I am not yet embracing the soft landing scenario after inflation

German industry is not living up to its promise, while our industry seems to be doing slightly better. The number of bankruptcies decreases in July, but the trend is upwards. Inflation is falling and the beneficial 'soft landing' scenario is becoming more likely. But I'm not embracing it yet. China, meanwhile, continues to struggle and may have entered a balance sheet recession.

Last week I wrote here enthusiastically about the surprisingly strong increase in new orders that the German industry recorded in June after an also surprisingly strong figure in May. Will German industry finally recover? That hope and the associated optimism were skilfully dashed to the ground on Monday morning. Production fell 1,5% month-on-month and 1,7% year-on-year in June. There was, however, a slight improvement in the energy-intensive sectors. There, production increased by 1,1% month-on-month, but the production level was still 12,2% lower than in June 2022 and even almost 18% lower than in mid-2021. Before the spectacular rise in European gas prices began.

The first picture shows that something remarkable has happened in recent years. The development of orders and production have historically been in sync with each other, but this has not been the case at all in recent years. I don't have an immediate explanation for it, nor do I have an idea what exactly this implies for the future. Logically, you think that the production level must also be above the order level for a while. We will see.

In the past I have regularly referred to the decoupling between Dutch and German industrial production in recent years. In June, production in the processing industry in our country was 7,7% lower than one year previously. That doesn't sound good and it isn't. But it is partly a result of strong growth last year and it is better than in the previous two months. In addition, production in May and June increased month-on-month by 0,8% and 0,7% respectively. Production in the energy-intensive chemical industry was still 5,7% lower than a year ago, but has fortunately picked up in recent months after the fall in energy prices started. In May and June, production increased month-on-month by 3,6% and 6,0% respectively. That gives the citizen courage.

It should be said, however, that energy prices are now rising again. Oil prices were around $75 a barrel in May and June, but are now fluctuating between $85 and $90. OPEC predicts excess demand. The European gas price has also risen in recent days. While it recently fluctuated between €25 and €30 per MWh, in recent days there has suddenly been almost €40 on the plates. The prices for delivery from December to the end of next year are all above €50 MWh. The American gas price is approximately €8,50 MWh. That is less than a quarter (!!!) of the European price and therefore clearly bad for our competitive position. The US futures contract for December 2024 is trading at around €13 MWh.

Number of bankruptcies decreases in July
In July, corrected for court days, according to Statistics Netherlands, 219 companies (excluding sole proprietorships) went bankrupt, less than the 274 in June, but much more than the 126 in July 2022. The following picture shows that the number of bankruptcies decreased considerably during the corona crisis . The number of bankrupt companies is now normalizing. Over the period 2020-2022, about 3.500 fewer companies went bankrupt than might have been expected if the trend of the three previous years had been followed. It seems to me that a large number of those 3.500 will still go under.

A round of inflation
Statistics Netherlands already reported last week that our inflation was 4,6% in July, compared to 5,7% in June. Core inflation fell from 6,1% in June to 5,8% in May. Over the next two or three months, inflation will fall further sharply due to base effects. Indeed, in August and September last year, prices rose month-on-month by 2,0% and 2,4% respectively.

There is a lot of fuss about 'prices in the shops', especially food prices. Food price inflation has dropped considerably in recent months. Just under 12% in July; in June it was still more than 13% and earlier this year it was almost 19%.

This decline is also largely due to base effects. Month-on-month there was again a slight increase in July: +0,2%. However, it was less than the monthly increase in July last year. It must be strange if food price inflation does not moderate further. Food prices in the shops follow world market prices and energy prices with a lag. The next picture shows the relationship between our food price inflation and world market prices. Food price inflation is about eight months behind world market prices and you can expect it to continue to fall for the time being. However, food prices in the shops are now responding much more strongly to world market prices than in 2008 and 2011, when the FAO Food Price Index also rose sharply. Undoubtedly, this has everything to do with the development of gas prices.

US soft landing is approaching, but I don't trust it yet
In contrast, US inflation rose slightly in July: 3,2% compared to 3,0% in June. This increase was also due to base effects. Month-on-month, the price increase was only 0,2%. Even without food and energy, prices rose by 0,2% in July. Year-on-year, core inflation fell marginally to 4,7% from 4,8% in June.

Food price inflation is also falling in the US. That process started months earlier than with us. In July, food prices were 4,9% higher than a year earlier. At its peak, it was still 11,4%. Food price inflation is also falling further in the US.

