Higher interest rates and inflation do not make things better

It's not looking good. Inflation is being boosted by the war, the Fed and the Bank of England are raising interest rates, growth momentum is declining in the eurozone, the US and China and an oil boycott will pose major challenges for Europe. That is also annoying for Putin, but he can sell his oil elsewhere. 

The war in Ukraine has given many raw material prices a new impulse. I just picked (Thurs afternoon) some numbers from Trading Economics. If you go and see for yourself, no doubt those prices will be different, it's volatile, but it's the idea.

Source: Trading Economics

It is perhaps best to read the table in such a way that the price change for 1 year is currently largely incorporated in the inflation, while the price increase of the last month may not have (fully) reached the consumer level. So there's more to come.

The messages of this overview are unambiguous.

1. Energy prices have risen sharply in the past month and also very sharply compared to a year earlier.
2. Gas prices in Europe had already risen sharply, but US gas prices have also risen sharply recently.
3. Food prices have also risen considerably, both on a monthly basis and over 12 months, but less than energy prices.
4. Prices for metals have actually fallen recently. That suggests that the global economy is weakening. It doesn't bode well.
5. Batteries for electric cars will not be cheaper for the time being, given that lithium is more than four times as expensive as a year ago.
6. Meat eaters are less expensive than vegetarians, unless you only eat corn.
7. This applies especially to Christians and not to Jews or Muslims, since pork has become cheaper in particular.

Fed raises interest rate 0,5%, Bank of England 0,25%
This week, both the US Federal Reserve and the Bank of England raised interest rates. It was the fourth rate hike in a row for the Bank of England. Three of the 9 members of the policy committee would have preferred an increase of 0,5%. It was the Fed's second rate hike in a row, and Chairman Powell said it will also hike rates by 0,5% in upcoming meetings, likely two. After that, interest rates will rise further, but perhaps in smaller steps. We will see.

Powell spoke a number of times about the tightness in the American labor market. Rightly so. The so-called JOLTS report (Job Openings and Labor Turnover Survey) shows that no fewer than 11,5 million vacancies were open in March. There were 'only' just under 6 million unemployed that month. Never before have there been 1,9 vacancies per unemployed person. And never before has the number of vacancies been 7,2% of existing employment. The labor market is unprecedentedly tight.

In the pandemic, many Americans have left the job market, an unforeseen shock to the economy. Policymakers hope that many people will return anyway. That process is ongoing, but disappointingly slow. The participation rate dropped abruptly during the pandemic from over 63% to over 60%. We are now back at over 62%. The tight labor market leads to an acceleration in wage growth, which keeps the inflation process going.

US economy strong, but losing momentum
During his press conference, Fed boss Powell was asked whether the US economy could weather the rate hikes unscathed. The idea was for the Fed to raise interest rates, thereby bringing inflation under control without sending the economy into recession. Powell said there's a good chance the Fed will pull it off (I'm paraphrasing). He argued that by pointing out that the US economy is currently doing very well. Although GDP contracted in the first quarter, this paints a strongly negatively flattering picture, as the contraction was mainly caused by stock depletion. We hope, of course, that Powell is right. In any case, many indicators are still green for the time being. This does not alter the fact that the underlying growth momentum is also weakening. Business confidence in the industry, for example, fell from 57,1 in March to 55,4 in April according to the leading ISM measure. That's well above 50, the dividing line between growth and contraction, but the peak in this range is more than a year behind us.

Don't forget the Chinese lockdowns
The growth momentum in the rest of the world is certainly not improving. Now that we have our freedom back, it is easy to forget that large parts of China are still in lockdown with major consequences for the Chinese economy. Business confidence fell significantly in April, according to the central bank's benchmark, in both manufacturing and services. Both sectors have reached their lowest point since the start of the pandemic.

The Cheung Kong Graduate School of Business (CKGSB) conducts a monthly alumni survey to measure trust among this group. I have been following the results of that survey for years and the picture is not very positive at the moment. It is inevitable that the Chinese lockdowns will also affect us in the form of further logistical disruptions, increasing problems with deliveries, etc. This will also not help inflation in our kind of countries in the short term.

