A polarised US rate debate, China's lost reform and the £25bn question

It's Friday the 14th of August and this is your capital economics weekly briefing. I'm David Wilder, coming up, UK taxes may be going up to fund the new Prime Minister's policy ambitions, but how high and which taxes? But first, at the end of another week and yet another heat wave, it's Group Chief Economist Neil shearing to weed through another week in macro and markets, I kneel, hi David, how you bearing up? I'm alright, I can see rain in the forecast, so I'm ending the week on an optimistic note. Exactly, yes. A lot of melts. I never want to hear anyone ever again complain about the rain in the UK. I want to start with, I mean, where else but the US, because we've had July, CPI and PPI data over the past few days, they've been released smack dab into this debate about the outlook for US interest rates. So you've been sifting through all the numbers, how is the inflation picture looking? Well, the short point is that the data have come in on the soft-ish side. So we spoke last week about the CPI numbers, didn't we? And we said we needed to wait for the PPI numbers this week in order to form a view about what might happen to core PCE in inflation, which is the number that the Fed really looks at for July. And the short answer is that they've all been pretty positive for the Fed. So the PPI data this week overall were pretty soft. There was interestingly some evidence and further evidence of awkward pressure in goods related to the AI build act. That's the only real part of the report that was strong, though. Elsewhere, it was pretty disinflationary. Put all that together. It looks to us like core PCE has increased by about 0.16% month or month in July. That would be a target consistent pace, apparently, of the Fed's targets 2%. So a target consistent increase in core PCE by the looks of things in July will have one more CPI reports for August before the FOMC meeting in September. And of course, we have another payroll report. But I think if you put the data that we've had over the past month or so together, you've got that weak payroll report, you've got a weak CPI number, you've got a weak PPI number and it looks like what have a weak core PCE number, doesn't feel like the Fed's about to pull the sugar on a rate high in September. As you say, the latest in an admittedly fairly short stream of soft data, what is the hawkish case on the FOMC? Because it's still quite a split committee in terms of where rates should be going. What's their case for higher rates at this point? I think there are several arguments in favour of the need for tighter policy, and indeed, we've been arguing that the Fed will raise interest rates this year. So I think you probably put us on the more hawkish side of the debates. What is that argument? Well, there are two or three strands to it. One is that yes, the payroll numbers may have been soft, and indeed we had that fall in non-farm payrolls for July, but actually the breakeven rate for non-farm payrolls now is incredibly low, and in other words, the rate that you need in order to maintain for an employment is very low because of changes on the supply side of the labour market. So the labour market is still pretty tight. Underlying inflation pressures are still pretty strong. OK, we've had one or two months of target-consistent increases in the monthly rates of both core PCE and core CPI, but that comes on the back of stronger increases earlier this year. The AI bill, as I just mentioned, looks to us like it's more inflationary than it is disinflationary at this stage. And fundamentally, the US economy is in pretty good shape. We get lots of questions about where we think the neutral interest rates in the US might be, and of course, helpful concept, quite difficult to see in practice. But the fact that the US economy has been so strong, particularly outside of the housing market, in rate sensitive sectors, suggests to me that monetary policy itself might not be very restrictive in the US, but of course, fiscal policy is incredibly supportive. We've got this enormous budget deficit, 6% of GDP, and more once we start to factor in tariff refunds. So they're the arguments in favour of tighter industry policies that, yes, we've had one or two months of better inflation numbers, but the economy itself is in pretty good nick. The labour market is pretty tight, underlying inflation pressures are in pretty strong, fiscal policy remains extremely accommodative, such that monetary policy probably has to be a bit more restrictive, and it doesn't look like it's in restricted territory just yet. So September potentially off the table now, but beyond September still alive to bake. That feels right to me, yes, and with the markets, as we're speaking, currently pricing in just over one in three chances of rate hike in September, that feels about right to be honest. But I think the bigger point here is rather than getting fixates done whether or not there will be a September rate hike, it's what's the broad trajectory of rates over the next six to nine months, and my sense there is that, as I said last week, far more likely to be up than down at this stage. I did say at the start that the smack dab into a debate about the US rate outlook. I mean, a big chunk of this debate relates to the new Fed chairman and his communication style, and at the risk of