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Cover image by: Sofia Sergi
Moreover, the first quarter numbers do not likely fully reflect the impact of recent lockdowns in Shanghai and elsewhere. That impact will probably show up in the second-quarter numbers. Meanwhile, there is no indication that, despite the economic disruption, the authorities have any intention of reversing or easing the zero–COVID-19 policy that has disrupted the economy. That, in turn, raises questions about how China will be able to get back on a favorable path.
Let’s look at the details. In the first quarter of 2022, real GDP was up 4.8% from a year earlier, slightly better than the 4% growth clocked in the fourth quarter of 2021. Real GDP was up 1.3% from the previous quarter, which is an annualized rate of 5.3%. This was slower than the 1.6% quarterly growth clocked in the fourth quarter of 2021. By output category, the government reported that industrial production was up 6.5% in the first quarter versus a year earlier, including a 6.2% increase in manufacturing output. The services sector, however, grew only 2.5% in the first quarter. However, IT-related services were up 10.8%. Retail sales were up 3.3% in the first quarter.
Data for March, however, showed a worsening situation, likely due to the pandemic-related measures taken by authorities. Thus, retail sales fell 3.5% in March versus a year earlier after having grown strongly in the previous month. This was the first decline since early 2020. By major category of spending, sales were down 6.3% for cosmetics, down 12.7% for clothing, down 17.9% for jewelry, down 7.5% for automobiles, and down 8.8% for furniture.
China’s industrial production was up 5% in March versus a year earlier, much slower than in the previous two months. While some categories of production did well, automotive output fell 1%. In addition, business fixed investment decelerated sharply in the first quarter.
What happens next? Given the severe lockdown in Shanghai, a city of critical economic importance to China, and given restrictions imposed in many other cities recently, it is likely that second-quarter growth will be modest at best. Meanwhile, the decline of the property sector continues, thereby slowing growth even in the absence of pandemic-related problems.
Moreover, the government appears keen to take a strong stand against the virus. It was reported that Chinese media stated that “only one can live and the other must die” in the fight between humans and the virus. This goes against the epidemiological notion that humans will have to find a way to live with the virus, as has been true with pandemics in the past. Yet if the policy is to fully eradicate the virus, it does not bode well for returning to normalcy, in terms of economic performance, interaction with the outside world, and the ease of doing business.
Therefore, the COVID-19 crisis in China could be the most serious threat to the global economy at present. There is no indication that the strict government response to the outbreak is likely to abate any time soon. Shanghai remains in severe lockdown. On April 20, the authorities said that the outbreak was under “effective control” and agreed to let roughly half the population of Shanghai leave their homes. Then, on April 22, many restrictions were reinstated. Those who test positive are required to stay home. Many residents are having trouble obtaining food and other necessities, especially given the severe disruption of delivery services.
At the same time, more than half of China’s big cities are under at least partial lockdown, including cities that are critical to global transportation, such as Shenzhen, Guangzhou, and Tianjin. Lockdowns entail massive and frequent testing, meant to identify and isolate those who are infected. This comes despite the high vaccination rate in China. Yet the Chinese vaccine is not highly effective.
The result of these measures is twofold. First, production and distribution of goods have been severely disrupted, thereby reducing global supply chain efficiency and setting back progress on alleviating global disruption. This, in turn, will likely exacerbate global inflation and reduce global output. Second, the lockdowns are reducing domestic demand in China, thereby contributing to a marked slowdown in economic growth. One positive side effect of this could be a sizable decline in demand for globally traded commodities, thereby helping to reduce global inflationary pressure.
The big question remains as to how long this situation will last. Statements from government authorities offer little hope of a change in policy. Rather, China appears to be doubling down on the zero–COVID-19 policy. So long as the policy remains in place, it is likely that economic activity will be suppressed. Keep in mind that the Yangtze River Valley surrounding Shanghai accounts for about one-fifth of China’s economic activity. The lockdown of Shanghai severely limits activity in the region.
