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Weekly Update 12/2/2022: Fed To Slow Interest Rate Hikes Going Forward as Progress is Being Made on Combatting Inflation

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Domestic Economic News

The government’s primary measures of US third-quarter economic activity painted a mixed picture of the economy’s momentum after a lackluster first half of the year. Inflation-adjusted gross domestic product, or the total value of all goods and services produced in the economy, increased at a 2.9% annualized rate during the period, Commerce Department data showed Wednesday. That reflected upward revisions to consumer and business spending, and compares with a previously reported 2.6% advance. Meanwhile, another key official gauge of activity -- known as gross domestic income -- rose at a 0.3% rate in the third quarter after falling 0.8% in the prior period. It’s a measure of the income generated and costs incurred from producing those goods and services. The average of the two figures, a gauge the National Bureau of Economic Research’s Business Cycle Dating Committee uses when making any recession call, increased 1.6% after falling in the first half of the year. For Federal Reserve policy makers raising interest rates at the fastest pace in a generation, the overall growth picture is one they want to see: in line with or slightly below the economy’s long-term trend, perhaps enough to slow inflation but not yet signaling a recession. Meanwhile, a key inflation gauge -- the personal consumption expenditures price index excluding food and energy - - rose an annualized 4.6% in the third quarter. The underlying picture of growth proved similar to the preliminary release. While the details showed resilient consumer spending and business investment, the biggest contributor to GDP was the volatile net exports category. Government spending also rose.

Stripping out the trade and inventories components, a key gauge of underlying demand known as inflation-adjusted final sales to domestic purchasers increased just 0.9% in the third quarter. The GDP data showed personal consumption, the biggest part of the economy, climbed at a 1.7% pace, a slowdown from the prior quarter but up from the previously reported 1.4% increase. Services spending increased, while outlays on goods fell for a third quarter. Looking ahead, household spending is set to drive growth in the fourth quarter. Prior to the release, the Federal Reserve Bank of Atlanta’s GDPNow model estimate for economic growth in the final three months of the year was 4.3%. After-tax profits as a share of gross value added for non-financial corporations, a measure of aggregate profit margins, shrank in the third quarter to 14.9% from 16.2% in the second quarter. Across the economy, adjusted pretax corporate profits decreased 1.1% last quarter, marking the first decline since 2020, and were up 4.4% from a year earlier. This year many companies have successfully passed along higher costs of labor and materials as they try to protect or even expand their profit margins. But some companies have recently indicated a hesitation to pursue further aggressive price hikes amid the uncertain economic environment.

US job openings fell in October, reversing a surprise jump in the prior month, in a hopeful sign for the Federal Reserve as it seeks to curb demand across the economy. The number of available positions decreased to 10.3 million in October from 10.7 million a month earlier, the Labor Department’s Job Openings and Labor Turnover Survey, or JOLTS, showed Wednesday. The figure was roughly in line with the median estimate in a Bloomberg survey of economists. The report suggests demand for workers, while still robust, is moderating amid a darkening economic outlook and rising interest rates. Even so, many employers are still struggling to fill open positions. Labor-force participation is stuck below pre-pandemic levels, and businesses continue to raise wages to attract and retain workers. The persistent mismatch in supply and demand could continue for quite some time, which has led many economists to predict businesses will hoard employees even as consumer spending wanes. Economic uncertainty paired with recent layoff announcements at several large companies also appeared to have made Americans more hesitant to leave their current roles. The quits rate, a measure of voluntary job leavers as a share of total employment, dropped to 2.6%, the lowest since May 2021. Some 4 million Americans quit their jobs in October. Some of the largest decreases in vacancies were in state and local government, excluding education; nondurable goods manufacturing and federal government. Openings increased in other services and finance and insurance. Hires eased slightly to 6 million, while layoffs edged up. The October JOLTS data provides an important signal that labor momentum is cooling -- and in a way the Federal Reserve will welcome. Demand for workers is easing, albeit slowly, and layoffs remain extremely low.

