Panic stories and too much optimism about the economy

The magnitude of the economic uncertainty is apparent from the noises that can be heard from various quarters. The CPB calculates that the purchasing power loss will be 2,7% on average this year, but that purchasing power will increase again by 1,9% next year. The CPB also predicts 3,7% economic growth for this year, just as high as the European Central Bank (ECB) coincidentally also expects. That may sound unrealistic. However, it should be borne in mind that the so-called statistical overflow is already 2,7 percentage points. In the last quarter of last year, GDP was already 2,7% higher than the entire annual average. So even if GDP stays the same as the fourth quarter of 2021 for the full year, growth of 2,7% will be on the books for 2022.

Nevertheless, the growth forecasts of CPB and ECB seem unrealistic. They see the war as a temporary shock that we quickly recover. The ECB does have two alternative scenarios, a worse and a much worse scenario, but remarkably enough, during Mrs Lagarde's press conference on Thursday, the word recession was not mentioned.

Perhaps these optimistic sounds demanded a response. VNO-NCW foresees a prolonged recession and chairman Ingrid Thijssen gives the impression that the war has caused a sort of infarction in which a large number of deliveries have come to a standstill. I try diligently to inform myself. The chairman of VNO-NCW will not pull this off her thumb. A few entrepreneurs I spoke to recognize themselves much more in Thijssen's story than in that of the CPB and the ECB. The logistics chain is once again completely disrupted. Purchasing prices continue to rise and suppliers often do not even want to submit quotations. The problem, of course, is that we don't know how long this will take.

I too lean more towards the VNO-NCW story, but I still have my doubts about that negative view. Statistics Netherlands recently published an article about our trade with Ukraine. Imports from that country have increased twelvefold in twenty years. That is a major achievement by the Ukrainian exporters. But the total amount was just over €2 billion last year. And these are the main products:

If that all comes to a halt, that's annoying, but I don't think it's the start of a protracted recession. I understand, of course, that it is not just about the mutual trade relationship, but still… The economy of Ukraine in 2021 was slightly less than one sixth of the Dutch economy.

We imported €2021 billion from Russia in 18,4, of which €16,1 billion is mineral fuels and a mere €2,3 billion other products. We really can't do without those fuels and most of them will continue as usual for the time being. If the gas tap were to close, major problems could be foreseen.

The problem for institutions like the CPB and the ECB is that they work with models and that recent major shocks, such as the war, are difficult to process quickly. My personal opinion is that the CPB and the ECB are probably too optimistic. On the other hand, the problem for an organization such as VNO-NCW is that they are confronted with the emotion of the day. And I suspect that the forecast of a prolonged recession is too negative. It is clear that the uncertainties are enormous. This is most clearly evident from the European gas price which has fluctuated between €75 and €300 per MWh in the last four weeks while a price of €15-€20 MWh was normal for the pandemic.

The US has a giga-inflation problem
Inflation in the US rose further in February: 7,9% and excluding food and energy: 6,4%. Due to the further rise in oil prices, inflation will certainly not come down any time soon.

Inflation has also risen in Europe. Still, I think the problem is much bigger in the US than it is here. During the ECB press conference, Ms Lagarde reiterated that more than half of inflation in the eurozone is caused by energy prices. In the US, the inflation process is much broader. The following picture shows the difference between headline inflation, also known as 'headline', and core inflation (ie excluding food and energy for the US and excluding food, energy, alcohol and tobacco for the eurozone). I would like to draw your attention to the most recent development. The difference between the two measures of inflation is much greater in the eurozone than in the US. This confirms that inflation in the US is broader in nature than in the eurozone.

This does not alter the fact that energy prices are also a major culprit in the US. The good news is that energy prices will not continue to rise indefinitely at the recent pace. Once that increase stops. Then inflation falls. And if energy prices fall, inflation will even fall quickly. In that sense, central bankers are right that the current high inflation will be temporary. But the big question is how quickly and to what level inflation will fall.

I told you so
A huge problem for the US is the housing market. House prices have risen sharply. Rents in the US follow house prices, albeit with some delay. Rents of houses that are actually let have a weight of 7,4% in the US inflation basket. Rents imputed to homeowners even have a weight of 24,2%. Rising house prices are therefore tapping into the inflation figure with some delay. I have written about this regularly. The following chart shows that imputed rents are now 4,3% higher than a year ago. Figures from Zillow (say the US Funda) on rents suggest that the increase is accelerating rather than slowing down. When energy prices stop rising, the total inflation rate can never reach 2% quickly. I suspect US inflation will remain above 4% for a long time.

In contrast to Europe, wage growth in the US has already picked up strongly. An interesting indicator for this is compiled by the Federal Reserve of Atlanta, the 'median wage growth tracker'. As the following picture shows, the median wage growth has since accelerated to 5,8%, the largest increase ever, ie in the 25 years that these numbers have been tracked. If you assume that productivity in the US will rise by a 1%-1,5% trend, it is difficult to see how inflation could fall below 4% in the foreseeable future, given this wage increase.

For the time being, wage growth in our part of the world appears to be much more limited than in the US. That's why I think the inflation problem in the US is much bigger than it is with us. But it may be that the acceleration of wage growth in Europe is already underway but has yet to appear in the statistics. Incidentally, the labor market in the Netherlands is much tighter than in other euro countries.

Powell will speak next week
The Federal Reserve's Policy Committee will meet next week. It is inevitable that they will raise interest rates. We are curious what they will say about the impact of the war on the economy, on the financial markets and therefore on the outlook for monetary policy. Although the influence of the war on the US economy is less pronounced than on our own, I think that the Fed will also initially underestimate its influence. Ultimately, I suspect they will moderate the pace of rate hikes somewhat over the course of the year.

Prolonged recession a bit exaggerated
The economic outlook is very uncertain. The forecasts of the CPB and the ECB seem unrealistically optimistic to me. In the eurozone, some economic contraction seems inevitable to me. It is only logical that the uncertainty has shaken confidence among companies. And it seems logical to me that the logistics chain has been disrupted again. Still, I think that the prospect that VNO-NCW outlines, a prolonged recession, is a bit exaggerated. The Russian and Ukrainian economies are not big and important enough for that.

Inflation in the US is now 7,9%. The Fed has made a huge error of judgment here. Even if a decline eventually sets in, I estimate that US inflation will remain above 4% for a long time. Although the Fed may make slightly fewer rate hikes this year in connection with the war than it would have done without the war, the US official interest rate should eventually rise quite sharply.

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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