waiting into that, I have to ask you, there is a line popular among certain parts of the financial commentary that the inflation reports of the past week have vindicated Kevin Waters approach this. I want to call it his say nothing policy. You might have a different description of it. Do you buy that? Does this justify that July press conference? No, fundamentally, the phones. There I say that the debate around monetary policy has become not only increasingly polarized, but increasingly partisan, so people are cherry picking bits of data in order to support their priors or their prejudices. And moreover, the debate I've noticed over the past week or so has shifted in a way that warships defenders, the outriders, are criticising markets for wanting to be quote-unquote spoon fed, in other words, the Fed to tell markets where rates are heading. I think that completely misrepresents what the kind of criticism or concern about July's press conference by Wash really was getting at. I speak to investors all day, really smart investors, and they absolutely do not want to be spoon fed by the FOMC. In fact, they want the exact opposite because if the Fed is telling you where rates are going and then is acting upon that, then there's very limited opportunity to trade around it. So they definitely do not want to be spoon fed by policymakers, but we do need some clarity of communications, what is helpful is to get a sense of where the Fed sees the balance of risk to the outlook, how they might respond in the event of different shocks. What their quote-unquote reaction function might be, and what the factors they're going to be looking at when weighing decisions on monetary policy in the coming months. So this is not about being spoon fed. The fact that we've had soft CPI data over the past month or so is not a vindication of water strategy, and the concerns that I had in the wake of the July FOMC press conference where we had those mixed messages and tortured metaphors about referees and balls have frankly not gone away. Lots of attention now and what's happening at the long end of the US, the yield curve, the treasury yield curve. I know that you and the team are beginning lots of questions about why yields have been rising. What extent do you think that is a reflection of uncertainty around the Fed because of how water is obfuscated to some of the policy outlook? I think there might be something to it, I'm going to want to overweight that to be perfectly honest. I wouldn't put all of that at Walsh's door far from it. In fact, if you look at what's been happening at the long end of the curve, clearly what drives long yields is a combination of the expectation of the part of short term rates over the lifetime of that bond plus a term premium, and one of the things that we've seen and observed in the data over the past really two or three years is an increase in that term premium. From extremely low levels, with the term premium on 10-year bonds, for example, was negative around the pandemic, so we were kind of returning to more normal levels of term premium in the bond market. That can reflect a number of different things that could reflect uncertainty over the outcome of the monetary policy, as you say. It might reflect some concerns about institutional drift in the US. It might reflect the balance of supply and demand for US treasuries and fiscal policy. So it's all those parts of the yield at the long end of the curve that can't be explained by the expected part of short term rates over the lifetime of the bond. So it's partly, I think, there's an element there in which it's uncertainty around the monetary policy, and what's happening at the Fed, but I think it's probably a small part. My sense is more, it's a return to normal levels of term premium after being extremely compressed and even negative around the pandemic. The question is, will it go much further from here, because we're now back at the level of term premium that we had saying 2014, 2015, the 10-year part of the curve is just under one percent, but it got well above one percent, of course, in the mid-1990s. So the question to my mind is, will it continue to inch up further, and that's why tightening up communications around monetary policy is going to be important, because it will have an impact on that long end of the curve, but of course, it's not the only thing, fiscal policy is the other key issue here, and that's the elephant in the room, and that no one's talking about. And as we've discussed on this podcast before, it's a major source of concern. the other fact the US is running a deficit of 6% of GDP or more. Well, at full employment, I think there's a good chance that look back in a decade's time. We're going to look at that, look back at that as a colossal policy error. Okay, from giant deficits to giant surfaces, we don't generally do obitories on the weekly briefing, but I thought the death of Zhu Rongji is notable. He was the Chinese premier in the late 1990s coming into this century. What's interesting, I think, is how the news of his death has sparked this discussion about a time when China was aggressively reforming, and how that reflects on what's happening in China today. So, let me ask you, why do you think that Zhu Rongji's death has had such an impact on the debate among people who are watching China's economy? I think for a couple of reasons. One is that, as