It’s a year since the worst of the Covid-19 outbreaks, and with most people fully vaccinated in many countries, economies are getting back to work. The biggest concern, though, around the world is soaring inflation which is well-entrenched now and broadbased, so interest rate hikes to tame it are in full swing.
The tightening of monetary policy and increase in interest rates is causing discomfort to the financial markets, it appears. Not that they don’t think it’s necessary, just that they appear to be concerned about the pace and intensity of the tightening. With the result that many economists and market commentators had started talking up the fears of recession around the end of 2021 itself in media.
The strange thing is that we actually have one in the US now, in the technical sense of two successive quarters of contraction. Yet no one wants to call it that just yet, until the NBER says so, because there are several other economic indicators especially on the employment front that suggest that economic recovery in the US is strong. US June quarter GDP fell by -0.6% better than the -0.9% reported earlier. This follows a contraction of -1.6% in the first quarter. The better reading comes from better US exports and a smaller drop in federal government spending. Across the pond in the UK, the economy did contract in the June quarter by -0.1% quarter on quarter, but grew 2.9% over the previous year. Most of the contraction is being attributed to a 0.4% fall in services of the healthcare and Covid-19 related kind, and a 0.2% drop in household consumption quarter on quarter, reflecting a cost-of-living crisis. In August 2022 alone, retail sales by volume fell -5.4% year on year in the UK.
Inflation in the US and UK are at four-decade highs, at 8.3% and 9.9% respectively. While consumer price inflation seems to be on the downward path in the US, it continues to rise in the UK – barring the month of August 2022 – despite all the interest rate hikes by the Bank of England which began its rate tightening cycle much before the Federal Reserve did. The Bank of England is of the view that inflation will rise even higher in the UK and that the economy will enter a recession in the fourth quarter of 2022. All of this makes grim reading, as the UK is also in the midst of a political crisis, with the ouster of Boris Johnson and a new Prime Minister, Lizz Truss, at the helm. Meanwhile, Brexit continues to be a niggling problem that won’t go away.
Still farther across the pond, Europe has surprisingly grown its economy in the June 2022 quarter. Both the Eurozone and the EU have registered GDP growth of 0.6% each with Spain and Italy growing at 1.1% and 1.0% respectively. Europe’s largest economies, Germany and France were less impressive, with the former stagnant in the June 2022 quarter and the latter growing at 0.5% quarter on quarter, annualised. Here too, inflation is a major cause for concern; according to a flash estimate issued by EuroStat, consumer price inflation was 9.1% in August 2022, led by energy prices which soared 38.3% on the year, although down from its June highs of 42%. The ECB increased interest rates for the first time in 11 years at its last policy meeting, from levels that were negative, let us also remember. So, it has a long way to go in controlling inflation.
That said, let us also accept that inflation in Europe is of a different kind, mostly led by surging energy prices, which are so closely correlated with the price and availability of Russian gas. That is what policymakers in Europe seem to be preoccupied with: having announced an embargo on Russian gas, how to wean themselves off it. At the moment, governments in Europe are considering a slew of measures, from how to cap energy prices to windfall taxes on energy producers and relieving households of some of the pressures of soaring energy bills. The more immediate plan of action in Europe is to increase storage of gas for the approaching winter months.
At a special EU meeting held in Brussels to discuss this, there will be several ideas put forward, but it appears that some countries are implementing national plans as detailed in this article from Bruegel, a think-tank, while others are calling for an EU bloc-wide cap on energy prices. However, at the summit, it was decided to drop the idea of capping Russian gas prices. Another article also from Bruegel, calls for a grand bargain to control energy prices, but some of the measures outlined appear to be too timid and I wonder if they will be adequate in providing Europe ample energy supplies and energy security. Not merely for this winter, but for several more to follow, for who can tell how long the Ukraine crisis will drag on.
If Europe is to follow through on its embargo of Russian gas, it has to immediately identify alternate sources of gas imports. Germany shifting to lignite to augment electricity generation in the absence of nuclear energy is not desirable; for one thing it will increase use of a dirty fuel and defeat its commitment to the Paris Climate Accord, and it is too small a measure to actually make much of a difference. Ideally, Germany should consider restarting its nuclear power plants and upgrade them, making amends for what I think was a flawed policy of Angela Merkel’s government, one of the rare few, perhaps, in her regime of otherwise stable and solid leadership.
Having identified alternate sources of gas imports, Europe then needs to enter into long-term contracts to keep prices stable for all its member countries for a few years. At the same time, it must avoid the kind of mistake it made during the orders for Covid-19 vaccines; while the long term-contract is common to the EU, it must allow for procurement and usage to be on a national basis. Either way, economists are of the view that the Eurozone, along with many other developed economies will enter a mild recession in the second half of 2022, lasting perhaps a year or so.
