News of the week summary - 09/15/2024

ECB cuts rates to 3.5% 

The European Central Bank (ECB) has reduced its key interest rate by 0.25 percentage points, bringing it down to 3.5%. This decision comes in response to a decline in inflation across the Eurozone and growing concerns about economic stagnation. ECB President Christine Lagarde confirmed that this rate cut was unanimously agreed upon by the central bank’s governing council, signaling a shift from earlier, more divided decisions.

Inflation in the Eurozone has slowed to 2.2% in August, close to the central bank's target if 2%, down from 2.6% in July, which has reduced the pressure for aggressive monetary tightening. Meanwhile, weak industrial output in Germany and Italy is raising fears of an economic slowdown, as private consumption and investment remain tepid. 

Wage growth, which previously posed a risk to inflation, is now being absorbed by reduced corporate profit margins. The ECB's recent forecasts predict modest growth of 0.8% for 2024, a slight downgrade from earlier projections. Despite this, inflation is expected to remain elevated, with core inflation (which excludes energy and food prices) projected to reach 2.9% by the end of the year.

Although more rate cuts are anticipated later in the year, Lagarde hinted that the next move may not happen in the upcoming October meeting, given the short window for further economic developments. As a result, the euro and German bond yields saw slight increases, reflecting investor confidence in the ECB’s cautious approach.

In addition, the ECB announced plans to adjust the terms for banks borrowing from the central bank, though this is expected to have little immediate impact. With financial conditions still restrictive and demand softening, the focus remains on balancing inflation control with sustaining economic growth across the Eurozone.

Markets expect FED to cut interest rates as inflation cools

With US inflation easing to 2.5% in August, speculation is rising that the Federal Reserve (USA central bank) will cut interest rates at its upcoming meeting. The inflation drop, down from 2.9% in July, is seen as a positive signal that price growth is nearing the Fed’s 2% target. This development has increased market expectations for a quarter-point rate cut, with traders placing the likelihood at around 85%.

Currently, US interest rates stand at a 23-year high of 5.25% to 5.5%. While the central bank has traditionally moved in 0.25% increments, some analysts believe that a more significant 0.5% cut is possible if officials feel that economic risks are growing. 

The decline in inflation comes primarily from a slower rise in core consumer prices, which exclude volatile food and energy costs. Core inflation remained steady at 3.2%, while shelter costs (housing-related expenses) were a primary driver of the month’s overall inflation increase.

As inflation retreats, the US economy shows signs of resilience, bolstering the argument for cautious, incremental rate cuts. However, with a presidential election looming in November, political pressure could influence the FED’s decisions. Vice President Kamala Harris has welcomed the news of falling inflation, while her opponent Donald Trump has suggested that the FED may be cutting rates to boost her election chances.

International Energy Agency expects prolonged oil prices decline

Fatih Birol, the head of the International Energy Agency (IEA), has predicted that oil prices will likely keep falling due to ongoing excess supply and weak global demand. Despite geopolitical tensions and production disruptions in places like Libya and the Middle East, the current surplus of oil, especially from non-OPEC (the OPEC is an association of major petroleum exporting nations acting as an economic cartel) countries like the United States, is exerting downward pressure on prices.

Recently, benchmark Brent crude oil prices (the international benchmark) dropped below $70 per barrel for the first time in nearly three years. This decline follows concerns over slower economic growth in major markets such as China and the US, which has prompted OPEC to postpone plans to reverse production cuts.

The IEA chief highlighted that oil demand grew at its slowest rate since the COVID-19 pandemic during the first half of the year. A significant factor in this slowdown is China's decelerating economic growth, which historically has been a major driver of global oil demand. Additionally, China’s push towards clean energy, including a surge in electric vehicle adoption and improved fuel efficiency, is reducing fossil fuel consumption.

Oil demand is influenced by a range of factors that interact in complex ways. Strong economic performance generally leads to higher oil demand. As economies grow, industrial activity, transportation, and overall energy consumption tend to increase. Conversely, economic slowdowns or recessions usually result in reduced oil consumption. Since oil is a major fuel source for vehicles, ships, and airplanes, changes in transportation patterns and vehicle efficiency can affect demand. For instance, increased use of electric vehicles or improvements in fuel efficiency can reduce oil consumption. The IEA’s latest report also notes that oil consumption is expected to rise by 900,000 barrels per day this year, a significant drop from the 2 million increase seen in 2023. 

FED scales back proposed capital increase for banks 

The FED has significantly reduced its proposed increase in capital requirements for the largest US banks following strong opposition from both the banking industry and politicians. The agency's revised plan will raise capital requirements by 9%, a reduction from the originally proposed 19% increase.

