What's going on with the global economy? A chief economist's view

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Janet Henry, Global Chief Economist at HSBC: Inflation was already at a multi-decade high in many places when the current commodity price shock struck. A stronger than expected recovery in global goods demand against a backdrop of supply problems had driven a lot of upward pressure on commodity prices: virtually every type of commodity price from energy to metals to food products. And then following Russia's invasion of Ukraine, the sanctions that were initially rolled out by the West and then gradually escalated, as well as some degree of retaliation from Russia and even some third countries facing a sharp surge in food prices have actually started to impose some restrictions on their own exports of certain agricultural products.

So all of these factors have lifted inflation to a new high. Most countries have seen a big impact the from the energy side, but not just from oil. Europe is clearly much more exposed via utility prices, given its reliance on Russian gas. So for consumers gas and electricity prices have gone up a lot more than in the likes of the US. And in a number of countries, particularly some of the emerging economies, the big impact on inflation as a consequence of the Russia situation has actually been through much bigger impacts from higher food prices.

Robin Pomeroy: So how do you as a chief economist predict what could happen next, because there are so many more variables in this than there would normally be, I imagine, in an economic cycle.

Janet Henry: Well, when we look at what is happening to inflation currently, what's happening on commodity prices is certainly key. But as you say, Robin, it's very difficult to say at the moment what is going to happen to even oil prices. Demand was already very strong. We were already seeing quite a lot of discipline from OPEC+ regarding the supply of oil prices.

And then we just have to make a judgement call. We have oil analysts, all sorts of institutions make projections for oil assumptions, but we also know that the outlook for oil will hinge very much on what happens regarding the war in Ukraine.

So we've taken a view that the current backdrop is going to be with us for the foreseeable future. For our economic forecast at HSBC, we are working on an assumption that the oil price will continue to trade in the $100-110 a barrel range.

But of course there are many other commodities, and for energy prices we need to consider the pass through to household utility prices. The US, for instance, hasn't seen the big increases in gas prices or utility price rises. That is a European story. So we take the wholesale prices for gas in particular, and we assume that there will still be supplies. But that is in itself is an area of uncertainty given the geopolitical backdrop. And then similarly, we take our analysts forecasts for food prices for a whole range of food commodities. But we know that we can't make those forecasts with a huge amount of certainty either, whether it's a further rise in prices or indeed a decline in prices from here.

But that's just the commodity price element. We need to remember that it's a whole array of input costs for firms that are rising at the moment, and much will depend on how much companies are able to pass through to consumers. That in turn will depend on how strong demand is. Some companies are operating with very large margins. Some of them already have tighter margins. We've already got instances, for instance, in parts of Europe, where some energy intensive industries like areas of paper manufacturing, are already shortening production hours or even closing factories because they can't make the sums work given the extent of the price increases. For other industries where energy makes up a much smaller share of their inputs, they are not under as much pressure.

So there's a lot we need to consider in terms of the pass-through from producer prices into consumer prices, and that will depend on the strength of demand in certain countries, as it has over the last year. Everywhere has seen much stronger producer price inflation, but the likes of China have had much slower consumer price inflation. And that's partly because in Asia the consumer story has been a lot weaker. Asia has had a much more export- and industry-led recovery than in the West and in the emerging economies in Latin America and Central and Eastern Europe. In all of those economies, and particularly in the advanced economies, it's been a consumer-led recovery, and that strength of consumer demand has allowed companies to be able to pass on those price increases to consumers.

And then, of course, there is an extra element regarding inflation, and this is really the one that central banks are becoming increasingly concerned about. Such high rates of inflation and the risk that even if they peak out, they could take a long time to calm down, increases the risk of wage pressures building. Again, this risk varies around the world, but clearly in some economies, wage growth is already on an upward trend, but it's still well below inflation. The risk is the longer inflation stays high for, the greater the likelihood that wage growth continues to accelerate risking some kind of wage price spiral.

Robin Pomeroy: So let's look at the policy options then. Central banks have certain policies they can put in place, but it seems to be with these extraordinary circumstances right now, maybe the policy levers that might have worked in a normal inflationary period might not work so well now, is that the case?

Janet Henry: Monetary policy, which is set by central banks, is really designed to iron out periods of cyclical weakness or cyclical strength in the economy. When demand was much too weak, and certainly when inflation was too low, what they would try to do is stimulate demand by slashing interest rates and by adding an enormous amount of liquidity into the economy. That's certainly what they did following the impact of the global financial crisis and at the start of the pandemic.