The US housing market pulled back even more in September, with prices slipping 1.2% from a month earlier. It was the third straight decline for the seasonally adjusted measure of prices in 20 large US cities, according to the S&P CoreLogic Case-Shiller index. The housing market suddenly started to cool this year, driven in part by higher borrowing costs as the Federal Reserve hiked its benchmark rate to tamp down inflation. The more-than-doubling of mortgage rates this year has sidelined potential buyers and slowed demand, leading sellers to list fewer properties. “As the Federal Reserve continues to move interest rates higher, mortgage financing continues to be more expensive and housing becomes less affordable,” Craig Lazzara, a managing director at S&P Dow Jones Indices, said in a statement Tuesday. “Given the continuing prospects for a challenging macroeconomic environment, home prices may well continue to weaken.” Although prices are rising year-over-year, they are slowing fast. A nationwide gauge increased 10.6%in September from a year earlier, down from a nearly 13% gain in August. Of the 20 large US cities, Miami and Tampa, Florida, as well as Charlotte, North Carolina, posted the biggest annual price increases through September. San Francisco and Seattle had the weakest gains.

US consumer confidence fell in November to a four-month low amid the double blow of persistent inflation and rising interest rates. The Conference Board’s index decreased to 100.2 this month from a revised 102.2 reading in October, data out Tuesday showed. The median forecast in a Bloomberg survey of economists called for a drop to 100. A measure of expectations -- which reflects consumers’ six-month outlook -- fell to 75.4, while the group’s gauge of current conditions decreased to 137.4. US pending home sales fell for a fifth month in October as demand continued to sag under the weight of high mortgage rates. The National Association of Realtors index of contract signings to purchase previously owned homes decreased 4.6% last month, according to data released Wednesday. The median estimate in a Bloomberg survey of economists called for a 5.3% drop. The housing market is especially exposed to changes in borrowing costs and the average 30-year fixed mortgage rate hit a two-decade high in October against the backdrop of the Federal Reserve’s most aggressive tightening campaign since the 1980s. As a result, pending sales are down 36.7% from a year ago on an unadjusted basis. Americans are seeing home buying conditions at their worst levels in at least a generation, which is resulting in fewer transactions across the board. “October was a difficult month for home buyers as they faced 20-year-high mortgage rates,” Lawrence Yun, NAR’s chief economist, said in a statement. “The upcoming months should see a return of buyers, as mortgage rates appear to have already peaked and have been coming down since mid-November.” Since topping 7% last month, mortgage rates have since declined abruptly as inflation shows signs of easing and amid investor concerns the economy will falter early next year. Contract signings fell in three of four regions, led by a 11.3% drop in the West and a 6.4% decrease in the South. Pending home sales are often looked to as a leading indicator of existing-home purchases as properties typically go under contract a month or two before they’re sold. The index is based on a sample that covers about 40% of multiple listing service data each month.

Recurring applications for US unemployment benefits rose to the highest since February, suggesting that Americans who are losing their job are having more trouble finding a new one in a labor market that’s gradually cooling. Continuing claims, which include people who have already received unemployment benefits for a week or more, rose by 57,000 to 1.6 million in the week ended Nov. 19, the biggest jump in a year. Initial unemployment claims meanwhile decreased by 16,000 to 225,000 in the week ended Nov. 26, Labor Department data showed Thursday. The median estimate in a Bloomberg survey of economists called for 235,000 applications. Economists have been watching continuing claims more closely in recent weeks as they serve as an indicator of how hard it is for people to find work after losing their job. They’ve also been known to hint at upcoming recessions. Although the gauge has been rising for the last two months, it’s still near historic lows. The jobless claims data tend to be more volatile around holidays, and last week included Thanksgiving. The four-week moving average, which smooths out such volatility, edged up to 228,750.