In all this confusion and gloomy scenario, the news from India announced at the end of August 2022, was heartening. The Indian economy reported a GDP growth in the June quarter of 2022 of 13.5% year on year. This was mainly led by a manifold improvement in the services sector, many of which returned to business and to growth. What’s more, private final consumption and gross fixed capital formation both increased their share of GDP from 54% to 59.9% and from 32.8% to 34.7%, respectively. Further, both registered a healthy growth over the pre-Covid year, 2019-20 as well, private consumption growing by 11.8% and gross fixed capital formation by 9.5%.
That said, there is reason to be cautious going forward, for a variety of reasons. For one thing, India is a huge importer of oil and gas and that has already caused our imports to balloon over the past year. For just the June 2022 quarter, India’s imports have surged by 37.2% and our trade deficit is widening, even as our exports are growing. Next, the Indian economy has seen huge outflows of capital since the start of 2022, anticipating interest rate hikes by the US Federal Reserve. Some of that seems to have returned in August 2022, but one can’t tell if it will endure since these are volatile and uncertain economic times.
Then, we do have the problem of high inflation as well, albeit at lower levels than in the developed economies. For a low to middle income economy such as ours, 7% consumer price inflation is indeed high and core inflation at around 6% which has been stubborn is another worry for the RBI which is also in the midst of a rate hike cycle.
And most important, when we look at economic growth figures for India, or even monetary policy tightening, we rarely ever discuss the unemployment rate. I suppose that is because most employment in our country is in the informal sector, though that shouldn’t be a reason for neglecting it. Already high levels of unemployment surged to over 8% in August according to CMIE (Centre for Monitoring the Indian Economy) at 8.28%, with urban India unemployment even higher at 9.57%. With so many in India out of work, the government must make tackling inflation high priority, as well as creating jobs. The conundrum is that if gross fixed capital formation is growing, as the data suggests, and if most of that is business investment, why aren’t more jobs being created in India. The government needs to answer this, and find a lasting solution to the problem.
On the global level, what we can expect is a long path to slowing inflation and therefore a slowdown of the global economy. The news from the Jackson Hole conference of central bankers in August this year is that they will continue to raise rates to tame inflation, though Japan and China have said they will pursue accommodative policies for a while longer. One hopes that inflation will come down sooner than economic growth does, and that we don’t end up with stagflation. It will not be recession across the board, I hope, because Asian and other developing economies are only now emerging from the Covid pandemic after they were badly impacted by the Delta variant. This should help ease the global chip shortage and help stabilize global supply chains, much of which lies in this region.
For Europe, the war in Ukraine continues to be the biggest factor impacting the economy, on account of high energy prices. However, with the Euro having weakened considerably against the US dollar – they have been at par for a while now – it is an opportunity for Europe to boost its exports. Export-led economies such as Germany, and the other three largest economies ought to find ways to grow their exports to markets in Asia (including China) and other countries around the world.
The most vulnerable economies are those in Africa and Latin America. There is no way of knowing how prevalent Covid still is in African countries, since testing is low and so is the vaccination rate. Besides, since these economies are commodity exports dependent, they are likely to be adversely impacted by such a global slowdown, unless China can ramp up its economic activity soon enough to compensate for it. Many African countries are also badly affected by the shortage of wheat supplies, dependent as they are on Ukrainian imports; the recent agreement to allow Ukraine to export some of its foodgrain will provide relief to many of these African nations.
In Latin America, many economies are large enough to grow on their own steam, though they too are export dependent. The big problem there – predating even the pandemic – is high inflation and also political upheavals. Many countries in Latin America have been raising interest rates to control inflation, but it’s not been very effective thus far. Chile, having fought for two years for a new constitution, has just rejected it with an overwhelming majority. Columbia has produced a new leftist leader in a June election and elections are expected in Brazil next month. The wide trend across the continent is a shift towards the political left, as is to be expected after such a devastating pandemic. That would usually mean a demand for higher state spending on social welfare, which is not a bad thing in itself, provided it is accompanied by higher taxes on the wealthy and on business. Although at a time like this, that could also aggravate inflation. Latin America also has some of the highest inequality, as does South Africa.
Coming back to my country, India, the top priority ought to be job creation, and tackling inflation. We also need to make our economy more competitive in a strategic, long-term manner and the end of the pandemic ought to start a new chapter for us to grow.
Peripatetic Perch 