So if we think about those low points of the pandemic in early 2020 when demand absolutely plummeted because of such severe restrictions across the board, monetary policy did prevent a systemic financial crisis and helped to underpin demand. And remember, it also allowed governments to be able to undertake a lot of borrowing and to support the economy through fiscal policy so higher spending and tax cuts.

Now it's a very different situation as inflation is not just driven by the demand side but by the supply side. So when you've got such severe supply constraints, the questions central banks are asking themselves is how much will they have to slow demand in order to curb further price rises and send inflation back on a downward path. It is really the open question, how much they will have to slow demand? In other words, how much of a sacrifice in growth will they have to pay in order to lower inflation? But also, given the huge amount of uncertainty on the supply side that central banks are facing themselves, the biggest issue at the moment is is maintaining their credibility.

We need to remember for the last three decades, inflation expectations have been really anchored at around the 2% level in most of the advanced economies. Before the pandemic inflation had actually fallen a bit too low and central banks had started thinking about how to shock inflation expectations a little bit higher, at least back towards that 2% level, maybe slightly above. And now they fear their credibility in the other direction. How are they going to re-anchor inflation expectations back down to that 2% level, even if they accept that these supply challenges mean that it's going to take somewhat longer in order to get that inflation back down.

But there's only so much central banks can do in this world other than try to maintain their credibility regarding their willingness to take whatever necessary action is required to maintain relatively low and stable inflation.

Robin Pomeroy: And if they were to increase interest rates by a long way, the usual repercussion of that is, as you said, a slowdown in economic growth. Presumably, that's something they want to avoid in most parts of the world. How do you assess the risk now for growth slowing down to dangerous levels or of recession? Is that a genuine risk around the world?

Janet Henry: There have already been some recessions in the world. If we look at some of the emerging economies, Brazil, for instance, had had quite a strong recovery from the pandemic. And it's historically tended to be a slightly higher inflation economy, and they had very aggressive monetary tightening even in 2021. So even in the second half of last year, Brazil had a recession.

And when we think about the advanced economies, we know that historically most Fed tightening cycles do end in recession. Since about 1960, there have been three soft landings for the US economy, but there have been about eight hard landings following a Fed tightening cycle. The timeline has varied. The severity of the recession has varied. So it wouldn't be unusual for a tightening cycle to actually end in a recession.

Clearly, central banks never start a tightening cycle intending to deliver a recession, at least not since about 1980. Subsequently, as inflation started to come under control, they always begin to tighten policy just to slow demand down a bit, maybe accept a period of below trend growth in order to prevent the economy completely overheating and to bring inflation back to more comfortable levels. But they genuinely do not intend to deliver a hard landing.

And the difficulty we've got for central banks at the moment is not just what's happening internationally in terms of the fallout of the Russian invasion of Ukraine and the ongoing escalation of sanctions, but also a lot of uncertainties relating to the slowdown in China as a consequence of what is still largely a zero-COVID strategy. So it's very difficult to call the timing of the reopening that will follow in China and what the global impact of that will be on supply chains and world trade.

But even when policy makers in the advanced economies look at their domestic economies, they know that there is a severe real wage squeeze at play. Even if we take, for instance, the US where inflation hit 8.5% in March, wage growth is still less than 6%. Even if the Fed considers that to be too high it still amounts to a real wage squeeze of 2.5% or more, and actually we think the squeeze on real incomes in the UK will be more like 4% this year. In the euro area it might be about 2%. In any normal world, without a doubt, you would be getting a significant consumer recession in this world.

Robin Pomeroy: What does that actually mean - a squeeze of 4% on on real incomes. That means someone has 4% less income to spend than they had before?

Janet Henry: Absolutely. Our forecast for the UK economy this year is that on average inflation will be over 8% for the rest of the year. In fact, the Bank of England recently announced that it would hit 10% in the final quarter of this year. So wages are running at less than 6%. In fact, currently they're even lower than that. And we've got some tightening of fiscal policy, some tax increases – so the income consumers are receiving relative to inflation is less. This is the so-called cost of living squeeze.

So the question is, are those which have accumulated savings during the pandemic now dip into those savings in order to smooth their spending? And this is where there is a distributional issue. If you look at the major advanced economies, whether it's the UK, the Eurozone or indeed the U.S., in aggregate, a large amount of savings has been accumulated. We estimate in the U.S. that actually the stock, the excess savings, the extra savings that people made each month during 2020 and 2021, relative to what they were saving in 2019, is currently equivalent to about 12% of total household disposable income.

