Monetary experiment with interest and inflation unprecedented

My friend Hans does not understand why I am talking about a recession. After all, the most important characteristic of the period before a recession is that there is no recession yet. The Dutch industry is losing momentum. US inflation has declined slightly and will continue to decline in the coming months. But the rise in rents stands in the way of a return to 2% inflation. And there is an extremely interesting experiment going on in monetary policy

Earlier this week I received a call from a good friend (his name is Hans) who informed me that he did not agree with me. He had heard me on BNR, where I had said that it seems very likely to me that the eurozone economy, as well as our own country, will experience a recession within a few quarters. He himself is a businessman in the field of education. If I have understood him correctly, his sector is running like a charm. Now Hans and his industry have been through some tough times in the past, so he knows what he's talking about when it comes to recessions.

I told him that we are not in a recession yet, that it is just a prediction for the future. The most important characteristic of the pre-recession period is that there is no recession yet. He objected that we now have such a strong economy that some downturn is quite possible, but that a contraction of the economy as a whole still seems unlikely to him. These are special times. Consumer confidence has reached an all-time low. Business confidence has been weakening in many countries for several months, but is still much less negative than consumer confidence. In our own country, the difference between the two has never been greater (if you use Statistics Netherlands' standards).

It suggests that companies are less affected by the inflation chaos than consumers. Companies are again dealing with logistical disruptions, very high transport costs, staff shortages and October is approaching, the month in which they must start repaying any tax debts incurred during the pandemic. Sky-high inflation is eroding household purchasing power to an unprecedented degree, but many families have built up extra savings during the lockdowns of recent years and with life free again, there is plenty of spending despite extremely negative consumer confidence. In addition, not all households are already affected by the higher electricity and gas bills, because some had fixed prices for a longer period of time.

Who's right?
Because this situation is so special, predictions are surrounded by more than usual uncertainty. As an economist, I have to answer the question of which of all these factors will ultimately be dominant. I will put inflation and the loss of purchasing power at the top of my list. Ultimately, a fall in the volume of consumer spending seems inevitable to me and I believe that will cause a fall in GDP. Of course I hope I'm wrong.

But maybe Hans is right and there is enough growth momentum to stay out of a recession. In addition, some problems on the manufacturing side of the economy appear to be easing. Logistical disruptions and very high freight rates are still holding back the production side of the economy, but the situation is improving and that offers room for growth. The New York Federal Reserve has developed an indicator with which they try to measure the pressure on production chains: the Supply Chain Pressure Index. He has shown some relaxation in recent months. 

 And container prices are also falling. According to Freightos' global indicator, container rental costs averaged over USD $6.000 this week. That is four times higher than before the pandemic, but a lot lower than the more than $11.000 in September last year.

Freightos Baltic Index (FBX)

Growth in manufacturing industry weakens
The processing industry in our country has recently distinguished itself very positively from most other countries in Europe, but production growth is now also slowing down in our country. In June, the production level was still 6,2% higher than a year earlier, against 9,9% and 13,8% in May and April respectively.

'Machine Construction' and 'Electrical and Electronic Appliances' remain the fastest growing sectors. However, things have deteriorated in recent months. In five of the first six months of this year, production fell slightly compared to the previous month. Caution is advised here, because those monthly figures jump up and down, but still. It is positive that things seem to be improving somewhat with the transport equipment industry. That's where production picks up. After the production volume was about 10% lower in the first months of the year than a year earlier, a +7,0% was recorded in June. Does that perhaps indicate that the chip problems in the sector are easing?

US inflation slows down
US inflation fell in July: 8,5% from 9,1% in June. As a result, inflation in the US is lower than that in the eurozone for the first time in years. In our own country, inflation rose further in July and is now well above the American rate, both on the European and national measures.

The ECB has only recently raised its official interest rate, while the Fed has already started to do so in March and has since implemented a 2,25 percentage point rate hike. ECB boss Lagarde has long argued to justify the divergent approach that inflation in our country is very different from that in the US. Some banking economists call it that after her. With us, energy is the main culprit, while the US economy, unlike ours, is said to be overheated. To a certain extent that is true. Core inflation, excluding food and energy, is clearly higher in the US than in the United States. Although we have now started to catch up, core inflation in the US has been flattening for months, as the following chart shows.

My objection to the view of Lagarde and her supporters is that supply and demand in the economy are also not in balance in our economy. Unemployment in the eurozone has never been lower than it is now and there is a shortage of labor everywhere. You may not directly call it "overheated", but still.

An incredibly interesting experiment
There is, in my view, an extremely interesting experiment going on in monetary policy. Inflation is a huge problem everywhere and to a certain extent the situation in the various countries is quite comparable, although there are also differences from country to country. However, the differences in policy are remarkably large and the question is whether this is justified. For example, consider the situation in Brazil, the US and the Eurozone. Inflation in Brazil is higher than in the US or ours. That has been the case for a long time, but the rise in inflation is running fairly parallel. The central bank of Brazil has already raised interest rates twelve times and started doing so in March 2021. We'll see how this ends. Incidentally, I note that the European gas price (TTF) is again above €200 MWh. That's not good for us.

                                   Source: Datastream Refinitiv

US inflation key for financial markets
What happens to inflation in the US is of great importance for developments in the financial markets. After all, inflation has a major impact on US interest rates and is an anchor for other markets. I see something positive and also something less positive. On the positive side, inflation in the US is near or perhaps just past its peak. Of course you have to keep the necessary blows up your sleeve. But one of the previous charts showed that core inflation has been stabilizing for months. We also see some relaxation in producer prices, especially where goods are concerned, as the following chart shows. Producer prices are sometimes slightly ahead of consumer prices.

I therefore think that US inflation will fall further in the near future. The question is, how far and how fast? Here I should note something less positive. I've written about it many times before. Rents (actual home rents and imputed rents to homeowners) make up almost a third of the US inflation basket (CPI). These rents follow house prices with some delay. Rents are now rising by about 6%, as the latest chart shows. That could go a bit further. If rents rise at such a rate, it will be very difficult to get inflation rates close to the Fed's 2% target anytime soon.

Closing
I think we are heading for a recession. My friend Hans thinks not. I'm an economist, say bookworm. He is a businessman with a large dose of common sense and a lot of experience with recessions, who has his feet in the clay. Our difference of opinion is indicative of how unusual the current situation is. I think the erosion of purchasing power is going to kill us. Hans thinks the economy has too much growth momentum to fall into recession within a few quarters. US inflation is slowing. I think that will continue, but the increasingly sharp rent increases are hindering a quick return to a world of 2% inflation for the time being.

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

© DCA Market Intelligence. This market information is subject to copyright. It is not permitted to reproduce, distribute, disseminate or make the content available to third parties for compensation, in any form, without the express written permission of DCA Market Intelligence.