you say, Zhu Rongji was most notably associated with China's push to join the WTA, put real impetus into that process, and frankly been stalling before he became premier. So, when China joined the WTA in 2001, actually was at the end of a 15-year process of China trying to join the WTA, undertaking reforms, America being concerned that China wasn't doing enough on the reform in front, actually parts of the party in China also being concerned about that the war was coming, was the phrase that was used, the idea that you let America into the back door, and that this would be bad for China. So, he was credited really with putting renewed impetus into that accession process and leading that from China's end, and of course, the reason why that resonates now is because of how China's position within the global economy and the implications for other countries has been transformed by its accession to the WTO, we can get into a bit of that. But also, I think it's important to realise that it wasn't just the reforms needed for WTO accession that Zhu Rongji was responsible for, you also can be credited with reforms across China's economy, everything from the labour market to the tax system to land reform, and of course, this is coming in a junk show where we're talking repeatedly about the need for a renewed package of reforms in China to rebalance growth away from this high savings, high investment growth model, to one that stimulates consumption, to one that liberalises and actually China's back paddled in that area, become more centralised over the past decade or so, so we renewed the liberalisation. So, it wasn't yet yes, the WTO accession and then his role in driving that was critically important, particularly for the rest of the world, but it was also his role in driving domestic reforms, which of course, have stalled and gone backwards in many respects over the past decade. So, that's why I think it's resonated, and it's opened up this debate about where are the great reformers in China, are there any great reformers? I think in some senses, I think the debate is not even discussed because I've seen some of people reflect and say, well, there's no one with the vision of Zhu today in China, and that's what's absolutely. And I don't think that's quite right. I think there's plenty of vision, it's just that the vision isn't quite in deliberising integrating type, the Zhu had, it was now much more about centralisation, it's about self-reliance, it's about the idea of dual-circulation, so this idea that China cuts its dependence on the rest of the world, but also increases the rest of the world's dependence on China. And that's what's now running through Chinese policy, and that's what's kind of created some of these enormous tensions and strains in the global trade and system, global financial system, global economy that we now have. So, I guess Zhu's impetus was that the reforms that you speak of there, land reform, reforming the state sector, cutting down the bureaucracy, opening up the housing market, joining the WTO, all part of a need, this critical need to reform the Chinese economy from the chaos of the 50s, 60s and 70s, and part of that process, whereas today it seems like the Xi Jinping outlook of the Chinese economy is that the critical need is this self-sufficiency, this self-reliance, and that that's what's fueling these imbalances, so how does this all develop them? Yeah, I think that's exactly right. That's exactly the point. It's not the absence of a vision in China. It's the fact that a vision is not the kind of liberalizing, integrating type that was predominant in the late '90s, early 2000s. It's now much more about centralisation, greater control, increasing self-reliance, increasing strategic dependency on China by the countries. The immediate way that this is manifesting itself is in a growth model that is producing these enormous external surpluses. When China joined the WTO in 2001, its trade surplus was $24 billion, signed a lot, but it's pretty modest as a share of global GDP, now it's $1.2 trillion. There's no historical precedent for a country running a trade surplus of $1.2 trillion, so it's producing these enormous surpluses. China became the world's biggest manufacturer in 2012, so within a decade of joining the WTO, it was the world's largest manufacturer, now it's responsible for about 30% of total global industrial outputs, and we've never seen a country that dominant in global industry in peacetime, in the US, got to those levels shortly after World War II, but in peacetime we've never seen a country so dominant in manufacturing. This is I think the paradox, if you like, is that viewed on its own terms, it's been enormously successful in terms of pushing this policy of dual circulation, China is becoming more self-reliant in some areas, not all areas, but some areas, and the rest of the world is becoming more dependent on China, but the consequence of that is these enormous external surpluses, and now I think it's what's going to be the undoing, because at some point the rest of the world will either push back against those surpluses, restrict the ability of China to run those surpluses either through trade restriction measures or restrictions on the ability of China to recycle those surpluses into Western financial assets, or every surplus requires a deficit, and those deficits will lead to the build-up