For global businesses that operate in or source from China, this situation creates a new layer of uncertainty and disruption. In my past life of frequent travel, I would often meet, in airports and on planes, business executives on their way to and from China. They needed to periodically check on factories and distribution hubs, negotiate contracts, explain new policies, and get an in-person reading of the local market. How will this take place if travel is severely restricted for a prolonged period? Indeed, these considerations are likely to accelerate the process of diversifying supply chains.
In recent meetings, clients have asked me where companies might go as they attempt to make supply chains more resilient and redundant. It was suggested that India might be a favorable alternative given political and economic stability, low labor costs, and strong IT skills. However, India has its own challenges and obstacles including relatively high barriers to trade and cross-border investment as well as weak infrastructure. Still, India is increasingly central to the US goal of offsetting China’s footprint in the region. Given its massive size, India could become a major destination for global investment if companies seek to reduce dependence on China.
Expected weakness of China’s economy is likely one of the factors lately contributing to increased capital outflows and downward pressure on the value of the currency. Other factors include the tightening of US monetary policy, the global rise in commodity prices, and fears of further tensions between China and the West in light of the war in Ukraine. Based on conversations I have had with clients, it appears that there is apprehension among business leaders about reliance on Chinese supply chains. I suspect that the diversification of supply chains is likely to accelerate in the coming year.
Meanwhile, another factor that might exacerbate Japanese inflation in the months ahead is the sharp decline in the value of the yen. In Japan, where the strength of manufactured exports is critical to economic success, the value of the currency is very important. If the yen rises too much, it reduces the competitiveness of exports by raising export prices and/or diminishing profit margins for exporters. If the yen falls too far, it raises import prices, thereby reducing domestic purchasing power. It also means higher costs of imported commodities and inputs for manufacturers, and potentially higher inflation. Thus, a degree of currency stability is desirable.
Lately, the yen has fallen sharply, hitting the lowest level against the US dollar since 2002. This is mainly in response to rising interest rates in the United States as well as the negative impact on the external balance stemming from rising commodity prices. The drop in the yen, combined with higher commodity prices, has led to a sharp surge in producer prices in Japan, although consumer prices remain relatively tame. This suggests that margins are being squeezed. Although the government has sought to boost consumer price inflation during the past decade, it is likely wary of a sudden acceleration.
The depreciation of the yen has not gone unnoticed by policymakers. The finance minister, Shunichi Suzuki, said that, when rising commodity prices “can’t be sufficiently passed on through higher prices, or wages don’t grow enough to make up for them, a weak yen can be considered a bad thing.” It is unusual for a finance minister to comment on the value of the yen. Thus, Suzuki’s comments led to speculation that the government may intervene in currency markets to boost the value of the yen. The problem is that, when governments purchase domestic money to boost the value of their currency, this necessarily entails a tightening of monetary policy. It means that the government is selling the central bank’s reserves, thereby reducing the monetary base. The monetary impact can be offset if the central bank purchases government bonds, thereby leaving the monetary base unchanged. This is known as “sterilized” intervention, the principal topic of my own doctoral dissertation many years ago. What I found in my research was that sterilized intervention is rarely effective when there are no capital controls. Thus, if Japanese authorities want to change the direction of the yen, they will most likely have to alter monetary policy.
As for the Bank of Japan, governor Kuroda said that monetary policy will remain accommodative to support a fragile economic recovery and avoid deflation. He said that “the recent falls in the yen, which lost about 10 yen to the dollar in about a month, is quite sharp and could make it hard for companies to set business plans. In that sense, we need to take into account the negative effect” of a depreciating yen. This ambiguous statement, typical of central bankers, will leave traders wondering and, therefore, might help to prop up the yen. Still, the bottom line is that, despite their concerns, there is not much the Japanese authorities can do to reverse the drop in the yen without a tightening of monetary policy.
Meanwhile, Japanese and US officials have recently discussed the possibility of a joint intervention in currency markets, similar to what happened in the 1980s and 1990s. The US administration likely sees value in a stable exchange rate. However, intervention that boosts the yen means a lowered value US dollar. That, in turn, could be inflationary for the United States. Thus, any joint intervention is likely to be limited in scope. It would likely be meant to create uncertainty on the part of currency traders, thereby causing them to be cautious about further suppressing the value of the yen. Traders don’t want to get caught with their pants down.