So for some people that have accumulated their savings, they may be taking home less in real terms, but they can draw on these extra savings in order to smooth their spending. But we know for a lot of people that's not the same case. And for those people, this will be feeling like something of a recession already. And some of those will either be resorting to borrowing - there is some evidence that we are seeing a pickup in borrowing of consumer credit and on credit cards, not just in the U.S., that there's some signs of a pickup in the likes of the U.K. as well - so for those people that can't draw down their savings because they haven't got any left, that they may actually increase their borrowing, where possible, to limit how much they have to cut back on spending. And that's what makes it very difficult to forecast the extent of the slowdown. And there is definitely going to be a slowdown. And some economies are already close to stagnation.

Robin Pomeroy: And the cost of living squeeze is truly global. Is it?

Janet Henry: It is truly global. Parts of Asia are actually currently registering a much lower rate of inflation. And in fact, I mentioned that much of Asia hasn't had the same kind of consumer recovery in their initial recovery from the pandemic which was very much export and industry-led. 2022 was meant to be the year of the consumer recovery, especially with exports likely to lose steam as the global recovery transferred from being goods-driven to service sector-driven. And obviously a lot of the Asian economies had started reopening, especially after the Omicron wave of the pandemic. So their inflation rates are a lot lower, but there's still going to be some pinch because there are some Asian economies where consumers spend a large share of their incomes on energy and, particularly, food - that's where they'll be seeing the pressures as well.

But elsewhere, yes, it is global. I've focused so far mainly on the advanced economies. I mentioned the UK, the Eurozone and the US. But when we look at some of the other emerging economies, it is really the commodity importers that are going to see the most cost of living squeeze. So some of the central and Eastern European economies, some of the African countries that are big food importers, they're going to see more of a hit from higher food prices.

Commodity producers should be less affected. Oil producers are seeing very big gains in terms of their oil revenues. Others from their metal revenues. And in some of those economies, whether it is parts of Latin America or many of the Gulf countries, governments may be supporting the impact on households and offsetting some of this inflationary impact that they may be seeing in other areas.

Robin Pomeroy: Because there was this Ipsos poll - Ipsos with the World Economic Forum - into the cost of living crisis across 11 countries. Twenty-five percent of the public say they found it quite or very difficult to manage financially. Two-thirds of people in Turkey. It's very widespread. What's the light at the end of a tunnel like that? Because you mentioned the inflationary pressure that would come from wage demands. If people want to maintain their standard of living, they need to have a pay rise in line with inflation. The other options, I guess, are targeted government support, as you just mentioned. What are what are the best policies? Is that something you look into? And also what are the risks from social unrest if 66% of your population is feeling it's only just struggling to get by? Is that also something a chief economist would look at?

Janet Henry: Well, as a chief economist, we have to inevitably take account of political decisions. We don't make political forecasts in a way that we can say what the direct impact will definitely be based on a political forecast and what that means for the macroeconomic forecast. We respond to political developments as they actually occur.

But in terms of the cost of living impact, you mentioned Turkey, which has actually just overtaken Argentina as the highest inflation economy that we forecast currently. And that is an extreme situation if inflation is already running at over 60%. Elsewhere, inflation rates are at multi-decade highs, but they are far off the current rates of inflation that we are seeing in the likes of Turkey and in Argentina.

But it is increasingly a political issue. Some of the lowest income economies are particularly dependent on food imports or government subsidised food, and some of their governments already have fragile fiscal positions so they are very vulnerable. We've already had Sri Lanka actually default on its hard currency debt which was a political decision they took in order to offset some of the pain on their population from the impact of these higher food prices. They needed to provide some support to their domestic population. We may see some other lower income economies take a similar approach.

Then when we turn to some of the more advanced economies, in the Eurozone we have seen individual economies already take measures to limit the impact of utility price rises. And in April, global oil prices were a little bit lower than they were in March. That should already start to impact on the inflation releases as long as we don't see another spike in oil prices. And we've seen the announcement of some subsidies on fuel costs more broadly to limit the impact on consumers.

Somewhere like the UK, the Chancellor had initially hoped, I suppose, that oil prices would be lower later in the year and that the rise in wholesale gas prices would also abate later in the year. So he initially announced a programme that would require some of the initial support to be offset later in the year. Now, given the current political backdrop, the geopolitical backdrop, and the current rate of wholesale gas prices, the government may actually find itself having to announce further subsidies in the face of a growing need to to support some of the lower-income parts of the population. But currently, and it's in the Bank of England forecasts, those extra utility price rises are going to be happening in October, so the Bank of England expects them to lift inflation above 10% in the absence of any additional government support.

Robin Pomeroy: As of now, what are the big things you'll be looking out for that might change your calculations for the economic outlook? Are there big things coming up on the horizon that you'll be waiting to see?