Growth momentum in Europe is also declining
Growth momentum is also declining in Europe. The European Commission's leading indicator, 'Economic Sentiment', fell from 106,7 in March to 105,0 in April. This means that this index is still 5 points above the long-term average, but the decline has been significant in recent months.

In Germany, manufacturing orders fell 4,7% mom in March. In February, they were also down 0,8%, although that was better than the -2,2% originally reported. Such a decline as in March is going fast. Capital goods orders fell 8,3% from February. Orders from abroad contracted much more than those from Germany itself: -6,7% against -1,8%. In that light, it was not surprising that goods exports also declined in March. The export value decreased 3,3% in March compared to February. Due to the sanctions against Russia, exports to that country fell by no less than 62,3%. But less was also exported to China, -4,3%. Manufacturing output fell 3,9% mom in March.

The sanctions against Russia
The European Union is going to impose new sanctions against Russia. The most important element is most likely an oil boycott. Some countries are still resisting and they may have longer to get rid of Russian oil. Incidentally, the boycott will not take effect immediately, we are taking six months to find other suppliers. There are those who argue in favor of stopping the importation of Russian oil much sooner. That would pose big problems for us. The European Union produces hardly any oil, partly because we have discouraged exploration. About a third of the oil we use comes from Russia. That is 3 to 4 million barrels per day. We'll have to get it elsewhere. That's not chinsinne. The oil market is tight. About 100 million barrels of oil are produced and consumed worldwide every day. It's not like there are a few million barrels a day 'on the shelf' somewhere. And one oil is not the other.

We import a lot of crude oil that we refine ourselves. Our refineries are geared to Russian oil and cannot process, for example, much lighter US shale oil. Saudi Arabia has opportunities to expand production and produces suitable oil for our refineries. But that country is in OPEC+ with Russia and that partnership has just decided to expand production only slightly from 1 June. Actually, we'll have to find those 3 to 4 million barrels by outbidding other buyers. With parts of China in lockdown, oil demand is still somewhat subdued at the moment, but if those lockdowns end, I think further price increases are lurking. That boycott will really cost us something.

The next question is how hard Russia will be hit by an oil boycott. I understand that we do not want our euros to feed Putin's war chest. But Putin will find other buyers for the Russian oil and thus keep his war chest full. I suspect that the world market price will rise and that some buyers of Russian oil will negotiate heavy discounts as is already the case. What will happen to Russian oil revenues on balance seems uncertain to me. For Putin, the boycott is annoying, but I don't think much more than that. I can't imagine the end of the war coming a day nearer.

I follow developments in the Russian economy with suspicion. It is undeniable that they suffer a lot from the sanctions. The central bank expects an economic contraction of 8-10% this year. Whether we can trust the figures we get from Russia, I don't know. What certainly stood out this week was that business confidence in Russian industry improved slightly in April. The purchasing managers index rose from 44,1 in March to 48,2 in April. If you read the press release, that increase seems to paint too positive a picture, but the increase is striking.

strong ruble
What is also striking is that the Russian central bank has not only succeeded in stabilizing the ruble, but the Russian currency is now even stronger than before the war. That reduces the risk of financial chaos in Russia and dampens inflation. I come to the sad conclusion that the economic situation is deteriorating almost everywhere in the world, but that it is precisely in sanctioned Russia that some improvements can be seen. I really understand the sanctions very well, but I think that they hit our own economy firmly, especially an oil boycott will cause major problems. If the purpose of the sanctions is to get Russia to stop with that terrible war, then I fear that the sanctions are not (or will not be) very effective.

Closing
The economic outlook is not very encouraging. The growth momentum is declining. This is due to a combination of factors. High inflation destroys purchasing power and creates uncertainty. The Chinese lockdowns will exacerbate supply chain problems. The rise in commodity prices since the start of the war has not yet been (fully) reflected in inflation. Rising interest rates will initially affect the most interest-rate-sensitive sectors, and in any case have a dampening effect on economic growth. An oil boycott will present the European economy with new challenges. At the same time, the war continues and although the Russian economy has been hit hard by the sanctions, chaos does not appear to be in question. In fact, Russia is one of the few countries where there is something positive to report on the economic and financial indicators this week. It's sad to see that.

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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