Pay Attention to the Cyclical Economy

After reading news of India’s first quarter GDP for FY 23, which showed little sign of a base effect despite the fact that in FY 22, we had grown 20.1% in the same quarter, we are likely to think that base effects don’t matter anymore. It would be unwise to think so, however, because this recent quarter’s growth was attributed to a strong recovery in the services sector, especially in the financial services sector as well as the public administration and government-related services sector.

The fact is that services are staging a comeback around the world, which is good news, but manufacturing too ought to stay strong and resilient. That is not something we can take for granted, though, because as central banks hike interest rates, consumption demand is likely to slow and that will also slow investment demand to a certain extent. Which is why everyone from the IMF to the World Bank, and many economists expect a slowdown in 2023.

We must continue to pay close attention to the cyclical as well as the more long-term secular and structural changes in the economy, and make policy decisions accordingly. The economy also responds to policy decisions, so it makes sense to focus on the recovery that is cyclical as well as more enduring. One of the biggest factors in determining the trajectory of the economic recovery in countries around the world is inflation. It was caused by the surge in consumer demand that took place after Covid-related lockdowns were lifted, to which supply took a while to adjust. This led to supply chain problems and shortages, which fueled inflation as well. This was most felt in consumer goods that depended on semiconductors and microprocessors as their manufacturing and supply were hit, with strict lockdowns imposed in most of East Asia after the Delta wave of Covid. However, it was also felt in services later, as countries opened their borders to travel and labour supply was inadequate to deal with the surge in travel bookings, leading to the cancellation of thousands of flights.

Most of the initial inflation that was felt in the early days of economic recovery was in commodities, due to the demand-supply imbalance, and while some of it has cooled down in recent months, it is likely to stay at elevated levels as I have written in a previous blog post. The World Bank, in its latest report on commodity prices, does seem to indicate the same trend in commodity prices; that while some like crude oil and food have seen a downtick globally, many like certain metals and chemicals are still rising. The biggest factor in inflation and commodity shortages is the war in Ukraine, which will continue to keep inflation high and it will be a challenge for central banks to control it.

For example, in Europe, inflation is undoubtedly being fuelled by higher energy costs, contributing to as much as 38% of the inflation, and it would be safe to assume that almost all of it is being caused by Russia’s gas supply, given how dependent Europe is on Russian gas. If we look at how European countries plan to respond to the energy crisis that is also fuelling a cost-of-living crisis, they are considering a slew of measures, from reducing energy demand by 15% (household consumption, I would imagine), to capping energy prices and imposing windfall taxes on energy producers.

In the meanwhile, G-7 countries have also agreed to cap the price of Russian oil, as part of their efforts to hit Russia’s oil and gas revenues, and they claim that it will not affect the international price of crude. From what I have read, it appears that they plan to do this through trade, finance and insurance services relating to Russian oil, most of which the G-7 countries control.

Fortunately, at the most recent EU summit held to discuss energy policy, it was decided to drop the idea of capping the prices of Russian gas since there was no agreement among all member countries, which is just as well. Some central and east European countries that are more dependent on Russian gas were not in agreement with this idea, and Russia also issued threats to cut gas supply entirely, were EU to take such a decision. It is not clear how the price-capping policy will help solve EU’s more pressing problem, which is to find alternative sources of energy to replace Russian gas, as well as to keep energy prices affordable and stable. Besides, subsidizing consumption through price caps or higher taxes is quite at cross-purposes with reducing demand by 15%.

So much of energy policies are to do with geo-politics, as the world has known for decades. And if the G-7 decision does not go according to plan, it could destabilise global energy markets and prices, in a repeat of the oil-shock of the 1970s. Because it is not just Russia’s oil and gas industry that matters, but the OPEC that decides global oil and gas prices by determining production. And although OPEC had agreed to increase production to bring down prices a tad, they are now planning to cut production on lower demand projections, because of an economic slowdown expected everywhere. If the low and discounted price of Russian oil forces OPEC to also lower prices by producing more crude oil, the world would benefit. However, it is a risky strategy to pursue, a political game of who will blink first and it could impact most of the oil-importing, developing countries adversely.

The pressures of the Ukraine crisis impact Europe most immediately and the rest of the world in an indirect way. The world will be grappling with questions of how to grow their economies in the short term as well as manage issues to do with the long term. The energy pressures on the one hand, and the zero-carbon commitments to mitigating climate change on the other, for example. The prospect of EU countries having to resort to WFH once again as the norm, or even cutting back production in order to save on energy. The even more unthinkable prospect of EU being forced at some point in the near future to consider shale gas exploration and fracking in order to be more self-sufficient in oil and gas, an idea that European countries have shunned for environmental reasons. The real test is in managing the short-term, without compromising long-term commitments.

Ideally, we should be finding concrete solutions to the war in Ukraine, by trying to end it as soon as possible, as I have written before. I don’t see any concerted effort being made in that direction, and the sanctions against Russia are clearly not effective. The world’s leading powers must do this, not only for the sake of energy security, but for the sake of human lives and livelihoods. As I had written in one of my earlier Owleye columns, this war is different from previous ones of the past many decades, because it impacts the entire world. There were huge wheat and other foodgrain shortages at the start of the war, whose impact is felt most in developing countries in Africa. The prices of chemicals and fertilisers shot up, forcing the Indian government to raise its fertilizer subsidy, and I am sure many other countries had to resort to similar measures.

Cyclically, it appears that much of the developed world will be slowing down considerably, even going into a brief and shallow recession as rate hikes take hold and demand is reduced. What next? How do we restart growth, once inflation has cooled? And will they cool very much when the war in Ukraine is still raging? How do we also create investments that will generate new employment, let alone absorb those unemployed today? These are the questions that will occupy the minds of policymakers and businesses around the world over the coming months and years.

The animated owl gif that forms the featured image and title of the Owleye column is by and I am thankful to them.  

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