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Ian Stewart, chief economist of Deloitte UK, and Debapratim De, senior economist for Deloitte UK, offer some thoughts on the British government’s plans regarding energy:
The package caps annual household energy bills at £2,500 over the next two years. This is on top of the £400 energy bill discount announced earlier in the year. Energy prices for businesses will see an “equivalent cap” for six months with the government identifying and supporting businesses deemed vulnerable beyond six months. Energy companies are being provided with up to £40bn in support to reduce the risks of a liquidity crunch in the event of a sharp rise in wholesale gas prices.
The government’s plan will mean average annual energy bills rise from the current £1,971 to £2,500 eventually, instead of peaking at over £6,000 next year. Much lower energy prices mean lower inflation. We expect inflation to peak at 11% this winter, well below our previous forecast peak of 16% next spring. Nonetheless, underlying inflationary pressures remain strong. Core inflation, which strips out the effect of energy and food prices, is running at above 6%, the highest level in 30 years. It will take time for slower growth to dampen inflationary pressures. We expect price pressures to remain elevated through next year, with inflation falling to 4.6% by the end of 2023 and 2.2% by the end of 2024.
The energy package is expected to shield households from the worst effects of high energy prices, but may still leave them facing a squeeze on spending power. We continue to expect the UK economy to experience a recession, albeit a shorter and shallower one than had the government not stepped in with support. We think the recession will begin in the fourth quarter of this year, with activity falling by a total of 1.6% over three quarters, and growth resuming in the second half of next year. This is a much smaller contraction than those seen during the pandemic (21.5%) and the financial crisis (5.9%) and is slightly less than that seen in 1990–92 (2.0%), but it is likely to cause significant disruption.
As growth contracts, corporate insolvencies and unemployment are likely to increase. The labor market is running hot but shows early signs of a slight cooling. Job vacancies have dropped from record levels and firms’ hiring intentions have softened. As higher costs and weaker demand squeeze corporate margins, we expect the unemployment rate, which is currently at 3.6%, a 48-year low, to rise, peaking at 5% in the first quarter of 2024. This is roughly similar to the peak seen during the pandemic.
Although real wages are likely to decline through most of next year, savings accumulated during the pandemic and the energy price cap will offer some support to consumer spending. Overall, we expect household consumption to contract by 0.9% over the period of the recession. This is much smaller than the declines seen during the pandemic and the financial crisis but similar in scale to that seen in the early-90s recession.
In addition to helping consumers, the energy package is expected to result in a lower peak in inflation and deliver a shallower downturn. This is all too good to be true and, indeed, it is. There are no magic bullets in economic policy.
Injecting the equivalent of perhaps 5% of borrowed money into the economy sharpens the dilemma facing the Bank of England (BoE) as it seeks to dampen demand and bring down inflation. The fact that energy subsidies will bring down inflation, and that the economy is slowing, has not changed the view in financial markets that interest rates are heading sharply higher. Financial markets see the BoE raising UK rates from a current 1.75% to at least 2.25% at the next meeting, with rates ending this year at 3.5% and peaking at around 4.5% next summer. If the markets are right, we are heading for the sharpest, fastest tightening of monetary policy in more than 30 years.
Government spending on such a scale, funded by public borrowing, runs other risks too. If the package costs the exchequer about £150bn, it will raise the level of public debt from about 96% of GDP to 104%, the highest level since the 1950s. If energy prices remain high for more than two years, the cost of the scheme would escalate still further. A weak pound, high inflation, and rising public borrowing could yet test the patience of investors and push UK government’s borrowing costs higher.
Cutting energy bills is popular and, in many ways, essential. Only time will tell whether doing so on the scale and the manner chosen by the government is the right course of action.
All of this came about as the new Chancellor of the Exchequer, Kwasi Kwarteng, announced that the top marginal tax rate would be cut from 45% to 40%. He also announced a cut in the duty on home sales. This is on top of roughly 150 billion pounds of energy subsidies.
Conventional economic theory says that the problem with government borrowing is that, when the government borrows in competition with the private sector, it leads to higher borrowing costs, thereby stifling credit activity and business investment. This is known as crowding out. Today’s market reaction to the government plan is consistent with this theory. Evidently, the government’s theory is that lower tax rates will stimulate more business investment, thereby offsetting the negative impact of higher borrowing costs. This was once known as supply-side economics. In the long run, lower tax rates and lower regulation should generate more investment than otherwise, but boosting government borrowing at a time of high inflation is not necessarily consistent with stimulating the private sector.
