Inflation remains the main economic theme

Consumer confidence in the Netherlands fell again in February. The index came in at -30 (-28 in January), well below the historical average and just above the 2020 low (-31 in May 2020). The record low for this series was set in 2013: -43. It is striking that confidence is so low while economic growth is high and the labor market is very tight.

The first picture shows that the remarkable decline in confidence started when inflation (shown in the chart on an inverted scale) started to rise sharply. It is therefore very likely that consumer confidence will be seriously damaged by inflation. Incidentally, we see this development and coherence not only in the Netherlands but also elsewhere.

A record 66% of respondents say that prices have risen sharply in the past twelve months (you wonder what world the other 34% live in, but that aside…) One bright spot may be that the percentage of respondents that a stronger price increase expected over the next twelve months fell from 37% in January to 32%.

The question this raises, of course, is how this really affects the economy. In the end, it's not about consumer confidence, it's about their spending. The following picture shows that the relationship between trust and 'consumption households' is relatively loose. However, it is inevitable that inflation of 6,4% severely restricts the scope for spending because incomes do not rise correspondingly and the consumer ultimately has no other option than to spend less in real terms.

Statistics Netherlands has calculated that if energy rates remain at the same level throughout 2022 as in January, an average household will spend €1.321 more in energy than on the basis of energy prices in January 2021, an increase of 86%. Now these figures are somewhat flattering because the rise in energy prices has already started in the course of 2021. More importantly, many households have permanent contracts and are therefore not yet charged for the higher prices. But that's a stay of execution if prices don't fall before those contracts have to be renewed.

Dutch GDP increased by 0,9% in the fourth quarter compared to the third quarter. As a result, growth in our country was above the eurozone average and far above the contraction that was realized in Germany. Over the whole of 2021, the economy grew by 4,8%. That our economy grew in the last quarter of last year came as no surprise as we already had data on manufacturing output, the labor market and consumer spending and retail sales. Still, the growth is remarkable because of the tightened corona measures in November, the sharply rising omikron infection figures and the hard lockdown that was introduced just before Christmas. Apparently the restrictions on public life have less and less influence on economic life.

The hard lockdown obviously lasted a significant part of the first quarter, so it remains to be seen how badly the economy will prove to be hit in the current quarter. With restrictions largely removed by the middle of the quarter, this will undoubtedly be a two-faced quarter, with inflation and the resulting loss of purchasing power forming a significant shadow.

The following chart shows that our economy has slightly outperformed the eurozone as a whole during the pandemic. Our GDP was already at and above pre-pandemic levels in the course of 2021. The eurozone as a whole only managed to do that at the end of 2021.

Fed divided, but higher US interest rates coming
The minutes of the policy meeting of the Fed meeting in January show that there is still some division within the policy committee about how to proceed. It continues to be said that temporary factors set inflation in motion, while recognizing that inflation has broadened in the economy and that strong wage increases may hinder a rapid decline in inflation. The Fed is divided on how best to respond to this. It is clear that monetary policy needs to be adjusted. But some members of the committee believe that continued disappointing inflation should be met with a rapid and sharp hike in interest rates, while others point out that such policies can sometimes lead to financial instability and that caution should therefore be exercised. I think the latter group is right. Inflation will undoubtedly fall in the course of the year. And it won't be the first time that the Fed has pushed the economy into recession by tightening too aggressively. For now, however, it is not that far yet.

The following picture shows the difference between the effective yield on ten-year government bonds and that on two-year government bonds. If the line goes down, that difference gets smaller. The 'yield curve' then flattens out in the jargon. The gray shaded areas in the chart mark recessions. It is clear that every recession in the last 45 years has preceded a yield curve inversion, so that the effective yield on two-year bonds was higher than that on ten-year bonds. This difference is therefore a fairly reliable predictor of recessions. The graph shows that the curve has flattened in recent months, but is by no means negative. It is important to keep a close eye on this.

Incidentally, the American consumer continues to spend. Retail sales rose by no less than 3,8% in January compared to December. The following chart nicely shows that the US consumer has quickly recovered from the sharp decline that occurred when the pandemic broke out. Supported by increased benefits and generous checks the Trump administration sent to all Americans, spending quickly bounced back. When the Biden government also sent checks, it was a celebration. Retail sales are now above the level that you would have expected had there been no pandemic at all and the previous trend had continued.

It should also be noted that these figures are in nominal terms. Higher inflation therefore clearly has a grip on these numbers, making it look nicer than it actually is.

That is why the last picture is important. It shows retail sales in nominal terms and in real terms. The effect of the 'Biden cheques' is clearly visible in the first part of 2021. In volume terms, the turnover has not increased further.

I have limited myself in this commentary to a modest number of indicators. The state of the economy can best be summarized as follows:

• The economy is doing quite well, not just here, but elsewhere too. However, we must not forget that many small entrepreneurs have used their financial buffers to survive and will have to try to pay off their debts in the coming period.
• As restrictions on public life ease in many countries, the economy will be able to move more freely.
• Asia is quite different from Europe and the US. The policy continues to be characterized by zero-tolerance towards the virus. Incidentally, inflation in Asia has hardly increased, if at all.
• The economic impact of restrictions on public life has diminished over time, so the 'opening up' is likely to have only a limited positive impact on the economy.
• Staff shortages and high inflation are a major drag on growth in the coming period.
• Inflation remains the main theme for the time being, both in Europe and in the US.
• In America, the Fed rate hike process will begin soon. In principle, count on five rate hikes of 25 basis points each this year.

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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