Thus, it must be disconcerting if not unconscionable for German policymakers to learn last week that producer prices were up in March at the fastest pace since 1949 when data on producer prices began. Specifically, producer prices were up 30.9% in March from a year earlier, up considerably from the 25.9% producer price inflation in the previous month. Moreover, this is quite sudden given that annual producer price inflation was only 5.2% in April of last year. Meanwhile, producer prices were up a stunning 4.9% from February to March, largely reflecting the impact of the Ukraine war on commodity prices. In February, prices were only up 1.4% from the previous month.
The very high annual number was heavily influenced by energy prices. Natural gas prices were up 144.8% in March from a year earlier while electricity prices were up 85.1%. When energy prices are excluded, producer prices were up a more modest 14% from a year earlier. Still, some nonenergy prices were up substantially. This included metals (up 39.7%), fertilizer (up 87.2%), and wooden containers (up 68.8%). The disruption of the war likely played a big role in these price increases. Ukraine is a major exporter of grain and fertilizer as well as some metals. The war has impeded the efficient production and distribution of these products.
Meanwhile, the fact that consumer prices are rising at a much slower pace than producer prices likely implies that consumer-facing businesses are taking a hit to their margins by not fully passing on cost increases to consumers. Moreover, the very high producer price inflation in Germany suggests that Germany is uniquely exposed to disruption because of the size and importance of its very energy-intensive manufacturing sector.
From the perspective of the European Central Bank (ECB), the surge in German inflation is yet another challenge in navigating the crisis. Germany now has some of the highest inflation in Europe, a fact that the ECB cannot ignore. On the other hand, the inflation has been, and is currently being, caused by factors that are not necessarily affected by changes in monetary policy. These are supply chain disruption and politically driven commodity price movements. Moreover, the sharp rise in commodity prices increases the risk of recession by reducing household purchasing power. Thus, it is not surprising that the ECB is being cautious and, for now, retaining a relatively easy monetary policy. Yet there is little doubt that, going forward, it will face considerable pressure to shift gears, especially from the German members of the ECB’s policy committee.
Meanwhile, ECB president Lagarde recently explained why the ECB is not following the Federal Reserve in boosting interest rates. She said that the Eurozone faces greater downside risks to growth than the United States, largely due to the dependence on Russian energy and uncertainty about the future trajectory of the war in Ukraine. She said there will be no action on interest rates until at least after the ECB concludes its program of asset purchases in June. She said, “That will then lead us to assess whether an interest rate hike is needed. For goodness sake, let’s wait until we have the data and then we move on to decide.”
As such, the People’s Bank of China (PBOC), China’s central bank, recently announced a 25-basis-point reduction in the required reserve ratio (RRR) for commercial banks. This was less than many investors anticipated. It follows 50-basis-point cuts in both July and December. The latest reduction will release the equivalent of roughly US$83 billion of liquidity into the system, enabling banks to boost lending. It is meant to increase credit market activity and, consequently, stimulate economic activity, especially on the part of small and medium-sized businesses. It is an easing of monetary policy.
On the other hand, it can be argued that easing monetary policy will do little to boost economic activity if it is being suppressed by measures aimed at controlling the spread of the virus. Easing credit conditions assumes that there is demand for credit not being met because of constraints on bank lending. This might not be the case. Economist Lord Keynes suggested that an economy could be afflicted by a liquidity trap in which greater availability of credit makes no difference if participants in the market economy are prone to save excessively. This renders monetary policy ineffective. Keynes suggested the solution to this dilemma is fiscal policy, where the government spends money that would otherwise sit on the sidelines. In fact, China is doing this as well, boosting spending on infrastructure. Meanwhile, it is not clear that banks will want to lend to small businesses in this environment, fearful that they might not get paid back on time.
For China, easing monetary policy could lead to destabilizing outflows of capital given that the US Federal Reserve is raising interest rates. In fact, the Institute of International Finance reports that foreign investors are rapidly withdrawing capital from China. This puts downward pressure on the value of the renminbi, compelling the PBOC to sell reserves if it wants to stabilize the exchange rate.