Janet Henry: There is plenty to to focus on in the coming months.

What happens regarding the war in Ukraine will still be vitally important globally as will any further escalation of sanctions that are delivered by the Western economies in particular. Clearly, there's a lot of uncertainty on the oil side and the timing of any phasing out of gas reliance from the West and indeed the actions from Moscow as well could impact on the global economy, particularly if it did lead to an outright disruption of gas supplies in Europe.

China

I'll also be looking at what's happening in in China. So in terms of the April data that we've seen, it was very weak. It looks like May is going to be worse, but we are seeing some signs of some of the restrictions in China being eased in certain areas and there is a lot of policy support in the pipeline. So if China is able to reopen and the second quarter does prove to be the worst of the China activity data, we should be seeing some signs of stabilisation thereafter given the degree of policy support that's being delivered.

But if Omicron was to evolve further into a new variant or to spread further around the nation, then clearly that could also pose some downside risks to growth for later in the year. That, too, will impact globally both on the supply side in terms of disruptions as well as the demand side for the rest of the world given that China is still a vitally important export destination for nearly every economy around the world.

And all of this clearly matters from a policy perspective, as do domestic reactions in individual economies. I've already talked to some degree about the wage pressures, and as long as we have got these supply disruptions and price increases, primarily from Russia, but also via possible supply disruptions from China, the longer inflation stays high. It doesn't necessarily need to go higher, but the longer that it keeps it at these very high inflation rates, the risk that it feeds through into wage growth. And that would lead to a greater degree of concern by central banks. And as much as they wish to deliver a soft landing, they may come to realise that in order to restore their credibility, that they might need to accept some period of economic contraction, some kind of recession, in order to to restore their credibility. Already we've had the Bank of England announce that based on market forecasts for their own policy rates, the UK would actually have some kind of mild contraction in 2023 on their current forecasts.

Robin Pomeroy: Do you already have some feeling that you'll look back on this period or that we will look back on this period as one of those pivotal moments or memorable, infamous moments in economic history? You think about the oil shock of the early 1970s, which had these global repercussions. Do you think we're in a period comparable to that now, or is it too early to say?

Janet Henry: It will certainly be a very memorable period. And you're absolutely right, already comparisons are being drawn with the 1970s because there are some similarities.

One of the similarities is that the oil embargo that was imposed following the Yom Kippur War, happened at a time when inflation was already on an upward trend. So now we have a period where inflation was already on an upward trend because of the pandemic, we now have this period of what I call economic conflict because of the sanctions and some retaliatory action and some third party kind of action happening when inflation has already risen a lot. So there are some similarities there.

There are also some differences, So yes there's a huge amount to be learnt from economic history when thinking about the future, so we need to be able to identify the similarities, but also where things differ. And one of the areas where certain events obviously differ is regarding still some degree of flexibility in labour markets and lower labour unionisation. There are also certain periods of technological advance that may be different. One of the comparisons that people are making at the moment is clearly for the last 20 or 30 years, we've had not just rapid globalisation but huge automation regarding the goods sector in particular.

Robin Pomeroy: And finally then on energy, we've talked about natural gas flows, for example, because I'm working on another podcast right now about the energy transition, which primarily is about the transition away from fossil fuels to non-fossil fuel to clean energy. Is that something you look at as as a chief economist? And if you do, do you have any indication as to whether this situation is putting action to move away from fossil fuels? Is it going to speed that up or is it going to slow it down?

Janet Henry: In the big picture. I ultimately think the impetus for it will be to speed it up, but I don't think it's going to be a linear move.

We know that part of the issue with the surge in energy prices currently is a function of a lack of investment in fossil fuels in recent years. And now many governments are already resorting to incentives to raise fossil fuel production because of a realisation that, as much as renewables have become a lot more cost effective over the course of the last decade, a lot of these projects to produce renewable energy are quite long term. The energy transition is still going to take place over the course of the next couple of decades.

So governments are in a challenging position in terms of trying to incentivise fossil fuel producers to fill the near-term gap, even in terms of increasing domestic exploration in areas where previously they had actually been discouraging them from doing so. And also from a near-term inflation perspective, we need to be aware that in a world of energy transition-related taxes, like carbon taxes, structurally these could be an upside risk to inflation. There's a whole host of potential structural upsides to inflation as well as still some potential downside risks on the inflation side. So, yes, in short, I think ultimately the Russia/Ukraine situation will accelerate energy transition, but we won't necessarily see the impact in terms of the reduced reliance on fossil fuels immediately.