Financial instability is a major risk in 2022

Dutch consumers and producers in industry disagree. While the mood among entrepreneurs is remarkably elated, consumers are depressed. It is indicative of the current economic situation.

The coronavirus comes over us in waves and variants. And that leads to tightening and reversing restrictions on public life. But the economic consequences differ greatly from sector to sector. The depressing feeling of consumers is undoubtedly related to the increased number of corona infections and the measures. Inflation will not have been good for consumer confidence either. It is mainly entrepreneurs in the service sector that are suffering the most, while the industrial sector has actually recovered strongly.

Of course they are also dealing with delivery problems and rising costs, but industrial production is increasing and order books are well filled. The picture below shows the indices of consumer and producer confidence in the industry. The picture shows the difference between the two indices over the last twenty years. Obviously, the current constellation is unusual.

Dutch inflation further up
According to preliminary figures, inflation rose further in December. The inflation measure, according to the European HICP calculation method, was 6,4% last month, compared to 5,9% in November. The Central Bureau of Statistics will not release comprehensive figures until next week, including the national benchmark which was 5,2% in November. Increased energy prices are undoubtedly the biggest culprit. In particular, the gas price is high and volatile. Before the corona crisis, the gas price was just under €20 per MWh. In mid-2021 this was approximately €35. After that it went fast, to €90 per MWh at the end of September. In November, the price fluctuated between €65 and €95 per MWh. Then the price flew to €180 just before Christmas, to end the year at €70. Gas now costs €95 per MWh again.

Since the Dutch government has lowered the energy tax since this year, inflation will be squeezed from January onwards. Well, that's how I can do it... and don't forget that rents (with a total weight of about 23% in the inflation basket) have also been restricted. In this way, our market economy is slowly moving towards direct price controls.

Eurozone inflation also higher
Inflation in the eurozone also rose to 5% in December. That was 4,9% in November. Energy was also the main culprit here. Energy prices were 26% higher than a year earlier. With energy having a weight of 9,5% in the inflation basket, this component was responsible for almost half of total inflation.

Excluding food, energy, alcohol and tobacco (core inflation), the increase was 2,6%. That is the same as in the month of November. The story that inflation is almost entirely driven by energy therefore does not hold. The chart below shows that inflation in services and industrial goods (excluding energy) has also risen sharply in recent months. Whose deed.

The end of the pandemic?
Are we going to put the corona pandemic behind us this year? And how will the economy develop? Those are the big questions at the start of this year. We have already counted ourselves rich with regard to the corona crisis, only to be disappointed after all. So we have to be careful. However, the experiences in various countries with the omikron variant suggest that this variant is more contagious than previous ones, but has milder effects. Then there is much to be said for lifting the strictest restrictions. Several countries have already made that choice. For example, the number of infections related to the population size in Denmark is currently high, but the restrictions on public life are limited.

When life becomes freer, in my view the economy has a strong recovery power. Because a large part of the economic damage ended up on public finances, the damage in the rest of the economy is relatively modest. However, it is unevenly distributed. A group of entrepreneurs in the retail and hospitality sectors has been hit hard and they deserve further support from the government. But the financial position of the vast majority of families has improved rather than deteriorated. Despite high inflation and a decline in purchasing power from current incomes, consumers do have considerable spending power. In addition, corporate profits have developed favourably, as a result of which companies can also focus on growth. When logistical disruptions ease, there's little to stand in the way of continued economic growth.

For this year, in addition to unfavorable developments with regard to the corona crisis, I see a major challenge and partly related risk. First the challenge. In many countries (and certainly in the Netherlands) the labor market is tight. That was already the case with us before the corona pandemic. There are a few possible consequences. First, staff shortages can put a brake on production. In the battle for staff, wage increases are accelerating. It is also conceivable that companies will boost productivity by investing in labour-saving technology. Since the corona crisis has shown that working from home is possible for more activities than we practiced before the pandemic, it is only natural that companies in countries with a tight market are recruiting 'home workers' in other countries. In this way the national labor shortage can be overcome. Incidentally, this does change the competitive environment on the labor market, to the detriment of employees.

US labor shortage leads to wage increase
The picture below outlines the situation for the United States. The orange line is based on figures from the 'JOLTs' report and shows the number of vacancies per hundred unemployed. In the Netherlands, the number of vacancies currently exceeds the number of registered unemployed. For the third quarter, Statistics Netherlands reported 126 vacancies per 154 unemployed. In the United States, that figure was even XNUMX in November.

The blue line is from the National Federation of Independent Business survey and represents the percentage of companies that say they plan to raise salaries in the near future. It is clear that plans to increase salaries depend on the tension in the labor market. If the salary increases are realised, there is a danger that the inflation caused by energy prices and logistical disruptions will become more permanent.

For a long time, the Federal Reserve has maintained that this higher inflation is temporary and that tightening monetary policy was neither necessary nor justified. Between September and December, there has been a significant shift in the Fed's thinking. While a majority of the policy committee members in September believed that rate hikes would not take place in 2022 (a minority considered one or two rate hikes likely), in December a majority believed that three hikes were necessary. The pace at which bond purchases are reduced has also been stepped up.

The published minutes of the meeting in December contain two more surprises. For example, the first rate hike may come earlier than expected. In addition, the Fed is not only considering stopping bond purchases, so that the bank's balance sheet will no longer increase, the Fed may also start shortening the balance sheet more quickly. It does this by not reinvesting the money from soon-to-be redeemed bonds in bonds. The stock market was quite shocked by these minutes.

And that is, in my opinion, the biggest risk for 2022. If inflation remains higher and more persistent than currently forecast and the Fed has to raise interest rates much more strongly than expected, or capital market rates rise because market participants believe that the Fed is too late and inflation expectations are rising, then financial instability threatens. A sharp rise in US interest rates could send a shock wave through other financial markets. For now, in my view, that is nothing more than a risk.

The inflation genie isn't out of the bottle yet
The most important question is whether the Fed is already too late. Experiences from the 7s and 4,7s suggest that it will cause economic damage if the inflation genie has escaped from the bottle and the central bank tries to force that genie back into the bottle. Some argue that that inflationary genie is long out of the bottle. Indeed, headline inflation in the United States was nearly XNUMX% in November, while the Fed's preferred measure stood at XNUMX%. I am saying that the development of inflation expectations determines whether or not the inflationary spirit has already escaped the bottle.

There are several measures of inflation expectations. They all paint a similar picture: inflation expectations first fell after the corona pandemic, but rose from mid-2020. The level reached so far is by no means alarming, as the chart below shows. I therefore conclude that the inflation genie is not out of the bottle yet. However, the Fed would certainly be wise to start tightening monetary policy before inflation expectations rise any further. Ending bond purchases in March and a first rate hike in the same month therefore seem sensible measures to me.

Closing comments
I may be naive and hard-learned, but I have hopes that we will put the pandemic behind us during the course of this year. The economic prospects are then favourable. Staff shortages do pose a significant challenge, although they already were before the pandemic in the Netherlands.

Inflation will continue to rise for the time being. The eurozone is about more than energy. The main risk to the economic outlook is that inflation will remain more persistent and higher than anticipated. If such a development results in an unexpectedly strong (mainly US) interest rate rise, this could subsequently lead to significant financial instability. Although I think that central banks underestimate inflation, a scenario of financial instability remains no more than a risk for me too.

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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