US manufacturing contracted in November for the first time since May 2020 as output weakened in the face of a third-straight month of shrinking orders. The Institute for Supply Management’s gauge of factory activity slid to 49 from 50.2 in the prior month, according to data released Thursday. The measure has fallen in five of the last six months and stands below 50, the threshold separating expansion and contraction, for the first time since the pandemic lockdowns. “The November composite index reading reflects companies’ preparing for future lower output,” Timothy Fiore, chair of ISM’s Manufacturing Business Survey Committee, said in a statement. The median projection in a Bloomberg survey of economists called for a reading of 49.7. Just six manufacturing industries reported growth in November. A measure of prices paid for materials used in the production process fell for an eighth straight month, the ISM report showed. Input prices shrank at the fastest pace since May 2020 in a welcome sign goods inflation is easing amid less stress on supply chains. The group’s measure of new orders has contracted for the fifth time in six months, while the production gauge retreated to 51.5 in November. The weakest readings for both order backlogs and imports in more than two years also indicated softer demand. A measure of customer inventories showed stocks shrank at the slowest rate since April 2020. That may help explain the falloff in new orders to manufacturers and fuel concerns about the inventory glut seen at some retailers. The overall gauge was further weighed down by shrinking payrolls in the sector, as manufacturers cope with both labor shortages and a moderation in demand. A separate manufacturing survey from S&P Global showed similar results. The group’s final November purchasing managers index fell from a month earlier to 47.7, the first contraction since mid-2020. The US figures are consistent with a broader slowdown in manufacturing around the world. The S&P Global measure of factory activity in the euro area pointed to contraction, while in Japan, the gauge dropped below 50 for the first time in almost two years. Electronic hubs Taiwan and South Korea were also sluggish.

US employers added more jobs than forecast and wages surged by the most in nearly a year, pointing to enduring inflation pressures that boost chances of higher interest rates from the Federal Reserve. Nonfarm payrolls increased 263,000 in November after an upwardly revised 284,000 gain in October, a Labor Department report showed Friday. The unemployment rate held at 3.7% as participation eased. Average hourly earnings rose twice as much as forecast after an upward revision to the prior month. The median estimates in a Bloomberg survey of economists called for a 200,000 advance in payrolls and for the unemployment rate to hold at 3.7%. US stock futures declined sharply Treasury yields climbed following the report, as investors anticipated a more aggressive stance from the Fed. The overall job gains were welcome of course but the lower labor participation and stronger than expected wage gains were the opposite of what Jerome Powell said he was hope to see earlier in the week. This is a classic case of for the most part good news leading to a sell-off in both stocks and bonds. Job gains were concentrated in a few categories, led by growth in leisure and hospitality, healthcare and government. Meanwhile, employers in retail, transportation and warehousing and temporary help services cut workers. The better-than-expected payrolls increase underscores the enduring strength of the jobs market despite rising interest rates and concerns of a looming recession. The persistent mismatch between the supply and demand for workers continues to underpin wage growth and has led many economists to expect businesses will be more hesitant to lay off workers in a potential downturn. That said, some sectors are beginning to show more notable signs of weakening. Many economists expect unemployment to rise next year -- significantly in some cases -- as tighter Fed policy risks pushing the US into recession. 

Interest Rate Insight and the Fed

Chair Jerome Powell signaled the Federal Reserve will slow the pace of interest-rate increases next month, while stressing borrowing costs will need to keep rising and remain restrictive for some time to beat inflation. His comments, in a speech Wednesday at the Brookings Institution in Washington, likely cement expectations for the Fed to raise interest rates by 50 basis points when they meet Dec. 13-14, following four straight 75 basis-point moves. “The time for moderating the pace of rate increases may come as soon as the December meeting,” Powell said in the text of his speech. “Given our progress in tightening policy, the timing of that moderation is far less significant than the questions of how much further we will need to raise rates to control inflation, and the length of time it will be necessary to hold policy at a restrictive level.” Policy-sensitive 2-year Treasury yields fell on Powell’s remarks, erasing increases on the day, and the S&P 500 index reversed losses to trade higher. The dollar slipped in value against major rivals on foreign-exchange markets. The Fed’s actions -- the most aggressive since the 1980s -- have lifted the target range of their benchmark rate to 3.75% to 4% from nearly zero in March. Powell said rates are likely to reach a “somewhat higher” level than officials estimated in September, when the median projection was for 4.6% next year. Those projections will be updated at the December meeting. Investors see the Fed pausing hikes in the second quarter once rates reach about 5%, according to pricing in futures contracts. While traders expect rate cuts later in the year, Powell said a reduction isn’t something the Fed wants to do soon.

