Bright spot in supply chain on the threshold of the new year

2021 is coming to an end. This is my last weekly macro commentary of the year. It has again been an unusual, but very interesting year for economists.

The economic recovery, which had already started in the second part of 2020, rumbled on, albeit in fits and starts, heavily influenced by the tightening or easing of restrictions on public life. Totally unexpectedly, the economy was hit by logistical disruptions that contributed to a sharp rise in inflation. Initially, all of this was dismissed as temporary. In the end, the distortions and inflation proved to be much more persistent than assumed and the rate of increase in prices also picked up much more than many had predicted.

My highlight of 2021: Ajax – Borussia Dortmund
I stick to all the rules and have already received my 'booster', but I am slowly getting tired of all those restrictions on life. For me personally it was a huge disappointment that as a football supporter I am no longer welcome in the stadium, although I immediately add that being present at Ajax – Dortmund was fantastic. What a match, what an atmosphere, that makes a lot of good. A few days later there was a small encore when PSV came to visit (although they are now at the top…).

The shortest day is thankfully near and Christmas is the festival of lights. We crave that light. Determined to find bright spots in the economic news, I can report that I have found something. A very crucial bright spot, possibly all-determining for 2022.

Yesterday, IHS Markit released the preliminary December results of surveys they conduct monthly in many countries to assess the confidence of purchasing managers. The eurozone composite index, ie manufacturing and services combined, fell from 55,4 in November to 53,4, its lowest level in nine months, but still above its long-term average. Of course, this figure is not yet the bright spot I spoke of. However, we know why business confidence is weak: this is mainly due to the service sector, which is again suffering from the tightened corona measures to put a stop to the omikron variant. Of course we don't know how effective all this will be, but it is certain that we will overcome this wave again and then the service sector will open again. Business confidence in the manufacturing industry also weakened somewhat in December in the eurozone: 58,0 versus 58,4.

This makes me very excited
But the bright spot I want to draw attention to is what the press release says about the disruptions in logistics in the world and the supplies of raw materials, consumables and semi-finished products that this causes. I quote: December saw the largest expansion of production since September thanks to an easing of supply constraints." Later it continues with: "Although supply chain delays continued to run far higher than anything seen prior to the pandemic, the lengthening of delivery times in December was the least marked since January." And I got really excited about: "Input buying consequently rose at the fastest pace since August and pre-production inventories grew at a rate unprecedented in more than two decades of survey history, facilitating higher output in many firms." (Italics and underlining are mine).

President Lagarde also said something about it at the ECB's press conference yesterday. Reports of alleviating supply chain problems have apparently also reached the ECB, but Lagarde immediately downplayed them as being very minor improvements. A swallow doesn't make a summer, that's true, but in recent weeks we've also seen a few other signs of improvement. Perhaps Lagarde is right that this is only a small improvement that we don't know if it will continue. Still, I think it's very important. According to an ancient Eastern folk wisdom, a long journey begins with a single step.

I suspect that reducing supply chain disruptions can be a self-accelerating process, just like with a puzzle after a difficult start, the pieces eventually come together more easily. If so, 2022 could well be another good year economically with positive surprises in terms of economic growth. I look forward.

Central bankers make a turn
The US Federal Reserve is going to accelerate the reduction of bond purchases, which the central bank has been making since the outbreak of the pandemic. That reduction started in November and it was then planned that the purchases would end in June, but now that will be March. Fed boss Powell also indicated that rate hikes will follow soon after.

The members of the policy committee all give their forecasts for the official rates of the central bank every quarter. In September, nine of the eighteen members thought that there would be no rate hike in 2022, six thought of one rate hike next year and three members anticipated two rate hikes. This week, not a single member thought that interest rates will remain unchanged in 2022 and ten members now foresee three rate hikes. It's quite a twist.

This turn is mainly motivated by inflation. As is known, it is higher and more persistent than previously expected. Powell emphasized that the inflation that is currently occurring is different from the inflation that was expected. In fact, that was a way of temporarily not using the word, but it does mean more or less the same thing. I don't think the Fed is overly concerned about the longer-term inflation outlook. But it is apparently realized that a monetary policy of zero official interest rates and still large monthly bond purchases is not appropriate in a booming economy, where inflation is heading towards 7%, where the labor market is clearly very tight. and where wage growth is therefore accelerating.

Labor costs the key
Powell was asked during the press conference when and why he had changed his mind about the necessary policy steps. He reiterated that the economy is very strong, referring to inflation figures in recent months and specifically mentioning the 'Employment Cost Index' (ECI). That's a quarterly series that is perhaps the broadest measure of labor costs. Powell said he was shocked by the 5,7% figure for the third quarter. I had to look in the statistics because the 'headline' ECI in the third quarter was only 3,7% higher than a year ago. The 5,7% Powell mentioned corresponds to the annualized percentage of the quarter-over-quarter increase in the ECI for private sector employees. The following chart shows for the total ECI that it is one of the strongest increases in labor costs in the last thirty years. The message that comes from this is that the shortage on the labor market is beginning to translate into a sharp rise in labor costs, a development that I have been taking into account for a long time.

