a lull once the numerous existing orders have been processed. At least the previously stubborn bottlenecks in international supply chains appear to be gradually easing.

Services, too, are now in a downturn after an interim high in the spring. High inflation is dampening household spending, which is increasingly impacting sales in the retail and hospitality sectors, for example. At least, given the shortage of skilled workers, most people need not worry about job losses at the moment. However, high inflation means that many employees are facing wage losses when adjusted for inflation. People with low and medium incomes in particular are thus threatened with financial difficulties. Despite the relief packages adopted by the German government to date, many people and companies are looking to the future with great concern. These justified fears are additionally curbing the propensity to consume and invest and threaten to exacerbate the recession even further.

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UK economy: A really hard winter and a slow recovery

The UK economy is currently in deep troubles during these days after the death of the Queen. The energy crisis and high inflation rates will most likely lead to a recession. Starting in the summer of 2023, there will be a slow recovery. I think that the recovery will be slower than some other forecasters think. Liz Truss, the new Prime Minister faces many challenges. As one of her first measures, she rather surprisingly introduced a cap on energy bills. This will be popular and should limit the burden on households and will tend to dampen inflation. However, a couple of open questions remain and despite that, many people are suffering and private consumption will contract.

In the second quarter of 2022, the UK economy already contracted by 0.1 percent. I think that we will see negative rates of around 0.5 percent until the first quarter of 2023. Overall, there will still be economic growth in 2022 on average (+2.9 percent), but stagnation on average in 2023. The recovery will start in the summer of 2023 and show up in higher annual growth in 2024 (+3.1 percent). Inflation will further increase and may even approach 14 percent in the winter when compared to the previous year. It will stay high in 2023, but I think that inflation will be reduced somewhat faster than others expect. Interest rate increases by the central bank will be fully effective in 2023, which means that they will reduce inflation but also dampen economic activity. By 2024, inflation will be back to around 2 percent. Currently, the bank rate is at 1.75 percent and will further increase this year to more than 3 percent. A first decrease might be conceivable in the fall of 2023.

Somewhat underestimated is currently that the depreciation of the pound will help UK exporters in 2023 and 2024 during the recovery. In the meantime, however, the negative effects of the depreciation become visible in higher import prices and inflation.

In the medium term, the UK economy faces the challenge to improve productivity growth. In the past decades, the United Kingdom has seen only meagre productivity growth rates. This will be one of the main challenge of the new government. In addition, one should not underestimate the possibility of an independent Scotland that may be associated with political tensions and high uncertainty.

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What caught my eye: Monetary policy post-pandemic, investment treaties, the financial stability implications of digital assets, and much more…

François Villeroy de Galhau: Monetary policy post-pandemic – balancing between science and art, predictability and reactivity

Speech by Mr François Villeroy de Galhau, Governor of the Bank of France, at the “Reassessing Constraints on the Economy and Policy” economic policy symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, 27 August 2022.

https://www.bis.org/review/r220830b.htm

How Much Did Supply Constraints Boost U.S. Inflation? By Julian di Giovanni

https://libertystreeteconomics.newyorkfed.org/

“Entity-based vs activity-based regulation: a framework and applications to traditional financial firms and big techs” by Claudio Borio, Stijn Claessens, Nikola Tarashev:

https://www.suerf.org/suer-policy-brief/51573/entity-based-vs-activity-based-regulation-a-framework-and-applications-to-traditional-financial-firms-and-big-techs

The future of investment treaties:

https://www.oecd.org/investment/investment-policy/investment-treaties.htm

CBO’s Projections of Federal Receipts and Expenditures as Measured by the National Income and Product Accounts: 2022 to 2032:

https://www.cbo.gov/publication/58356

“The Financial Stability Implications of Digital Assets” by Pablo D. Azar, Garth Baughman, Francesca Carapella, Jacob Gerszten, Arazi Lubis, JP Perez-Sangimino, David E. Rappoport, Chiara Scotti, Nathan Swem, Alexandros Vardoulakis, Aurite Werman:

“The value of assets in the digital ecosystem has grown rapidly, amid periods of high volatility. Does the digital financial system create new potential challenges to financial stability? This paper explores this question using the Federal Reserve’s framework for analyzing vulnerabilities in the traditional financial system.”