Furthermore, a process of normalization is still underway. During the pandemic, the lockdowns and the resulting change in consumption patterns, combined with logistical disruptions, led to very remarkable price developments. For example, the price of second-hand cars exploded. The next picture shows this and also that some normalization is now taking place. In July, prices were 5,6% lower than a year earlier. It seems unlikely to me that the price level will return to pre-pandemic levels, but some further decline seems likely. Although the weight of used cars in the inflation basket is small, it still adds up if the price changes are big enough. This pattern also plays out in some other categories.

Moderate inflation makes the soft landing scenario more likely. That is, inflation will move towards the Fed's target without the need for further rate hikes and recession. That's not the scenario I've been following for a while. I am more pessimistic and think that ultimately a cooling of the labor market is necessary and that this requires higher interest rates. But I can't deny the numbers. Of course, I can point out that core inflation is still well above target. This is largely due to the rents. In the US, these have a weight of approximately 40% in core inflation. Rental inflation has passed its peak and will continue to fall in the coming months. That will depress core inflation.

Still, I think it's too early to embrace the soft landing scenario. We have to realize that the fall in inflation is partly caused by a normalization of out of whack prices, such as those for used cars. Such prices will not continue to fall. In addition, house prices have been picking up for several months now, which makes it uncertain whether rental inflation will moderate enough. Finally, just like with us, wage growth is falling. Here too, the question is whether, given the tightness of the labor market, it will be sufficient to stick to the 2% inflation target in the long term. But I cannot deny that the recent numbers have made the soft landing scenario more likely.

Finally, the pricing policy of SMEs seems to stand in the way of a much stronger disinflation. In addition to inflation, the picture above also shows the so-called price intentions as shown by the monthly survey of the NFIB among its members. In the picture, the inflation series has been delayed by four months to get the best fit. It is not a law of meads and persians, but the correlation coefficient of these two series is 0,80.

China continues to struggle, is there a 'balance sheet recession'?
The problems of the Chinese economy remain a major theme this year. The abrupt end of the lockdowns at the end of last year has still not led to a convincing acceleration in economic growth. In July, the value of imports was 12,4% lower than a year earlier. In June it was -6,8%. This was partly due to high import figures in July last year, but such a sharp decline also indicates weakness in domestic demand. The export value was no less than 14,5% lower than in July last year. The weakness of the international economy, particularly in industry, is also clearly playing a role in China.

Meanwhile, inflation in China has fallen below zero. In July inflation was -0,3%. As elsewhere, Chinese inflation has been falling for months. Because it had not risen as far as with us, you will reach 0% faster and in this case even below it. The Chinese authorities believe that negative inflation is temporary. We will see. When Japan sank to negative inflation, it turned out to have a crippling effect on the economy. It was also difficult for Japanese policymakers to get rid of negative inflation. Stimulation packages proved to be hardly and invariably only temporarily effective. There was talk of a 'balance sheet recession'. Many entities were plagued by unhealthy balance sheet ratios and used any improvement in current financial conditions for balance sheet repairs rather than ramping up investment or consumption. Balance sheet repair thus sucked every dynamism out of the economy.

Economists are saying that China has also ended up in such a 'balance sheet recession'. Naturally, the development of the Chinese economy has consequences for inflation. If there is no convincing recovery in growth, this will have consequences for commodity prices. That helps keep inflation down for us. A strong recovery in China, on the other hand, is pushing up commodity prices. This therefore has consequences for inflation.

Closing
The promising recovery of orders in German industry has not yet led to strong production growth. The energy-intensive industry seems to be recovering somewhat, but the production loss compared to the highest point is still very large. The fear remains that part of that production has disappeared forever. The Dutch industry is producing considerably less than a year ago, but month on month things have been slightly better for two months now. And the recovery of the energy-intensive industry seems somewhat more convincing to us than in Germany.

Inflation is falling, both here and elsewhere. That process will continue in the coming months due to base effects. However, we must realize that the picture remains unclear. Some prices that had risen in the pandemic are now falling, but are not continuing to fall. Wage growth is slowing down. A further weakening of wage growth is necessary to ultimately stay with the central banks' 2% target. The question is whether this will succeed in the current tight labor market. However, I cannot deny that the soft landing scenario has become more likely. An unexpected increase in energy prices could seriously disrupt the picture of declining inflation. Oil prices have risen in recent weeks and the European gas price has recently also risen sharply. That may be temporary. Fingers crossed.

The Chinese economy is still not showing a convincing recovery. It is a setback for the international economy. On the other hand, it is positive for the international inflation picture.

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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