of external vulnerabilities in the deficit country's financial vulnerabilities, that at some point cause something to break, and you get a sudden stopping inflows to those countries, a collapse in domestic demand, a recession that pulls down imports, and causes the deficits to narrow, which therefore causes the surpluses to come down. So that's why I think it's important, it's not the absence of a vision in China, it's the fact that there's vision and there's focus on self-reliance, it's producing these enormous external surpluses, and now in itself is unsustainable, and if it's not brought about by some coordinated policy response, which are across countries, which I don't see a great hope for, frankly, then it will be brought about by some kind of crisis or coordinated pushback against China, and that could lay the season the next big global downturn. Neil Shearing on Durong-D, the global threat from China's political economy, and the latest alerts in the US rates debate. On China, the team is doing fresh analysis on the implications of global imbalances, which we will be publishing after summer, and talking about in a host of in-person and virtual events across Europe, Asia, and North America starting in September. These are for capital economics clients, so if you want to join and all get access to all of our coverage of US deficits, Chinese surpluses, and the global outlook, go to our website capitaleconomics.com, and sign up for a trial today. I will also link to our events page in the podcast so you can register interest in an event near you. Now, a report by our Deb T. Chief UK economist Ruth Gregory got a lot of press attention this past week, because she warned that the new Andy Burnham government could be looking to raise taxes in the order of something like £25 billion. That implies an autumn budget similar in size to Rachel Reeves' controversial 2024 tax rate. I spoke to Ruth earlier this week, and I started by asking why this new government could feel the need to raise so much tax. Yes, so the PM has so far outlined pretty ambitious plans, including returning council housebuilding to pre-war levels, making social care free at the point of use, things like raising the income tax per se allowance, as well as increasing defense spending. If you add up the cost of all these spending proposals, they come to between 46 and 63 billion or 1.5 to 2% of GDP. Now by contrast, the measures that have been discussed so far to raise revenue only yield around 2.5 billion, so the funding gap of over 45 billion is very big. Now, it's no surprise that there has been more talk of policy ambitions rather than revenue razors, as a new government won't want to expend all its political capital on day one. And it may be that some of the PM's more ambitious pledges are delayed beyond this year's budget. So, for example, the really big spending items, such as making social care free at point of use, will be subject to of much discussion and scrutiny before anything happens. Even so, there is this pressure to increase spending, such as on defence. And if the PM were to go ahead with unfeasing the personal income tax allowance, for example, that could cost 9 billion a year. And with Labour MPs, unlikely to stomach big spending carts, the markets, unlikely to tolerate big increases in borrowing, then taxes will probably need to rise to fund some of the, some of the PM's policy ambitions. The budget is scheduled for October 28th. How much do you see? think they could be looking at trying to raise through taxes in that budget? Well, we doubt that the ambitions will be realised in full as I mentioned. I think a more plausible outcome is that there's a big increase in the size of the state with higher spending on things like defence, council housebuilding, for example, perhaps of no more than 34 billion and higher taxes, perhaps of up to 20 to 25 billion and higher borrowing than otherwise. So we think the market would tolerate perhaps a rise of up to about 15 billion if it is for investment purposes. OK, so the starting point of your latest report on the Burnham government spending ambitions and the costing for it and the funding for it is this party commitment not to raise these pellet taxes, corporation tax, VAT income tax and employee contributions to national insurance. So where are the funds going to come from? If those taxes are ruled out, where do you see the tax revenues coming from? Well, as you say, the PM, he is hemmed in by this pledge to stick to the tax commitments in the Labour Party manifesto and that that has ruled out the rises in the four biggest revenue raising taxes and he has ruled out tax rises on 54% of the tax base as a result. Now, that doesn't mean he's out of options. He could change taxes that haven't been ruled out. He could create new taxes. He could increase the size of the tax base. He could even break the manifesto. But I think stepping back, I think three things stand out from all of this and the first is that this tax-raising budget could well be almost as big as the last when taxes were hiked by 26 billion. Admittedly, as I mentioned earlier, some of the PM's more ambitious pledges may be delayed beyond this year's budget. But if spending is to rise significantly, then taxes will probably need to rise too. The second point to make is that the balance may be shifted away from the hikes on businesses that we've seen