While economists see a recession in the next 12 months as more likely than not, Powell said a so-called soft-landing for the economy -- or a “softish” landing -- remains “very plausible” and “still achievable,” though he acknowledged the path to such an outcome has been narrowing. Regarding rate hikes, “we think that slowing down at this point is a good way to balance the risks” to the economy from inflation and slower growth, Powell said. The Fed’s Beige Book regional economic survey, also released Wednesday, said economic activity in recent weeks “was about flat or up slightly since the previous report, down from the modest average pace of growth in the prior” period for the review that ran through early October. Powell said the central bank is forecasting 12-month inflation based on its preferred gauge, the personal consumption expenditures price index, of 6% through October, and a 5% core rate. That’s about in line with private economists’ estimates ahead of official figures due to be released Thursday. There hasn’t been enough strong evidence to make a convincing case that inflation will soon decelerate, he said. “It will take substantially more evidence to give comfort that inflation is actually declining,” he said. “The truth is that the path ahead for inflation remains highly uncertain.” He added that “despite the tighter policy and slower growth over the past year, we have not seen clear progress on slowing inflation.”

The Fed chair walked through the components of inflation in the prepared speech. He noted that goods prices have decelerated, but added that it is “far too early to declare goods inflation vanquished.” Powell said that inflation rates on new home-rental leases have been falling. Powell then launched into a discussion of service costs, focusing on scarce supply in the labor market, with the gap in labor-force participation mostly explained by pandemic-era retirements in his view. “These excess retirements might now account for more than 2 million of the 3 1/2 million shortfall in the labor force,” he said. He said the labor market is only showing “tentative signs” of what he called “rebalancing,” while wages are “well above” levels consistent with 2% inflation over time. Powell’s remarks come as the Fed prepares to enter its pre-meeting blackout period at the end of the week. Despite higher borrowing costs, the US economy continues to grow, amid sustained demand and steady hiring. That resilience, while inflation remains stubbornly above the Fed’s 2% target, points to the need for ongoing rate increases, policymakers have said. As noted above, in another sign of labor-market cooling, data on Wednesday showed US job openings fell in October, while the quits rate, a measure of voluntary job leavers as a share of total employment, also declined. That is helpful for the Fed.

The unusually wide gap between the two main US inflation gauges is poised to narrow in the months ahead, giving Federal Reserve officials more cover to pause interest-rate increases in early 2023. Over the last several months, annual inflation as measured by the consumer price index has exceeded that of the personal consumption expenditures price gauge by the most since the early 1980s. Excluding food and energy, the difference in so-called core inflation is also the widest in decades. Data out Thursday are forecast to show the core PCE price index, which the Fed counts as a preferred inflation gauge, decelerated in October to 5% from a year earlier. Core CPI, which came out earlier this month, cooled to 6.3%. But some of the measurement quirks that have put more distance between the two metrics are set to fade in the coming months, while others are set to kick in and contribute to a narrowing. That will help inflation ease toward the central bank’s 2% target. Economists generally expect the core gauges to settle back into a 3-3.5% range by the end of 2023. “The convergence is going to be important for Fed policy next year and driving the discussion” because “you’re going to get less of those red flags coming from the CPI report,” said Jeremy Schwartz, senior US economist at Credit Suisse. “Because CPI is sending the strongest hawkish message right now, it will count extra that it’s slowing down, and catching down to PCE,” he said. Here are a few of the most important things to watch in coming inflation reports to track progress as the gap closes.

The Differences: Conceptually the two gauges measure different things. The CPI aims to capture out-of-pocket spending by Americans, leading to notable weightings for things like rent and cars. But the PCE tries to measure the costs of everything we consume, whether households directly foot the bill or not. The result is big differences in the weightings of categories, and in which costs are included in the measure. This is most notable in regard to health care. Unlike the CPI, the PCE includes all health care spending, including by employers on behalf of workers as well as taxpayer-funded programs like Medicare. As a result, health care makes up nearly a fifth of the core PCE gauge but only around 11% of the core CPI, said Omair Sharif, founder of Inflation Insights LLC. When taking into account methodology differences, medical care is on track to help bring down the CPI over the next year while the same category is seen as adding to the PCE gauge. As of the latest CPI report, the health insurance index has already started pulling down core inflation, a reflection of an annual update to the source data. That helps explain a 0.6% monthly decline in the broader medical care services category. In the PCE, however, medical care will not only be positive but could also accelerate as higher input costs like pay and equipment begin to filter through. “You really haven’t seen the full force of the increase in labor costs that we’ve seen in the health care sector over the past two years,” said Sarah House, senior economist at Wells Fargo & Co. 

