Meanwhile, core inflation (excluding food and energy) continues to decline. In February, core prices were up 2.8% from a year earlier, the lowest rate since March 2022. This means that underlying inflation is moving in the right direction. However, core prices were up 0.7% in February from a month earlier, suggesting trouble. The trouble, of course, is in services. First, prices of non-energy industrial goods were up only 1.6% from a year earlier and up 0.3% from the previous month. On the other hand, prices of services were up 3.9% from a year earlier and up 0.8% from the previous month. 

Thus, the main obstacle to bringing inflation down to the 2% target is labor-intensive services. Indeed, the unemployment rate in the Eurozone is now at a record low of 6.4% while real (inflation-adjusted) wages were rising at a rapid pace as recently as the third quarter of 2023. Given this, it is likely that the European Central Bank (ECB) will wait longer before cutting interest rates. 

By country, annual headline inflation in February was 2.7% in Germany, 3.1% in France, 0.9% in Italy, 2.9% in Spain, 2.7% in the Netherlands, and 3.6% in Belgium. 

US consumer spending slides while inflation in services is too high

• American consumers cut back on spending in January, at least according to the government’s latest report on consumer spending. Recall that, a few weeks ago, data on retail sales also indicated a drop in spending in January. It is worth noting that the monthly data are adjusted for seasonal variation. Moreover, there is currently debate within the government as to whether the seasonal adjustments made by the government remain appropriate following the pandemic. That is, the pandemic led to changes in consumer behavior that might not be fully reflected in the government’s adjustment for seasonal factors. If so, the January data could be downwardly skewed. Or the data could reflect a decline in spending. After all, real (inflation-adjusted) disposable income did not grow in January.

In any event, here is the data: In January, real (inflation-adjusted) disposable income (income after taxes) was unchanged from the previous month. Real consumer spending fell 0.1% from December to January. The personal savings rate increased from 3.7% in December to 3.8% in January. The real decline in spending included a 2.1% drop in spending on durable goods, a 0.5% drop in spending on non-durable goods, and a 0.4% increase in spending on services. 

Perhaps the most important part of the government’s latest data release was the data on inflation. That is, the Federal Reserve’s favorite measure of inflation is the personal consumption expenditure deflator, or PCE-deflator. The news on this was mixed. On the one hand, the year-over-year increase in prices continues to decelerate. On the other hand, monthly price gains accelerated, especially for services–which are labor-intensive. In other words, the tightness of the labor market, and the consequent rise in labor costs, is contributing to sustained high inflation for services. This, in turn, is preventing inflation from decelerating toward the 2% target. For the Federal Reserve, this implies a need to sustain a tight monetary policy to weaken the labor market and thereby ease wage pressure.

Let’s look at the numbers: In January, the PCE-deflator was up 2.4% from a year earlier, down from 2.6% in December and the lowest annual inflation rate since February 2021. However, the index was up 0.3% from the previous month, the biggest monthly gain since September. When volatile food and energy prices are excluded, core prices were up 2.8% in January versus a year earlier, the lowest rate since March 2021. Yet core prices were up 0.4% from the previous month, the biggest increase since February 2023. 

As for the details, prices of durable goods were down 2.4% from a year earlier and up 0.2% from the previous month. Prices of non-durables were up 0.5% from a year earlier while down 0.4% from the previous month. Now, here comes the problem: Prices of services were up 3.9% from a year earlier and up 0.6% from the previous month. The latter was the biggest monthly gain since March 2022. The strength of service inflation partly reflected continued rises in home prices. In addition, it also reflected increased demand for some services including hotels, personal care, and financial services. 

Going forward there remains a widespread view that the Federal Reserve will start to cut interest rates early in the second half of this calendar year. Yet that is already a shift from earlier expectations that the Fed would begin to normalize interest rates in March or April. The persistence of service inflation is likely one of the Fed’s biggest headaches.

Japan: Inflation decelerates, industrial output falls, and demographics worsen

• Inflation in Japan continues to decelerate, likely reducing pressure on the Bank of Japan (BOJ) to tighten monetary policy. In January, consumer prices were up 2.2% from a year earlier, down from 2.6% in December and the lowest inflation rate since March 2022. Prices were unchanged from the previous month. Moreover, in the last three months, prices only rose 0.1%. Recall that annual inflation had peaked above 4% in early 2023.

Meanwhile, when volatile food and energy prices are excluded, so-called core-core prices were up 3.5% in January from a year earlier, down from 3.7% in December and the lowest rate in 11 months. Core-core inflation had peaked in August at 4.3%. There was considerable volatility by category, with the price of hotel bookings up 26.9% in January versus a year earlier (due to strong tourist demand). On the other hand, energy prices were down 12.1% with electricity prices down 21%. 

