Recession or not, that's the question

High inflation is eroding consumers' purchasing power in an unprecedented way. Normally this would lead to a fall in the volume of consumer spending and then to a recession. However, households have a buffer: the extra savings they have built up during the lockdowns, on top of the savings they may already have. This buffer is currently being used to maintain consumption. If inflation falls to or below income growth, this buffer is no longer necessary. But if the buffer is 'depleted' while purchasing power is still shrinking, a fall in the volume of spending and with it a recession is inevitable. It's a race against time.

The volume of consumer spending in our country was 7,3% higher in May than twelve months previously. About 19% more was spent on services than in May 2021, on goods about 5% less. Those year-on-year figures are rather strongly influenced by base effects, which in turn are determined by the various lockdowns. That is why I have shown the index of consumption in the first graph. In May 2022, the volume of total consumption was 4,4% higher than in January 2020, just before the pandemic. Purchasing power has declined since then, so it's clear that families are currently diving into their piggy banks. Of course we have to take into account that not everyone has managed to build a piggy bank, so it is very difficult for some households at the moment.

In the meantime, the Dutch economy is already weakening. The unemployment rate rose slightly in June for the second month in a row: 3,4% against 3,3% in May. Unemployment will of course remain historically low. You could even argue that a further relaxation of the labor market would be welcome because of the existing labor shortages.

The number of bankruptcies has fallen sharply during the pandemic. Apparently, as an unintended side effect, the aid granted has kept companies alive that would probably have collapsed had it not been for the crisis and the aid measures. These companies employ people, but from an economic point of view that is not optimal. Those workers could be deployed more productively elsewhere in the economy. It is difficult to determine exactly how many people that is.

Total employment in our country currently stands at just over 9,5 million jobs. A visual inspection of the graph above suggests that there is little or no permanent job loss due to the pandemic.

US economy cools down
Recent figures imply that the US economy, or at least parts of the economy, is currently cooling off at a rapid pace. The housing market is an important driver of the American economy. I have already pointed out several times that the mortgage interest rate has risen very sharply in the first months of this year. This has repercussions on the housing market. The National Association of Home Builders publishes the results of a survey of contractors and real estate agents on a monthly basis. The NAHB index reflects overall confidence in the housing market. In July, that index came in at 55 against 67 in June. The chart clearly shows that there has been a rapid loss of confidence in recent months, but also that the current level is by no means low from a historical perspective. The average of the index from 1985 is 52.

Slightly 'nerdy' as I am, I also made a picture of the change of the index per month. That picture shows that the fall in the index in July (-12 points) is historically very exceptional. Only in April 2020 did this index fall more (-41 points) in one month. Why the index fell so sharply in July is actually a bit of a mystery because mortgage rates actually stabilized in July. Perhaps the fall in the NAHB index is a delayed response to the earlier rise in interest rates, or it may be related to continued high inflation and further weakening of consumer confidence.

The weakness of the US housing market is also reflected in the number of homes sold in the following chart.

And that the economy is losing momentum across a broader front, as is apparent from, among other things, the weekly figures on applications for unemployment benefits. In the week of July 16, that number was 251.000, again slightly higher than the 245.000 the week before. The Philly Fed index, which measures the confidence of entrepreneurs in the Philadelphia Federal Reserve district, also confirms the weaker economy. This index fell from -3,3 in June to -12,3 in July. The long-term average of this index is +8.

Elsewhere in the world there are more positive signs. For example, Korea's export orders rose 9,5% year-on-year in June, an improvement from the +6,0% in May. The figures suggest that global demand for technology products remains strong. The geographical distribution of orders also remains interesting. Korean companies booked more orders from Europe (+18,8%) and the US (+13,3%), much more from ASEAN member countries (+28,8%) and less from China (-14,5, XNUMX%). The latter undoubtedly has everything to do with the 'stop-go' nature of the Chinese economy, where Covid outbreaks are answered with strict lockdowns.

