How big is the economic shock?

The economic figures that have been published so far actually all relate to the period before the war. But that will soon change. A first post-war indicator appeared this week at the German Zentrum für Europäische Wirtschafsforschung (ZEW).

This organization polls a group of approximately 54,3 experts in the financial sector every month about their expectations for the German economy. This so-called ZEW index fell from 39,3 in February to -1991 in March. That was the biggest drop in a month since this series began in 8,1. The first chart shows that sentiment among this group of experts is now comparable to the depressed mood after the outbreak of the pandemic. The assessment of the 'current state of the economy' also fell, albeit significantly less, from -21,4 in February to -XNUMX in March. How much this says remains to be seen. It is of course not impossible that those taking part in this survey have allowed themselves to be influenced by their emotions. The risk of a recession is now being discussed at length, certainly in Germany. And since inflation is high, it quickly turns into stagflation. The uncertainties are of course great, as emphasized again this week by Fed boss Powell, our own Klaas Knot and the CPB.

Fed raises rates as first step in potentially long series
The US central bank, as expected, raised the official interest rate by 0,25% this week. The Fed has taken an unprecedented turn in recent months. In September, the median expectation by members of the Fed's policy committee was to raise interest rates once this year. By December, that had climbed to three rate steps, and at this week's meeting, the median year-end expectation for the Federal Funds Rate among members was 1,9%. That would equate to seven interest rate steps of 0,25%, or of course a smaller number of steps if one were to increase the interest rate by more than that 0,25% at a time.

The latter seems quite plausible to me. After all, inflation has gotten out of hand. It now stands at 7,9%, although the inflation measure that the Fed considers most relevant, the price index of 'personal consumption expenditures', excluding food and energy, was 'only' 5,2 in January.

But at Fed chief Powell's press conference this week, he frankly admitted that inflation has risen much more and is proving much more persistent than the Fed expected. When asked how much the Fed is 'behind the curve', he declined to answer. He also talked about the fact that the demand in the economy exceeds the supply, that this causes inflation and that the interest rate increase is necessary to bring supply and demand more into balance. Well, that demand would exceed supply, Larry Summers already calculated more than a year ago. Unbelievable that the Fed is apparently only now noticing this.

I find the combination of the following three pictures interesting in this light. The first picture shows inflation and the actions of the central bank in Brazil. When inflation there rose above 5% last year, the central bank started raising interest rates. It has since been increased from 2,25% at the beginning of last year to 11,75% now. And only recently have interest rates risen above inflation again. This is actually a traditional image as you might expect according to the textbooks.

The next picture shows the same for the US. That's just a really crazy picture. You wonder what exactly they have been doing over there in Washington for the past few months. "Sitting down", is an answer that comes to mind…

ECB doing well
Possibly even crazier is the picture of inflation in the eurozone and the interest rate policy of the ECB, as the following picture shows. I won't mince words this time. Let me limit myself to noting that the ECB is in any case doing well on diversity and climate and that Ms Lagarde shows where she stands by wearing a button in the colors of the Ukrainian flag at the last press conference.

Fed boss Powell was asked during Wednesday's press conference whether he and his colleagues are at risk of pushing the US economy into recession if the central bank does indeed raise interest rates as much as policy committee members expect.

He didn't think so because the US economy is very strong right now. The influence of the war in Europe will be limited, according to Powell, although it does create a lot of uncertainty. He pointed out several times that there are currently 1,7 job openings for every unemployed person and that the US job market has never been as tight as it is today. So the economy can withstand a rise in interest rates. I think Powell is right about that. But I would also like to point out that the economy has probably become more sensitive to interest rate rises. In 2019, it turned out that the economy could not handle an increase in the Fed Funds rate to 2,5%.

The following picture shows the absolute level of production in the US manufacturing sector. In February, production rose 1,2% from January and 7,8% from a year earlier, although the latter figure was flattered by a sharp drop in production in February 2021. Still, the chart shows see that production is at record levels. The high of this index of August 2018 has finally been surpassed. It's interesting what's going to happen next. Remarkably, production on balance completely stagnated between the beginning of 2015 and the end of 2019. Are we now entering a new growth phase?

During the press conference, Powell further pointed to the healthy financial position of companies and families. While high inflation is eroding purchasing power, it is offset by accelerating wage growth and many households' savings since the start of the pandemic. This will support consumer spending unless the war in Ukraine spoils sentiment to the point where consumers keep their purse strings. But that's not how I know the American consumer.

Bright spots for inflation?
I know this is from before the war, but I want to report it anyway. Over the past few months, inflation in the US and also in Germany has stabilized at producer price levels. In February, US producer prices were 10,2% higher than last year, from 10,1% in January and 10,0% in December. Now we really don't have to cheer about that, but it could be relevant. Producer prices always rise and fall much more than consumer prices, and producer prices rose slightly earlier than consumer prices last year. So perhaps these numbers suggest that inflation has approached its peak. Unfortunately, the war in Ukraine will give further impetus to inflation. Hopefully it's temporary. The situation is too uncertain to make firm statements about it. The European gas price has stabilized between €100 and €110 MWh in recent days.

Another bright spot from before the war is that supply chain disruptions eased somewhat. The New York Fed has put together an index that aims to measure the disruptions. As the following picture shows, there was some improvement shortly before the war, although this index was still at a high level. The war will not have made the picture any better.

Lower inflation in Asia
While inflation has risen sharply in our country, in the US and in many other countries, this is clearly less the case in Asia, as the following two pictures with figures from Japan, China, Korea and Taiwan show. In countries such as Malaysia and Indonesia, inflation is slightly above 2%, in the Philippines it is 3% and in Thailand slightly above 5% (the latter does) and in India slightly above 6%, although that is not the case for India very high. I've done some digging in the underlying numbers for Japan, but I can't quite put my finger on it. It seems that energy prices for consumers in these countries have risen somewhat less quickly than in our country.

Figures before the war have little relevance anymore
In terms of economic indicators, we have to draw a line at the start of the war. The figures from before the war have little relevance anymore. And we have hardly any figures from after the start of the war. That will of course change in the coming weeks. It is actually impossible to estimate how great the economic damage will be in our kind of countries. Organizations such as the CPB and the Fed point out that on balance households have built up savings in the last two years. Even if consumers do not withdraw money from their piggy banks, a return to normal saving behavior (i.e. a lower savings rate) can support spending.

The Fed has taken its first interest rate hike and it looks like there will be a whole series of them to follow. That will be time.

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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