in recent years and towards tax hikes on house. So perhaps on capital, on wealth and on income. And I think the third and final point to make here is that we suspect due to the PM's desire not to exacerbate the hit to households' real incomes that some tax hikes may be delayed. And that may help to limit the economic hit from higher taxes over the next two years or so. So I think in short, this tax-raising budget could be almost as big as the last with most of the extra burden perhaps falling on households. There's a lot more to talk about with regard to these spending ambitions, not least, the bond markets' tolerance for more government buttering. But I just want to pick you up at a point where you talked about perhaps a move to shield the economy from the impacts of higher taxes by perhaps delaying some of these tax hikes, given what you've just said about the size of this budget. What do you think the immediate economic impact is? And by immediate, I mean over the next year or so. Yeah, so I think if Burnham does raise borrowing, then that would mean a bit of a loosening in fiscal policy relative to current plans, albeit not as much as those costly ambitions imply. So I think there is a bit of an upside risk to our forecast for near-term GDP growth in the near-term, but we're certainly not expecting government policy to reignite growth by any means in the near-term. And I think there is an upside risk to our forecast for inflation to fall to 2% next year, and interest rates to be cut to 3% in 2027 as well. You talked about this shift in the focus of potential tax hikes towards households away from business. So a lot of controversy last time about raising national insurance, so that's off limits. But when we're thinking about the hit to households, how will that change the economy's response? And will there be longer-term damage if, for example, capital gains tax rates are raised? I think if you shift the tax burden away from businesses, it does shift the hit away from employers. And as you mentioned, who in recent years have been hit by higher payroll costs from the increase in employer national insurance, which in turn has dampened employment growth. I suppose the risk is that higher taxes on things like capital or pensions could, for example, increase the risk of a weaker and saving and investment incentives. It's worth saying, too, that if the chancellor uses a so-called smorgasbord approach of increasing lots of small taxes, the downside is that smaller taxes need to rise further than bigger taxes to generate the same amount of cash. And they can have distorting effects, for example, in the case of capital gains tax on things like which assets are bought, how long they're held for. And so I think if you do rely on smaller taxes to do the work in raising revenue, then there is a greater chance of some of these adverse effects on things like incentives, on saving and investment. Just to catch us up, we're speaking a day ahead of the monthly GDP release. We've got a load of key data releases in the coming week. What can you tell us about the state of the economy at the moment? So the economy seems to have weathered the Iran war relatively well in Q2, but we think that with inflation yet to peak, we don't think that this strength will last. So we are expecting GDP to stagnate in Q3 and only grow fairly modestly in Q4. Now we do get inflation figures published next Wednesday. And those figures will probably show that CPI inflation rose from 2.6% in June to 2.8% in July. And that this rise was almost entirely driven by higher utility prices. And as I mentioned, we do think inflation has further to rise in the coming months. We think that the lag defect from higher energy prices will lift inflation to a peak of perhaps around 3.7% later this year. But providing that the latest rebound in energy prices doesn't go much further. We still think that the weak labour market will prevent the rise in inflation over the coming months from morphing into something more sustained. And the inflation will fall back to 2% next year. We also get labour market figures published next Tuesday, which will probably show that the labour market is still very weak and pay growth is easing. So the big picture here is that the labour market still seems too weak to cause workers to bargain up their wages. And that supports our long-held view that the chances of second round effects on inflation, that the bank fears could trigger a sustained resurgence in inflation will be fairly limited. And that's why we think the bank will leave interest rates unchanged at 3.75% this year. And if we're right in thinking that inflation will fall to 2% next year, then we think the bank will cut rates to a more neutral setting next year, perhaps of around 3%. Ruth Gregory, on Higher Taxes and the UK Economic Outlook, I will add that note about the potential size and scope of this upcoming budget to the podcast notes, but do check out our UK team's growing body of analysis about the Burnham Government's policy plans and their economic implications. The team has an upcoming piece on what higher taxes could mean for the UK economy again. Sign up for a trial of our coverage today to make sure you get a copy of that report in your inbox as soon as it is published. But that's it for this week. We will be back next week with more for the world of macro and markets. Until then, goodbye.