ECB on thin ice
The ECB has hiked interest rates for the first time since 2011. All three official rates have been increased by 0,5%. This removes the negative deposit rate. The ECB has also introduced a new policy instrument: the TPI, Transmission Protection Instrument. Anyone reading this has probably already read about the ECB's decisions, so let me limit myself to the things that struck me during the press conference.

Lagarde stated that one of the reasons why interest rates have been raised more than the ECB itself announced in June is that inflation continues to disappoint. I find that a strange statement, because the ECB could have said the same in June and perhaps earlier.

The TPI seems like a monstrosity to me. It is an instrument with which the ECB aims to limit the interest rate differentials between countries when it believes that these differences frustrate the functioning of monetary policy and are 'disorderly and unwarranted'. But hey, what is 'disorderly and unwarranted'? The ECB gives itself enormous room for (in)discretion and subjectivity here. That seems to me to be asking for trouble and political interference. And what to do if interest rate differentials frustrate the functioning of monetary policy but are justified?

Before the ECB decides to buy up a country's government bonds under the TPI, it is examined whether a country qualifies. Four criteria have been drawn up for this purpose. For example, public finances must meet the well-known criteria. In reality, this means that a country does not qualify if there is an 'excessive deficit procedure' against that country. This does not happen often and the debt ratios seem hardly relevant for such procedures, while they can be very relevant for interest rate differentials.

Lagarde emphasized several times that the amounts that can be used under the TPI are in principle unlimited. At the same time, the ECB says that the liquidity created by the purchases will be offset (sterilized in economist jargon) so that the total amount of liquidity is not affected by it. It remains to be seen whether this can work in practice.

Lagarde also emphasizes that the first instrument used to limit interest rate differentials is not the TPI, but the reinvestments in the PEPP. Under the PEPP (Pandemic Emergency Purchase Programme), the ECB has bought large amounts of bonds. The purchases have since been discontinued. The money that the ECB receives when bonds in its portfolio are redeemed is reinvested. In addition, the ECB is free to use that money to buy bonds from a country of its choice. So when a Dutch government loan is repaid, the ECB can use that money to buy a government loan from another country with the aim of lowering the interest rate in that country. Lagarde said twice during the press conference that this is already happening. Unfortunately, none of the journalists asked for the amounts or other details.

From 'whatever it takes' to whatever we want'
On balance, I am not very enthusiastic about the TPI. It is surrounded by ambiguity. The ECB will use it when it believes it knows better than the market how large the interest rate differentials should be. I don't like such pedanticism from central bankers. The conditions that countries must meet before the ECB will use the TPI for a particular country will in practice be buttery soft, I fear. The danger of political interference seems great to me. The TPI also seems to me to be an invitation for central bankers to adopt a very activist policy. ING's Carsten Brzeski put it beautifully by noting that the ECB under Draghi committed itself to 'whatever it takes' to save the euro. According to Carsten, the new instrument is more of 'whatever we want'.

Before the pandemic, the differences in the size of the government debt in the various euro countries were already significant. And in a number of cases, the national debt was actually much too high. Those debt ratios have risen sharply during the pandemic. The latter is justifiable, but it would have been better if a plan had now been launched to gradually reduce debt ratios. After all, it is the debt ratios that have an important influence on the interest rate differentials.

Money boxes are finite
The global economy is weakening. For now, many consumers are drawing on their piggy banks built up during the pandemic to sustain their spending despite the massive erosion in purchasing power. Those piggy banks are finite. If inflation clearly falls before those reserves are used up, a recession can be avoided. Otherwise, one must fear that consumer spending will fall in volume. A recession is then inevitable.

The US economy is currently losing momentum. In particular, the deterioration of the housing market is progressing at a rapid pace. That raises the risk of a recession in the US.

The ECB has (finally) raised interest rates by 50 basis points. The ECB has also launched a new instrument, the TPI, with which it aims to tackle unwanted interest rate differentials between European countries. That TPI seems to me to be a step towards further politicization of the ECB and an opportunity for the ECB to pursue a very activist policy.

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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