Meanwhile, Shanghai continues to experience a lockdown. Yet the rate of infections in Shanghai, while up significantly, remains far below what has been seen in many other countries. Currently, the infection rate in several European countries is much higher. And yet those countries are easing restrictions and going on with their lives, confident that a high rate of vaccination will mean low rates of hospitalization and death.
China’s situation is different. The government is keen to enforce its zero-tolerance policy regardless of the economic cost. Locking down Shanghai means halting most forms of economic activity, with likely reverberations throughout the global economy. People are staying at home, factories are closed, and distribution is disrupted because drivers are locked down as well.
Thus, the biggest problem for China in the short term is the zero-tolerance policy toward the virus, which includes lockdowns and periodic shutdowns of factories and ports. It suppresses demand and disrupts supply chains. Moreover, it remains unclear whether the government will consider easing this policy. To do so would entail acceptance of a temporary surge in infections and hospitalizations.
It has been reported that neighboring Taiwan is now considering easing of COVID-19 restrictions. Taiwan has been successful in suppressing transmission and has retained strong economic growth. Yet, as other countries in the region open up, the government is concerned that Taiwan will get left behind if it does not attempt to live with COVID-19 as other countries have done.
Let’s look at the details. In March, consumer prices were up 8.5% from a year earlier, the highest since 1981 and much higher than the 7.9% rate clocked in the previous month. Prices were up 1.2% from the previous month, a dramatic increase. This was principally driven by energy prices, which were up 32% from a year earlier and up 11% from the previous month. Gasoline prices were up 48% from a year earlier and up 18.3% from the previous month. This was, of course, due to the dramatic surge in oil prices following the Russian invasion of Ukraine.
When volatile food and energy prices are excluded, core prices were up 6.5% from a year earlier and up 0.3% from the previous month. The latter figure was the lowest since September 2021. In other words, core inflation has decelerated. Still, try telling that to an American consumer who is facing significantly higher prices in many key categories. During my own recent trip to Italy, I left my dog in a kennel for the first time in two years. The cost was 20% higher than the last time. I was shocked. So are many people when they encounter new pricing, which threatens to create an inflationary psychology that could result in a damaging wage-price spiral. That is one reason the Fed is taking dramatic steps. More about that later.
Meanwhile, there are some interesting patterns to the current inflation. For example, from the previous month, used car prices fell 3.8%. Prices of smartphones fell 4.2% and prices of televisions were down 2.4%. On the other hand, airline ticket prices were up 10.7%, the price of renting a car was up 11.7%, and the price of staying at a hotel was up 3.7%. Evidently, people are starting to shift away from goods for the home and starting to travel more, while businesses struggle to satisfy changing demand patterns. Indeed, the price index for durable goods fell 0.9% from February to March while the price index for services was up 0.7%. Prices of nondurable goods, which include gasoline and fuel oil, were up 3.2%.
What are the implications of this inflation report? First, the sharp rise in the prices of essential energy and food goods means that households will have fewer resources available to spend on other goods and services. Although wages have risen, they have not kept up with prices. Effectively, this is a loss of real income. That could have a negative impact on economic activity. On the other hand, the economy is characterized by full employment and strong job growth. In addition, many households possess a vast pool of savings. Thus, a sudden decline in economic activity seems unlikely.
Second, the Federal Reserve has already begun a significant reversal of monetary policy, with the aim of quelling inflation. Yet the fact that the current surge is largely related to the war in Ukraine means that the Fed must be cautious lest it engineer a recession. The experience of 1974 is likely top of mind. At that time, a quadrupling of global oil prices set off a sharp rise in inflation combined with a loss of real income. This “stagflation” was greeted by a tightening of monetary policy by the Fed, which led to a deep recession.
Finally, the biggest unknowns right now are the trajectories the war in Ukraine and the recent COVID-19 outbreak in China take. The latter has led to lockdowns and severe disruption of supply chains. How these events unfold will likely have a significant impact on the future of inflation.