Moreover, there is an additional element at work, namely, monetary policy. At a time of ruinous inflation, the tightening of monetary policy also means higher borrowing costs. A good analogy to the current British situation is what happened in the early 1980s when, in the United States, an expansive fiscal policy under President Reagan was accompanied by a severe tightening of monetary policy by the Fed under Paul Volcker. The result was a surge in borrowing costs, a deep recession, and the end of an era of high inflation. What is different is that, in the early 1980s, high borrowing costs led to a surge in the US dollar, which was disinflationary. In the United Kingdom, the pound continues to decline, reflecting pessimism that inflation will be quickly stifled in the midst of an energy crisis.
Meanwhile, the zeitgeist within financial markets appears to be that, although the controversial energy subsidy can be defended, the fiscal stimulus cannot. There does not appear to be a significant constituency within markets for tax cuts at a time of very high inflation. My guess is that many investors would prefer that policymakers focus first on inflation before worrying about competitiveness issues such as marginal tax rates.
Meanwhile, industrial production in China was up 4.2% in August versus a year earlier, the best performance since March. The manufacturing component was up 3.1% while the utility component was up 13.6%. The latter was likely due to the surge in electricity demand because of the intense heatwave. Within manufacturing, automotive production was up 30.5%. Output grew slowly for chemicals and declined for food processing and textiles. The industrial economy was hit hard by lockdowns and continues to be suppressed by housing market problems and by a shortage of electricity.
Finally, fixed asset investment in China rebounded slightly in August. This fact, combined with the rebound in retail sales and industrial production, suggests that the Chinese economy may have already bottomed and is now in a modest recovery phase. Still, the country faces significant headwinds. These include a continued restrictive policy regarding COVID-19, continued weakness in housing (indeed, house prices fell in August versus a year earlier and property investment fell sharply), electricity shortages, and the impact of global weakening. To deal with these challenges, the central bank has eased monetary policy and the government has announced multiple initiatives aimed at jumpstarting the economy. Yet many critics point out that easy credit will do little if businesses are constrained by COVID-19–related restrictions or the threat of such restrictions.
Xu Si Tao, chief economist of Deloitte China, offers his perspective on China’s economic situation.
At present, the recovery faces three noticeable headwinds: 1) a struggling property sector; 2) financial stress brought about by global tightening, which has gathered momentum; and 3) the government’s zero-tolerance COVID-19 policy.
Regarding the property sector, sagging housing sales and investment levels have reinforced the bearish sentiment in offshore markets, where bond yields of major developers such as Country Garden and Greentown are hovering at around 30% and 10%, respectively. Taken together, data around investment, land auctions, and home sales suggests that weakness in the property market is likely to persist beyond the short term, meaning that the property sector will likely be a drag on overall growth for the next few years. In the immediate term, the policy objective is to get developers to finish existing projects and to prevent the mortgage boycott from spreading further. A relief fund of RMB200 billion was set up in late August with a stated mandate for developers to finish incomplete projects, but markets seem to have questioned its effectiveness. We are of the view that the government will not budge from its current stance that “homes are for living in, not for speculation,” but the reality is that local governments can only reduce their reliance on land sales in the medium term. Therefore, even in the absence of a potent stimulus to support the property sector, the policy mix will ultimately have to be aimed at preventing consumers from increasing their savings rate. Ideally, mortgage rates could be guided lower while developers would be incentivized to complete their projects.
Most Chinese consumers view property in terms of both consumption and investment. Banks will therefore have to sacrifice some profits through a narrowing of interest rates to provide future homeowners with more sweeteners. The question is to what extent commercial banks could lower the cost of capital against a backdrop of global monetary tightening. In our view, the People’s Bank of China (PBOC) could nudge banks to bring down mortgage rates more, but meaningful monetary easing could only be executed if the exchange rate is more flexible. China’s favorable balance of payments and relatively benign level of inflation will allow the PBOC to deviate from the Fed’s tightening, but the external environment still matters.
Regarding the impact of global monetary tightening, which puts downward pressure on emerging market currencies, the question is whether China should adjust its exchange rate in sync with the competitive depreciation policies (e.g., Korea) of some central banks. In our view, the PBOC is unlikely to replicate the Bank of Japan’s reflation strategy on the grounds of stability. Meanwhile, rising interest rates globally may cause risky assets in most emerging economies to underperform until US interest rates peak. Investors maintain the view that the Fed will raise rates by another 150 basis points this year.
The final challenge is COVID-19. Based on recent mobility data (passenger flows during Mid-Autumn Festival shrunk by 37.7% YoY), travel-related sectors have taken an additional hit as partial lockdowns have been implemented across many cities. The dynamic zero-tolerance COVID-19 policy has made a recovery in Q3 more anemic than previously expected, but it will always be possible to further optimize the current policy as we continue to learn how to better deal with the virus. Assuming lockdown measures would become more calibrated in Q4, and with the Fed entering its latter stages of tightening over the next couple of months, a recovery in Q4 remains possible. As such, we stand by our original 2022 GDP forecast of 3.5% with a caveat.