Michael Barr, the FED's top regulatory official, introduced these revised rules as a compromise after facing substantial criticism. The original proposal was intended to address vulnerabilities exposed by recent bank failures, including those of Silicon Valley Bank, Signature Bank, and First Republic Bank (see more on those here). 

The revised rules now apply less stringently, affecting only banks with assets of $250 billion or more, compared to the initial plan targeting banks with assets of $100 billion or more. This adjustment comes after intense lobbying from banks, which argued that the stricter capital requirements would negatively impact lending, economic growth, and minority communities.

The Basel III framework, implemented after the 2008 financial crisis, requires banks to maintain higher equity buffers to absorb losses during financial stress. In 2017, international regulators agreed to strengthen these rules. However, US banks criticized the FED’s interpretation as overly stringent compared to global standards, particularly regarding operational risks like cyber attacks and regulatory fines.

The updated rules will still address operational risks but will exclude some major non-lending activities, such as asset management, from the capital calculations. Additionally, the FED has removed a proposed internal loss multiplier that would have adjusted capital requirements based on historical operational losses. Requirements related to mortgages and tax equity financing will also be less severe, and banks will have more flexibility in assessing market risks using their own models.

Mario Draghi pleads for €800 Billion annual investment in European industry 

Mario Draghi has called for a major overhaul of Europe’s industrial strategy, recommending an additional €800 billion in annual investments to help the EU stay competitive against the US and China. Draghi's report, commissioned by European Commission President Ursula von der Leyen, highlights the need for urgent reforms in how Europe funds and manages its investments.

The proposed strategy includes relaxing competition rules to enable consolidation in sectors like telecommunications, centralizing the supervision of capital markets, increasing joint procurement in defense, and developing a new trade agenda to enhance economic independence. Draghi argues that Europe’s current approach is inadequate given the scale of global economic challenges.

Draghi emphasized that without this increased investment and better productivity, Europe risks falling further behind its global rivals. He suggested that the EU needs to boost its investment-to-GDP ratio to levels not seen since the 1970s, estimating the required additional investment at 4.4-4.7% of EU GDP.

The former European Central Bank President also called for the creation of common assets and joint EU funding mechanisms to support projects like energy infrastructure and defense procurement. However, he acknowledged that political resistance, particularly from more conservative governments like those in the Netherlands and Germany, could hinder efforts to secure additional EU funding or new joint debt.

Draghi warned that without significant action, Europe could face a decline in living standards and be forced to scale back its ambitions. While Von der Leyen supported the need for common funding for certain projects, she did not fully endorse the idea of new joint EU debt, suggesting that additional national contributions or EU-level taxes might be used instead.

Worsening deflation fears in China

China’s industrial producer prices fell by 1.8% year-on-year in August, the largest drop in four months. This decline, driven by weaker demand in sectors such as steel and agriculture, has intensified concerns about deflation in the world’s second-largest economy. The August decrease is sharper than July’s 0.8% drop and exceeds analysts' expectations of a 1.4% fall.

In contrast, China’s consumer price index (CPI) rose 0.6% year-on-year, slightly missing analysts' expectations but up from July’s 0.5% increase. The CPI rise reflects higher food prices, notably pork, which increased food inflation by 2.8% year-on-year, compared to a minimal rise in non-food prices.

Deflationary pressures are becoming a significant concern. Former central bank governor Yi Gang highlighted the urgency of adopting proactive fiscal and accommodative monetary policies to support demand. The negative GDP deflator, a broad measure of price changes, suggests persistent deflationary forces, potentially leading companies to cut investment, wages, and hiring, which could further depress consumption and living standards.

China’s ongoing property sector slump and intense manufacturing competition are exacerbating the situation. The 1.8% drop in producer prices in August is the steepest since April, when prices fell by 2.5% year-on-year. Key sectors like steel, agriculture, and energy have seen notable price declines.

On another note, in response to its aging population and declining birth rates, China plans to raise the retirement age for the first time since 1978. Starting in January, the retirement age for men will increase from 60 to 63, for women in white-collar jobs from 55 to 58, and for women in blue-collar jobs from 50 to 55. This gradual change, approved by China’s parliament, aims to address the rising old-age dependency ratio and relieve pressure on the pension system.

While the policy shift is intended to boost the workforce and support economic growth, it has sparked frustration among younger workers, who face extended working years, and older workers, who worry about reduced pension benefits. The change is also seen as necessary to maintain economic stability amid ongoing economic challenges and slow growth.