https://www.federalreserve.gov/econres/feds/the-financial-stability-implications-of-digital-assets.htm

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German economy does not get out of crisis mode

More than two years of pandemics and the energy crisis triggered by the war in Ukraine are causing permanent stress in the German society and the economy. The drought in summer and the low water levels of the Rhine and other rivers added to these problems. The already foreseeable decline in economic output in the third quarter of 2022 will probably be somewhat higher than recently expected due to the transport bottlenecks caused by the low water levels. A decline of half a percent would no longer be a surprise. For 2022 as a whole, economic growth is not expected to exceed 1.5 percent. In particular, many deliveries are delayed because ships on the Rhine can often only be loaded to less than half their capacity. It is true that less than ten percent of all goods transported in Germany are carried by inland waterway vessels. However, the goods transported on the Rhine, such as coal, oil or chemicals, play a central role for the German economy. The situation has recently eased a little – it is to be hoped that the rain will continue to fall regularly. The negative impact on the German economy is likely to be felt overall, albeit not dramatically.

However, this should not obscure the fact that the effects of climate change are becoming increasingly apparent and are impacting the economy. Extreme weather events such as long periods of drought, heat waves or, conversely, extensive rainfall with associated flooding will in all likelihood continue to increase. Plans to significantly reduce greenhouse gas emissions can only slow global warming, not stop it. The costs of climate change are likely to be increasingly felt in the economy as a whole, dampening growth in gross domestic product.

This summer’s drought also highlights an important aspect of global warming: the more frequent occurrence of extreme weather events is increasingly amplifying the effects of other negative events. At the moment, for example, capacity bottlenecks on the Rhine are exacerbating the energy crisis because coal and oil cannot be transported in the usual quantities. The drought is also exacerbating problems in many supply chains that arose in the wake of the Corona pandemic and the Ukraine war. A striking example is the increased demand for grain transport vessels on the Danube caused by the war, which coincides with higher demand for such vessels on the Rhine, where a single one can only be partially loaded. Last year, the pandemic and an extreme weather event already contributed to the supply bottlenecks for semiconductors: for example, the pandemic led to a huge increase in demand for electronic equipment and cars. At the same time, production capacity for semiconductors was limited – not only, but also because of an extreme winter event in Texas that temporarily halted production there.

There are indications that extreme weather events will occur more frequently in the future together with other negative events. We must assume, for example, that the geopolitical tensions with Russia and China will continue. The conflict over Taiwan in particular shows us how strongly we are dependent on semiconductor production there. It is important that we as a society become even more resilient in order to deal with such events and the advancing climate change. Supply chains will probably become more and more diversified. And in Germany and other countries, there is a huge backlog of infrastructure needs. The energy crisis is a particularly striking illustration of the huge costs of the energy turnaround, which has been delayed for years. The pandemic has made clear to us the gaps in digitization or in education. And there is obviously a need, in some cases considerable, for investments in the Rhine, for example, that can reduce the impact of droughts on shipping in particular.

It is impossible to fully prepare for crises, that is in the nature of things. To be sure, there is no denying that the German economy has been robust in recent crisis years despite all the problems. But that is no reason to rest on one’s laurels; the challenges are greater than ever. This makes it all the more important to quickly achieve the transformation to a climate-neutral and digital economy.

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Japan: Solid recovery from the pandemic this year, but clouds are gathering

The Japanese economy is doing well over the summer. Gross domestic product recovered at a solid rate of 0.5 percent in the second quarter of 2022. The recovery was mainly driven by robust consumption growth after lockdown measures to contain the pandemic were lifted. Business investment also increased, while private residential investment contracted as in previous quarters.

I expect economic growth to be rather solid this year. In the third quarter, I again think that the economy will expand at a relatively high rate before slowing down in the fourth quarter. As in many other countries, inflation is a serious risk to the outlook. Currently, inflation remains above the central bank target rate. Energy prices will probably remain high, but I do not see further depreciation pressures on the yen.

Overall, I expect economic growth to average 1.4 percent in 2022 and 1.2 percent in 2023 and 2024. Inflation will be at 2.2 percent in 2022 before decreasing to 1.6 and 1.2 percent in 2023 and 2024.

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