Economic Research syndicated feed

When prices first began to climb in the spring of 2021, central banks initially spoke of a temporary shock triggered by the major disconnect between the rapid post-Covid recovery in demand on the one hand and the fact that supply was still constrained by public health restrictions or otherwise unable to cater for surging order books on the other. At the time, it seemed reasonable to suppose the massive disruption in global supply chains and logistics could be remedied by normalising the conditions of supply, with vaccines coming on stream, and of demand, once catch-up effects had run their course, so that prices would eventually settle down.

However, far from easing, inflationary pressures persisted and even worsened following the outbreak of war in Ukraine as commodity prices – and energy prices in particular – surged afresh, propelling inflation to levels not seen for decades. As what was thought to have been a temporary state of affairs dragged on, central banks, responsible for guaranteeing medium-term price stability, had no choice but to toughen their tone and perform a U-turn by making combating inflation their number one priority. At the turn of the year, Federal Reserve boss Jerome Powell had to hold up his hand and acknowledge this collective misdiagnosis while signalling an aggressive tightening trajectory to prevent the inflation “bump” turning into an tidal wave, even if doing so meant sacrificing growth. Markets somewhat disingenuously welcomed this willingness to face reality: at the time, few had expected inflation to surge so quickly and powerfully. Lawrence Summers, former Treasury Secretary under the Clinton administration and renowned economist, had raised the alarm, warning that Joe Biden’s stimulus plan passed in March 2021 was excessive, with federal transfers to households far exceeding lost income during the Covid crisis, creating a risk that the economy might overheat once public health constraints were lifted. But other reputable economists such as Paul Krugman, drawing on the experience of the 2008 crisis, felt it was better to risk doing too much than too little in an effort to come out of the crisis on top, bearing in mind that, should the economy run too hot and the brakes have to be applied, the Fed would be well equipped and in familiar territory. In the end, the scenario that materialised was the one foreseen by Summers, with the Fed responding in line with Krugman’s recommendations, though Krugman himself was no doubt surprised by just how quickly the inflation genie escaped from the bottle.

With the Fed now determined to banish inflation, the European Central Bank (ECB) is coming under fire for not taking soaring prices seriously enough and waiting too long to kick off its monetary normalisation process. Yet, given the nature of the type of inflation it is supposed to combat, the ECB’s caution does not look unreasonable. In very simple terms, whereas the United States is dealing with a positive demand shock, Europe is faced with a negative supply shock as a direct result of the war in Ukraine, which is hitting the energy sector – gas in particular – as well as the food industry. While the Fed can work to bring down inflation by tightening financing conditions to ease demand, the ECB is powerless to relieve supply-side pressures and act on global commodity prices, with energy and food accounting for 70% of headline inflation. Yet the ECB, still playing for time, has ended up being overtaken by the influence of US monetary policy, with the single currency being battered by the US/Europe interest rate differential. As the euro weakens, heaping inflation on top of inflation, the ECB has resolved to follow in the Fed’s footsteps by stepping up the pace of its rate hikes.

Such an increase in pace is not a problem per se provided the goal posts are not moved further away: normalisation should bring interest rates back into neutral territory – admittedly a theoretical concept but nevertheless a compass that has the benefit of indicating the desired direction of monetary policy, in this instance neither accommodative nor restrictive. This signal will no doubt be enough to anchor inflation expectations and safeguard against wage drift. Having called time on the aberration of negative nominal interest rates, we should also see a move back towards having benchmark interest rates that are more closely aligned with the inflationary reality. Going beyond that into restrictive territory looks to be unwarranted in a European economy which, having barely recovered from the shock of the pandemic, is already glimpsing the looming threat of another recession if Russian gas supplies were to be completely shut off – unless the idea is to inflict pointless and avoidable economic harm in the name of monetary orthodoxy.

Inflation is expected to continue climbing, reaching 11% in October, primarily due to a further 40% increase in energy price caps.

The Queen's jubilee in June is likely to drag down Q2 growth figures, as there was one less working day during the month (the opposite effect will be visible in the third quarter). We expect GDP to decline by 0.5% in Q2 before experiencing a technical rebound of 0.4% in Q3.

With purchasing power expected to plummet this year (-2%, the biggest drop since the 50s, according to the OBR), households will have to dip further into the savings accumulated during the crisis to cover their spending.

The upwards trend of the major economies slowed down, and even broke down, due to the influence of widespread and persistent inflation, which has been adjusted substantially upwards. The recovery and higher volatility of interest rates are likely to continue, fuelled by inflation and more proactive and substantial monetary tightening. In the Eurozone, these movements are combined with higher sovereign risk premiums, which is a concern for the ECB.

The effects of the war in Ukraine are becoming more evident in the data, even though growth in the first quarter proved resilient, largely thanks to investment, which continues to perform well. The adverse effects of inflation on consumption are, however, already visible. Consumer spending declined in the first quarter, boosting savings in an environment marked by uncertainty.

Signals for the second quarter are difficult to interpret, still blurred by carry-over effects. Consumer and business confidence is certainly deteriorating, but the slowdown in production could be less pronounced than expected. Meanwhile, inflation has reached new heights. The very strong government support provided to households and businesses has helped to mitigate the effects of rising costs by preserving, in particular, household disposable income.

The scenario of a drawn-out conflict means that we are forced to base our outlook for the Eurozone on several working hypotheses that carry a high level of uncertainty. The solid fundamentals of the private sector in the Eurozone and the post-Omicron rebound will not be sufficient to fully offset the shocks linked to the war: a contained, localised supply shock for now.

We are downgrading our Eurozone growth outlook for 2022 and 2023, and its pace will fall below potential as of mid-2022. The GDP gap to pre-pandemic levels, which has already been closed in France, Italy and the Eurozone average, will be filled a little later in Germany, but will not be closed in Spain within our forecast horizon.

Average annual growth will remain high in 2022 at 2.5%, driven by a solid carryover effect (2.5%) and first-quarter growth of 0.6% (0.2% excluding the Ireland effect). However, average quarterly growth is barely above zero. Amid moderating inflation, growth will rebound modestly in the second half of 2023, reaching an annual average of 1.1%.

After rising 2.2% in Q4 2021, Spanish GDP increased 0.2% in Q1 2022. The effects of more persistent and more intense inflation in Spain than in its neighbouring countries and uncertainty over the duration of the conflict and the restoration of the orderly functioning of supply chains led us to revise our GDP growth forecasts downwards. They indicate growth of 3.8% in 2022 and 1.6% in 2023, which are lower than our forecasts made in the last fiscal year (4.6% and 3.6% respectively).