As the Fed has shifted policy, and as expectations of inflation have increased, bond yields have surged. The yield on the US Treasury’s ten-year bond increased from roughly 1.75% at the start of March to roughly 2.77% by mid-April. In addition, bond yields in other major countries increased commensurately. There are two principal components to a bond yield: an expectation of inflation over the life of the bond, and the real yield that is affected by supply and demand conditions in the bond market. The so-called breakeven rate measures the inflation expectations component. It has only risen modestly (about 20 basis points) since the start of March. Thus, the main factor driving increased bond yields in the past month is supply and demand. With the Fed first halting purchases, and then announcing the sale of bonds, markets are pricing in a flood of bonds into the market.
The surge in bond yields is already having an impact on markets. Mortgage interest rates have risen sharply, up about 100 basis points since the start of March. With home prices continuing to rise, this means a significant reduction in affordability. This augurs a slowdown in housing market activity. Meanwhile, the yield on so-called junk bonds has increased about 60 basis points in the past month. The volume of M&A transactions has fallen sharply. Thus, the Fed is clearly already having an impact. The challenge for the Fed will be to avoid tightening too much given the negative economic consequences of the sharp rise in commodity prices.
On the other hand, the sharp rise in mortgage interest rates could ultimately lead to a downturn in housing market activity, thereby hurting economic growth. In addition, heightened perception of risk has hurt the volume of M&A transactions on Wall Street. Still, a wide range of indicators still point to continued economic growth. These include healthy consumer balance sheets, continued growth of consumer spending, and strong job growth.
ECB president Lagarde said that “downside risks to the growth outlook have increased substantially as a result of the war in Ukraine.” She noted, however, that “the upside risks surrounding the inflation outlook have also intensified, especially in the near term.” Yet she evidently believes that a balanced approach is needed in order to avoid recession. She said that “we’ll deal with interest rates when we get there.” Regarding comparisons with monetary policy in the United States, Lagarde said that “comparing our respective monetary policies is comparing apples and oranges. Our economies do not compare and this is likely to be accentuated by the fact that the euro area is probably going to be more exposed and will suffer more consequences as a result of the war by Russia against Ukraine.”
Investors reacted to Lagarde’s comments by pushing down the value of the euro. It fell to its lowest level against the US dollar in nearly two years. Bond yields in Germany, France, and Italy all increased on expectations of higher inflation. Equity prices increased modestly, perhaps on the belief that the risk of recession is lower than previously expected. The ECB is now one of the few major central banks not to quickly tighten monetary policy. Rates have risen in the United States, the United Kingdom, Canada, Singapore, South Korea, and other countries. Only Japan, where inflation remains very low, have rates not been increased.
And yet, global trade continues to thrive. If deglobalization is coming, it is not yet evident in the statistics. The volume of global trade in early 2022 was roughly 9% higher than just prior to the pandemic, despite a slowdown in trade in China in early 2022. In fact, trade accelerated in recent months. Recent indicators of supply chain stress demonstrate that global business continues to struggle to satisfy strong global demand for traded goods. If there were deglobalization, supply chains would be turning inward.
Still, the hallmark of globalization has been the constant search for the lowest cost and fastest speed of producing and transporting goods. In the last two years, however, costs have risen and transport has slowed. This reflected the disruptive impact of the pandemic. The war in Ukraine and the recent lockdowns in China simply add to the disruption. But this does not necessarily mean that globalization is being reversed. Rather, it means that globalization has hit a roadblock and turns out to be more vulnerable than previously believed. If global businesses move to boost the resilience of supply chains through diversification, it does not imply a reversal of globalization.
Perhaps the pessimists are concerned less about the economic issues than the geopolitical issues. That is, there is fear that the economic relationship between China and the West will fall apart, especially if global companies fear that China might become subject to the kinds of sanctions that the West recently imposed on Russia. Such fear will likely cause supply chain diversification to accelerate. Yet this does not imply that supply chains will not be global or that companies will bring most processes back home.
Meanwhile, the debate continues. It is often said that “saying it’s so makes it so.” If true, then all the talk about deglobalization could turn out to be a self-fulfilling prophesy. Companies might act in ways that undermine globalization due to fear of being left behind.