Germany, meanwhile, has managed to accumulate a high level of gas reserves. Still, this has entailed a significant conservation effort in Germany, including having many manufacturers halt production. Robert Habeck, Germany’s economy minister, said that “it is not good news because it can mean that the industries in question aren’t just being restructured but are experiencing a rupture—a structural rupture, one that is happening under enormous pressure.” He said that companies ranging from small to large across many industries are experiencing “sheer angst.”
Meanwhile, German finance minister Christian Lindner said that the government is working on a relief package for German consumers. Still, this won’t bring factory activity back. As such, Germany and other European countries face a supply constraint that will very likely push the continent into recession. If, for example, a German chemical factory cannot operate because of a lack of gas, this will have reverberations throughout the supply chain, both upstream and downstream, affecting output and employment. This is just one more instance in which geopolitical events threaten to undermine economic activity, something to which the world is quickly becoming accustomed. Until just a few years ago, this had not been a factor in business for many decades.
Despite the recent decline in natural gas prices in Europe, electricity prices continue to soar, leading EU leaders to discuss emergency measures meant to stifle the increase. In Germany, for example, the spot price of electricity has risen sevenfold since June. Forward prices have risen even further on expectations of disruption. The rise in electricity prices is contributing to the acceleration in consumer price inflation. It is now widely expected that the EU will report annual inflation above 9% for August. It is also expected that this number will continue rising in the months ahead, thereby putting added pressure on the European Central Bank (ECB).
EU Commission president Ursula von der Leyen said that the way in which electricity prices are determined needs to be changed. She said, “We need a new market model for electricity that really functions.” Specifically, she and others are talking about reducing the link between gas prices and electricity prices, although with not much specificity. However, Italian prime minister Mario Draghi has talked about imposing a cap on prices. He said that he wants European governments to agree to cap the price they pay to Russia for natural gas. This will force Russia to accept that price or not provide gas at all. Draghi pointed out that the absence of such a cap has not prevented Russia from stifling the transmission of gas. Therefore, no harm will likely come from imposing a cap. At the urging of the Czech Republic, the EU intends to discuss Draghi’s proposal. Meanwhile, Draghi said that Italy will be free of Russian gas by the end of 2024 as it transitions to other sources, mainly liquid natural gas.
Interestingly, it is the fear of even higher energy prices that has fueled a sharp decline in the value of the euro, despite increasing expectations that the ECB will tighten monetary policy further. It is reported that the volume of investor bets against the euro has surged lately. Investors evidently believe that a likely further surge in energy prices will fuel accelerated inflation. All other things being equal, if inflation is higher in Europe than in the United States, it will lead to a decline in the euro versus the dollar. Currently, the euro is roughly at parity with the dollar for the first time in 20 years.
A specific cap has not yet been agreed upon. The G7 countries issued a statement saying that “the price cap is specifically designed to reduce Russian revenues and Russia’s ability to fund its war of aggression whilst limiting the impact of Russia’s war on global energy prices. The initial price cap will be set at a level based on a range of technical inputs and will be decided by the full coalition in advance of implementation in each jurisdiction.” The more countries that participate in the cap, the more effective it will be in reducing Russian revenue. Russia has already sought to boost exports of oil to other countries such as China and India. Russia warned that the cap will destabilize the global oil market.
When volatile food and energy prices are excluded, core prices were up 4.3% from a year earlier and were up 0.5% from the previous month. Prices of nonenergy industrial goods were up 5% from a year earlier and up 0.8% from the previous month. Prices of services were up a modest 3.8% from a year earlier and up 0.4% from the previous month. While annual nonenergy and nonfood price increases were modest, monthly increases accelerated, suggesting the possibility that underlying inflation is worsening. That explains the evident intention of the ECB to tighten monetary policy more than previously expected. Concern about inflation and expectations of further ECB action led to further increases in European bond yields.