The other big reason why core CPI is seen decelerating much quicker than core PCE in 2023 is because more generally, the categories that will help drag down the CPI have smaller weightings in the PCE. Take housing for instance. The so-called shelter category makes up about a third of the overall CPI and about 40% of the core measure. That makes sense given housing tends to be households’ single-biggest monthly expense. The run-up in rental prices has filtered into the official government measures with a lag. Similarly, the rapid deterioration in the housing market seen over 2022 will also take time to be reflected in the figures. But when they do, the impact on the CPI will be swift. The effect on PCE, despite similar measurement, will be much smaller, given the housing components have roughly half the significance they do in the CPI. “That’s probably the biggest driver of the divergence in the outlook for next year,” said Schwartz, who sees core CPI at 3.5% at the end of 2023 and core PCE at 3.1%. A similar dynamic is expected with autos. Used vehicles have already turned over, falling four straight months in the CPI. But the category has a smaller weighting in the PCE index.

Inherently there are also a few categories in the core PCE that just really aren’t reflected in the core CPI. One of those categories is food services, accounting for about 7% of the core PCE. Another is financial services, which measures what consumers may pay a financial advisor or the implicit costs banks charge to hold deposits. The grab-bag nature of it led several economists to emphasize how difficult it is to forecast. Credit Suisse’s Schwartz said the best predictor tends to just be asset prices. Inflation Insights’ Sharif said his general rule of thumb is when interest rates are rising, these costs tend to add to core inflation. The underlying distinctions in the two overall price gauges have mattered less amid extremely high inflation. But next year may prove to be different. “As inflation comes down and the Fed is trying to really calibrate policy back to its inflation target while trying to limit the damage elsewhere to the economy, I think the different measurements will come more into the fore,” House said. That would be a helpful and hopeful trend for sure!

A key gauge of US consumer prices posted the second-smallest increase this year while spending accelerated, offering hope that the Federal Reserve’s interest-rate hikes are cooling inflation without sparking a recession. The personal consumption expenditures price index excluding food and energy, which Fed Chair Jerome Powell stressed this week is a more accurate measure of where inflation is heading, rose a below-forecast 0.2% in October from a month earlier, Commerce Department data showed Thursday. From a year earlier, the gauge was up 5%, a step down from an upwardly revised 5.2% gain in September. The overall PCE price index increased 0.3% for a third month and was up 6% from a year ago, still well above the central bank’s 2% goal. Personal spending, adjusted for changes in prices, rose 0.5% in October, the most since the start of the year and largely reflecting a surge in outlays for merchandise. Similar to consumer price index data last month, the report shows that while inflation is beginning to ease, it remains much too high. While a deceleration is certainly welcomed, Powell emphasized Wednesday that the US is far from price stability and that it will take “substantially more evidence” to provide comfort that inflation is actually declining. Policymakers are expected to continue raising interest rates into next year, albeit at a slower pace, and remain restrictive for some time.

Impactful International News

China’s economic activity slumped in November and could drop further in coming weeks as Covid outbreaks spread across the country and protests against tighter virus restrictions escalate. Bloomberg’s aggregate index of eight early indicators showed a likely contraction in activity in November from an already subdued pace in October. With Covid cases spreading rapidly in each of China’s provinces now and major cities like Guangzhou, Beijing and Zhengzhou imposing new restrictions to limit residents’ movements, the outlook remains grim. The restrictions on movement are limiting residents from traveling around the country and within cities. Subway usage has plummeted in places like Beijing, Chongqing and Guangzhou. Only 12,000 trips were made on Chongqing’s subway last Thursday, well below the daily average this year of 2.7 million trips. Congestion in major Chinese cities also fell last week, as restaurants, businesses and some workplaces closed and people stayed home. Economists at Goldman Sachs Group Inc., Macquarie Group and Hang Seng Bank say chances are rising of more disruption to growth as authorities struggle to minimize Covid infections and deaths while gradually easing restrictions. Demonstrations erupted in cities like Beijing and Shanghai over the weekend as residents vented anger against the virus controls. The central bank is ramping up its stimulus to bolster economic growth as analysts downgrade their forecasts further. The economy is expected to expand just 3.3% this year, the latest Bloomberg survey shows, which would be the slowest pace since the 1970s, excluding 2020’s pandemic slump.