Going forward, there are favorable signs for a reduction in inflation. First, domestic demand remains weak, which contributed to real GDP falling in the most recent two quarters. Plus, real wages are falling as nominal wages fail to keep pace with inflation. Indeed, real wages fell 2.1% in January versus a year earlier, the 21st consecutive decline. This is different than in other advanced economies where real-wage increases are a headache for central bankers. Indeed, in North America and Europe, central banks are retaining tight monetary policies due to fears that tight labor markets will fuel continued inflation. 

This is not the case in Japan. Instead, the BOJ has maintained a very easy monetary policy throughout the recent spate of inflation, confident that the inflation was a temporary side effect of supply disruption and would ultimately recede. The BOJ is not concerned that labor markets will sustain high inflation as is the case elsewhere. Still, the BOJ has come under pressure to end the easy monetary policy. Although it has hinted at a change in policy, it has not yet taken action. 

• In Japan, there was a sharp decline in industrial production in January, disproportionately due to a dramatic downturn in motor vehicle production. Specifically, industrial production fell 7.5% from December to January, led by a 17.8% drop in motor vehicle output. There was also a 12.6% decline in output of business machinery. In fact, production fell in 14 of 15 major industries. Moreover, the sharp drop in manufacturing output suggests that real GDP might decline in the first quarter of 2024. This would be the third consecutive quarter of falling real GDP.

The drop in automotive production was partly due to temporary suspension of production at some automotive factories due to non-economic factors. In addition, there was a 21.4% decline in lithium-ion battery output, largely due to global EV production adjustments. Still, the decline in multiple industries suggests a problem, likely due to a combination of weak domestic demand and weakening export demand. 

• In the years to come, one of the key issues that will affect economic outcomes in many countries is demographics. In these pages I have written about demographic trends in China, the Unit
  • ed States, and Europe. The common trend is a low birth rate combined with an aging population. All other things being equal, this implies slower economic growth and greater difficulty in servicing the pension and health care needs of the elderly. 

  Nowhere is this a greater issue than in Japan. In 2023, there were a record low number of births at 758,631, down 5.1% from the previous year. In addition, the number of marriages fell 5.9% to 489,281, the first time in 90 years that this number fell below 500,000. Part of the problem is that the number of young people has been declining for some time, thereby reducing the number of births even if the birth rate doesn’t change. 

  A senior Japanese government official said that “the declining birthrate is in a critical situation. The next six years or so until 2030, when the number of young people will rapidly decline, will be the last chance to reverse the trend.” He said that the government intends to take “unprecedented steps” to address this issue. This will include enhanced childcare. Prime Minister Kishida has said that this is the “gravest crisis” the country faces. Finally, the government has estimated that, barring a significant change, the population will decline 30% by 2070 with 40% of the population being over 65.

  Russia’s economy is surprisingly resilient despite sanctions

  • Despite sanctions imposed by Western companies when the conflict in Ukraine began, the Russian economy has performed surprisingly well. In 2022, the year the conflict began, sanctions took a toll, leading to a 1.2% decline in real GDP. Yet in the past year, Russia has succeeded in boosting trade with non-Western countries, especially China and India. Plus, capital controls helped to stabilize the currency, leading to a sharp decline inflation. The result was that real GDP grew 3.6% in 2023. 

  As 2024 begins, the economy is doing well. Industrial production was up 4.6% in January versus a year earlier, led by manufacturing. Strong defense spending, roughly 10% of GDP, contributed to this. Real (inflation-adjusted) wages were up 8.5% in January while retail sales were up 9.1%.

  Part of Russia’s ability to boost production stems from access to parts from China, India, and even Western countries. Sanctions have not been airtight, so there are reports that Russia has been able to obtain inputs that were meant to be restricted.

  Why is this important to us? After all, neither Deloitte nor many of our clients are active in Russia. The answer is that the sanctions were meant to cripple the Russian economy and reduce its ability to fight the conflict in Ukraine. Evidently, this has not been the case. That is not to say that Russia hasn’t suffered. Russian consumers no longer have access to many Western products and services. Plus, the conflict itself has destroyed a large part of Russia’s military arsenal. Yet it is clear that Russia’s economy is sufficiently strong that the country can continue fighting. Moreover, if the United States fails to support Ukraine, Russia will likely win the conflict. And, if that happens, it will have a big impact on the global economy.