The establishment survey found that there were 431,000 jobs created in March, a strong number but the lowest since September. Among the industries that experienced strong job growth were manufacturing (up 38,000), retailing (up 49,000), professional and business services (up 102,000), and leisure and hospitality (up 112,000). The establishment survey also revealed that average hourly earnings of workers were up 5.6% in March versus a year earlier. This was an acceleration from recent months, but not dramatically so. Wages are rising more slowly than prices, rendering consumers with less real spending power. That, in turn, could threaten the economic recovery. On the other hand, the modest pace of wage gains means that we are not yet seeing the kind of wage-price spiral that could lead to sustained and prolonged inflation.
The household survey found that the labor force continued to grow faster than the working-age population, thereby boosting the rate of labor force participation. Employment grew even faster, causing the unemployment rate to decline to 3.6%, the lowest since February 2020. It should be noted that the job market is often a lagging rather than a leading indicator of economic performance. Thus, some observers fear an imminent recession despite current strong job market indicators.
The inversion of a yield curve is often seen as signaling investor expectations that future short-term interest rates will be lower than currently, likely due to the central bank easing of monetary policy in the face of recession. Thus, an inverted yield curve is often seen as predicting a recession. And, indeed, it is often correct—but not always. The fact that the 10-year three-month spread did not invert suggests that investors are not convinced that a recession is imminent. Meanwhile, there is plenty of discussion about the risk of recession in the business community, a discussion that did not seem to be present prior to the war in Ukraine. The shock of a big increase in commodity prices and uncertainty about which way the war will go have clearly frightened many people in the business community. Indeed, the volume of M&A transactions dropped sharply since the war began.
By country, the 12-month increase in consumer prices was 7.6% in Germany, 5.1% in France, 7% in Italy, 9.8% in Spain, 11.9% in the Netherlands, 9.3% in Belgium, 8% in Greece, and 5.5% in Portugal.
The European Central Bank (ECB) now faces a conundrum. On the one hand, it will likely tighten monetary policy in order to assure investors that it has inflation under control. On the other hand, Europe is at most risk of a recession emanating from the war in Ukraine. The risk is particularly acute given the possibility that the European Union, or at least some members, will halt purchases of Russian oil and/or gas. Thus, even higher prices and a shortage of energy could ensue. For the ECB, this means tightening monetary policy further creates a risk of recession.
Markit reports that the PMI for Chinese manufacturing fell from 50.4 in February to 48.1 in March. This was the lowest PMI since the start of the pandemic and indicates a significant decline in activity. The latest PMI included a sharp decline in output, new orders, and export orders. In addition, there was a sizable increase in both input and output pricing. China’s manufacturing sector was hit by two headwinds. First, government efforts to suppress the virus led to disruption of production, distribution, and consumer demand. Second, the war in Ukraine boosted input prices and created uncertainty that likely sapped consumer sentiment. Going forward, the outlook for manufacturing in China will depend on how the government addresses COVID-19. As of now, a lockdown in Shanghai continues. In addition, the resolution of the war in Ukraine will also have an impact.
In fact, this has already been happening during the past decade. Economist Barry Eichengreen has found that the dollar share of global reserves fell from 70% at the start of this century to roughly 59% now. Moreover, this was not offset by increased holdings of traditional reserve currencies such as the euro, pound, and yen. Instead, the share held in other currencies increased. The Chinese renminbi only accounted for 25% of that increase. The rest went into currencies issued by smaller market economies such as Canada, South Korea, Australia, Singapore, and Sweden. Evidently, central banks like holding reserves issued by stable countries with open capital accounts and the rule of law.
Going forward, there will likely be some further diversification of reserves away from traditional reserve currencies, if only as an insurance policy against geopolitical disruption. In that sense, the sanctions on Russia have created a greater sense of risk that warrants diversification. The sanctioning of Russia’s central bank was a landmark event, given the large size of Russia’s economy. Moreover, there will not likely be a significant surge in reserves held in renminbi so long as China retains capital controls and a lack of financial transparency. Thus, the world of reserves is gradually becoming more multipolar rather than unipolar.