The People’s Bank of China said last Friday it will reduce the reserve requirement ratio for banks by 25 basis points effective next week. That would inject 500 billion yuan ($70 billion) of liquidity into the economy, enabling banks to extend more loans to businesses hit by Covid disruptions. More concerted steps have also been taken recently to bolster the property market, currently in its worst downturn on record. The cut is aimed at “keeping liquidity reasonably ample” and “increasing the support for the real economy,” as well as helping banks support industries damaged by the Covid pandemic, the PBOC said in a separate statement. The RRR reduction -- the first since April -- was foreshadowed earlier this week by the State Council, China’s cabinet, which called for more efforts to solidify the economic recovery. The central bank has also cut its key interest rates twice this year, with the most recent move in August. This should help the economy moving forward.

Germany’s business outlook rose from historically low levels as the risk of energy shortages this winter receded and the government in Berlin prepares wide-ranging measures to shield households and businesses from surging costs. A gauge of expectations released Thursday by the Ifo institute improved for a second month, rising to 80 from a revised 75.9 in October. That was better than the 77 median estimate in a Bloomberg poll. A measure of current conditions slipped. Unusually warm autumn weather and gas-storage facilities that are almost at capacity have lowered the likelihood that German companies will face energy cuts in the coming months. At the same time, Chancellor Olaf Scholz’s government is preparing to spend more than 50 billion euros ($51.6 billion) to subsidize gas and electricity, mitigating the hit to incomes from the highest inflation since the creation of the euro. “Sentiment in the German economy has improved,” Ifo President Clemens Fuest said in a statement. “While companies were somewhat less satisfied with their current business, pessimism regarding the coming months reduced sharply. The recession could prove less severe than many had expected.” The Ifo numbers, however, remain depressed as Germany braces for a recession due to the fallout from Russia’s war in Ukraine. The Kremlin’s decision to curb natural-gas shipments to Europe’s largest economy is weighing on consumers and companies alike while raising questions about the country’s competitiveness. Surveys of purchasing managers on Wednesday signaled that German economic activity is receding, though conditions didn’t deteriorate from last month as economists had predicted. The OECD warned Tuesday that output will probably contract by 0.3% next year, compared with 0.5% growth for the euro area. Any good news on within Europe’s largest economy definitely helps sentiment.

In further good news emanating from Europe’s largest economy, Germany followed Spain and Belgium in reporting slower inflation, offering ammunition to those who want the European Central Bank to ease the pace of interest-rate increases. Consumer prices in Europe’s largest economy rose 11.3% from a year earlier in November, down from October’s 11.6% jump, the statistics office said Tuesday, citing factors including energy costs for the deceleration. Analysts surveyed by Bloomberg had expected an advance of 11.3%. In Spain, inflation abated for a fourth month and by more than anticipated, driven by declines in electricity and fuel costs, though a gauge of underlying prices quickened. The headline number in Belgium, meanwhile, slowed to 10.6%. Inflation data for the 19-nation euro zone are due Wednesday, with economists also estimating a slight moderation -- the first in 1 1/2 years. That reading will be crucial as ECB officials weigh a third straight 75 basis-point hike in borrowing costs or a smaller half-point move before a likely recession. Some officials already favored a more modest increment already in October, according to an account of that meeting, and their voices may get louder if price growth looks to be receding. Others are less convinced. ECB President Christine Lagarde said Monday that she’d be “surprised” if record euro-area price gains have peaked, while Executive Board member Isabel Schnabel said recently that it may be too early to slow the rate hikes. Cooling headline inflation may prompt officials to put a greater emphasis on the core gauge in determining whether a turning point has been reached. ECB Vice President Luis de Guindos said Tuesday that the underlying measure is “the signal we have to keep following.” Natural-gas costs will be key to determining the inflation path in Germany, which relied heavily on Russia as a supplier before the war in Ukraine. The government is now rushing to find other sources and is preparing to subsidize soaring bills for companies and households. Commerzbank AG economist Marco Wagner said it’s too early to give Germany the all-clear after just one dip in price growth. “Underlying inflation will remain high,” he said in a report to clients. “The collective-bargaining rounds have gained momentum and the unions are able to push through significantly higher wages than at the beginning of the year. In addition, companies have incurred high costs due to material and delivery bottlenecks.” We do hope inflation in Europe continues to trend lower.

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