The mystery of the declining employment rate in the US
Unlike the ECB, the Fed has a 'dual mandate'. While the primary responsibility of the ECB is to achieve and maintain price stability, the Fed must also aim for maximum employment. The latter was thoroughly questioned during the press conference. When is there maximum employment? Nobody knows exactly, but according to Powell there is 'rapid progress' towards this goal. And the acceleration of the rise in labor costs sends an unequivocal signal. Yet it must be said that something wonderful is happening in the American labor market.

With us, the number of people who have a job is now higher than before the pandemic. That is not the case in the US. The number of people with a job is still about 3,5 million less than before the pandemic, which is 2,3% of total current employment. The lower number of people in paid employment is not due to the number of possible jobs, because the number of vacancies is much greater than the number of unemployed. The pandemic and the enormous shock to the labor market in the US has led to a sharp plunge in the so-called employment rate, the percentage of the population (in the relevant age group) that makes themselves available for the labor market, as the following picture shows.

Why the employment rate isn't rising faster now that there's so much demand for staff is a bit of a mystery. Also for the Fed. Powell speculated as he pointed to a number of possible causes. He said that some people may still be too afraid of corona to want to go back to work. The lack of childcare would deter single mothers from entering the labor market. Furthermore, Powell pointed out that people with stock portfolios and houses have on balance done well in the last two years and that this may be a reason not to work, especially in families where there were two incomes before the pandemic. Another explanation is that people close to retirement have seized the opportunity of the pandemic to put a permanent, if somewhat premature, end to their working lives. The Fed hopes that the tight labor market and rising wages will eventually attract more inactive people into the labor market.

ECB follows at a great distance
The ECB will also reduce bond purchases. Purchases under the so-called PEPP (Pandemic Emergency Purchase Programme) will be reduced in the coming months and terminated in March. Purchases under the pre-pandemic APP (Asset Purchase Programme) will be increased in the second quarter to prevent the total amount of purchases from falling too abruptly. In the second part of 2022, the amounts under the APP will be reduced again to reach the current €20 billion per month in the last quarter. President Lagarde again indicated that interest rate hikes will not follow until the APP has ended. That is certainly not foreseen in 2022.

The ECB has again made significant adjustments to growth and inflation forecasts. For example, the estimate of inflation for 2022 went from 1,7% to 3,2%. Lagarde was questioned about this during the press conference on Thursday. Isn't such a figure a reason to take some more action? Lagarde brushed that aside by pointing out that more than two-thirds of the increase in the inflation estimate is caused by energy prices. It is not my job to take it for Lagarde or the ECB, but I would also like to add that part of the increase in the inflation estimate for 2022 is caused by the figures of the last few months. In November inflation for the eurozone stands at 4,9%. If that is still the case in January and inflation falls in a straight line in 2022, the year-on-year figure in December 2022 should be 1,5% to give an annual average of 3,2%. With such a figure, there is little reason for the ECB to tighten monetary policy significantly. Incidentally, I think that average inflation in 2022 will be higher than the 3,2% that the ECB considers likely, even if the figure is somewhat dampened by the statistical problems surrounding the temporary VAT reduction in Germany last year.

Old strategic objective is now being achieved, new one not yet
The ECB now forecasts an inflation rate of 2023% for 2024 and 1,8. In September, 2023% was still expected for 1,5. When I saw that 1,8%, I immediately thought that the target of 'below but close to 2%' has been achieved and that there is therefore reason to start normalizing monetary policy now. But then I remembered that the ECB modified its own strategy earlier this year and now has a symmetrical target of 2% over the medium term. And Lagarde also said that 1,8% is not 2%. I got acute itching. The ECB, like many others, has been so misguided this year with its inflation estimates that a 0,2% difference to 36 months ahead is certainly in the margin of error.

Finally, Lagarde was asked why the ECB's policy differs so much from that of other central banks that are more clearly opting for a reduction in emergency aid and for raising interest rates. In addition to the US, Canada and Australia and the UK were also mentioned, where the Bank of England unexpectedly raised interest rates slightly this week. Lagarde defended himself by pointing out that these economies are incomparable. For example, the US government has pursued a much more aggressive fiscal stimulus and wage growth is clearly accelerating. The latter is not (yet) the case in Europe. Lagarde also pointed out that although inflation expectations have risen slightly, they are far from levels that the ECB should be concerned about. I think Lagarde is right that the situation is different. But the question is whether the economic situation in the eurozone justifies the current monetary policy. I have my doubts… actually I just don't think so.

Pandemic will also have a major impact on the economy in 2022
The pandemic will also have a major impact on economic developments in 2022. A big difference from 2021 will hopefully be what happens to the logistics disruptions in the world. They remained remarkably persistent in 2021, but appear to be declining in 2022. That leaves room for pleasant surprises. It remains to be seen to what extent this will also limit inflation. I suspect it will still be higher than hoped. A gradually tighter monetary policy is logical, although I suspect the ECB will continue to lag considerably.

Hans de Jong

Han de Jong is a former chief economist at ABN Amro and now a resident economist at BNR Nieuwsradio, among others. His comments can also be found on Crystalcleareconomics.nl

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