Meanwhile, inflation varied by country. Some of the smaller economies in the Eurozone experienced negative monthly inflation in August. On the other hand, the highest annual inflation, by far, took place in the three Baltic states. Here are the numbers for selected countries:
Country M/M (%) Yr/Yr (%)
Germany 0.4 8.8
France 0.4 6.5
Italy 0.8 9.0
Spain 0.1 10.3
Netherlands 2.3 13.6
Belgium 1.8 10.5
Portugal –0.2 9.4
Ireland 0.1 8.9
Austria –0.2 9.2
Finland –0.4 7.6
Greece –0.3 11.1
The two ECB officials who spoke were Isabel Schnabel from Germany, who is a member of the ECB Executive Board, and Francois Villeroy de Galhau, who leads the Bank of France, a member of the Euro Area system. Schnabel said that “central banks are likely to face a higher sacrifice ratio compared with the 1980s, even if prices were to respond more strongly to changes in domestic economic conditions, as the globalization of inflation makes it more difficult for central banks to control price pressures.” The sacrifice ratio is the amount of pain to the real economy needed to achieve a particular inflation goal. In other words, she said that, to achieve lower inflation, there may be a need for worse growth and employment performance than would otherwise have been the case.
Moreover, in the case of the Eurozone, this is likely to be the case simply due to the huge impact of higher electricity prices, something that the ECB cannot directly target. Thus, for the ECB to achieve its goals in the face of energy disruption, it will likely have to tighten more than otherwise, thereby creating the conditions for recession. That is unrelated to the risk of recession coming from a potential cut-off of Russian gas.
Meanwhile, Valleroy de Galhau said that “our will and our capacity to deliver our mandate are unconditional.” In other words, he intends that the ECB will be entirely focused on hitting the inflation target regardless of the cost. He said that this is an important component in anchoring investor expectations of inflation. Moreover, the ECB has a single mandate to target low inflation, unlike the Federal Reserve, which has a dual mandate to target inflation and employment. Schnabel added that, if a central bank “underestimates the persistence of inflation—as most of us have done over the past one and a half years—and if it is slow to adapt its policies as a result, the costs may be substantial.”
These comments were hawkish and likely meant to prepare investors for what is coming, especially after a period in which the ECB has been cautious about tightening monetary policy. That caution stemmed from a belief that Europe’s inflation is largely an energy phenomenon as evidenced by relatively low core inflation. Plus, the ECB had the view that it could not influence energy prices and that severe tightening would add to the economic costs of the energy crisis. The views expressed above suggests a shift in the ECB’s thinking, with less concern about recession risk.
Finally, although leading central bankers expressed confidence that they can bring inflation down, even at the cost of recession, it was noted at Jackson Hole that the pandemic has left the world with persistent obstacles. Gita Gopinath, first deputy managing director of the International Monetary Fund, said that the very high inflation was first caused by supply chain disruptions that have not yet gone away. She noted that there is “disorderly global supply chain restructuring” taking place that could be affected by the desire to diversify supply chains. She also noted that the postpandemic labor supply is uncertain, a factor that could influence inflation. And she pointed out that the climate transition also poses risks to price stability. Consequently, central banks will have to take these factors into account as they navigate a new world.
The US government releases two reports on the job market: One based on a survey of establishments; the other based on a survey of households. The survey of establishments indicated that there were 315,000 new jobs created in August, a robust number but lower than the 526,000 jobs created in July. For the first time, employment exceeds the prepandemic level. However, due to a sharp decline in participation, employment is well below the prepandemic path. That is, absent the pandemic, if there had been steady job growth since early 2020, employment today would be much higher than it currently stands.
Employment grew at a healthy pace in many industries. This includes construction, manufacturing (but not automotive manufacturing), retailing, and financial services. Job growth was very strong for professional and business services as well as health care. Regarding leisure and hospitality, growth was good but not at the blistering pace seen earlier as the economy came out of the pandemic.
The report also indicated that wages remained tame in August. Average hourly earnings of workers were up 5.2% from a year earlier, the same as in the last three months and lower than in the previous three months. Thus, wages are not accelerated, merely rising. In addition, earnings were up 0.3% from the previous month, the lowest monthly rate since April. From the perspective of the Federal Reserve, this is good news in that there is not currently a wage-price spiral that could exacerbate inflationary pressures. One could argue that the Fed has been successful in anchoring expectations of inflation. Still, the modest wage increases remain surprising given the tightness in the labor market. From the perspective of workers, however, the news is not good. It means that workers are losing ground as wages fail to keep pace with prices. Yet, notably, consumer spending has remained steady due to rising employment, due to the ability of consumers to dip into their accumulated savings.
The separate survey of households found that, due to a sharp rise in the participation rate, the size of the labor force increased much faster than the civilian working-age population. Moreover, although employment grew at a brisk pace, it did not keep pace with growth of the labor force. Thus, the unemployment rate rose from 3.5% in July to 3.7% in August. This remains one of the lowest rates in the last half century. Meanwhile, the participation rate matches a high reached in March, which was the highest since the pandemic began—but it remains well below the prepandemic level. The rise in August is welcome at a time when the vacancy rate is historically high.
Cover image by: Sylvia Chang