That said, the US dollar and the euro are likely to remain substantially dominant, not only as reserve currencies but also, and more importantly, as principal trading currencies. Indeed, the dollar and euro together account for about 80% of all international transactions. The dollar and euro have some important attributes that make them highly attractive. These include a transparent financial system, rule of law, and in the case of the United States a vast and liquid market for government-issued securities. I believe if you asked a farmer in an emerging country how they would like to be paid for his wheat exports, they would likely say dollars rather than renminbi. As long as that is his answer, the dominant role of the dollar will remain.
Now comes word that the energy ministers of the G7 countries unanimously rejected Russia’s demand. Germany’s energy minister said that, to abide by Russia’s demand would violate existing contracts. He said that the G7 countries were prepared for “all scenarios” including the loss of access to Russian energy. If Russia now rejects payment in euros, it will experience a sharp drop in revenue. If Russia allows payment in euros, it will continue to receive revenue but will suffer a loss of credibility. Europe’s leaders likely hope that Russia will concede.
Meanwhile, European gas prices were relatively stable after the G7 announcement. Analysts said that, absent the G7 statement, prices would likely have fallen after reports that European gas storage was substantially replenished in the last few days, hitting levels not seen since 2018. European nations are actively attempting to boost access to alternative sources of energy. Germany last week said it intends to wean itself from Russian energy within the next two years. And the United States pledged a substantial increase in exports of liquid natural gas to Europe.
The risk, of course, is that a substantial reduction in gas supplied to Germany could lead to a dramatic rise in prices (and, therefore, inflation) as well as reduced economic activity—perhaps a recession. Yet Germany has lately been quite firm in its aversion to engaging Russia. It said it will not meet Russia’s demand to be paid in rubles, and it has pledged to quickly wean itself from both Russian gas and oil. The goal, however, is to bring Russia’s economy to its knees to limit its ability to wage war.
Still, the highly intrusive sanctions, especially those aimed at Russia’s banking system, mean that the market for trading rubles has shrunk dramatically. Thus, although the exchange rate is back to the precrisis level, the volume of trading suggests illiquidity. While the Russian government might point to the exchange rate as evidence that the sanctions are not working, the reality is that the sanctions are having a big negative impact on economic activity. Real GDP is likely to shrink significantly this year.
A study conducted at Harvard found that, following 2014, Ukraine’s exports shifted dramatically away from Russia. In 2012, 25% of Ukraine’s exports went to Russia. Today that figure is roughly 7%. The difference was mainly made up by increased exports to the European Union. One result of this is that Ukraine has become more integrated into European supply chains. For example, Ukrainian exports of electronics to Germany increased significantly in recent years. Moreover, EU direct investment in Ukraine increased commensurately. Roughly 128,000 Ukrainians are employed by EU companies. However, less than 2% of Ukrainian workers are employed by foreign companies—a much smaller share than in many neighboring countries. Notably, Ukraine’s increased economic engagement with the European Union mostly took place in the western provinces of Ukraine, leaving the eastern, Russian-speaking areas behind.
What can we infer from these statistics? First, Russia’s attempt to pull Ukraine away from Europe failed. Second, Russia’s actions led to weaker economies for the Russian-speaking areas of Ukraine. Third, it seems likely that the war was launched, at least in part, to halt any further Ukraine integration with Europe, especially a potential membership in the European Union. Finally, the evident failure of Russia’s invasion offers hope that Ukraine’s path toward greater economic integration with the West might resume.
This commentary is based on the latest US government data on consumer income and spending and prices in February. The data shows that, in February, real disposable household income declined 0.2% from the previous month. While nominal income rose, the increase was more than offset by high inflation. Notably, real (inflation-adjusted) consumer spending fell even more, mainly a result of rising savings rates. Specifically, the share of income that households save increased from 6.1% in January to 6.3% in February.
As for consumer spending, real spending on durable goods fell 2.5% from January to February. Spending on durables was 8.5% below the peak reached in March 2021 but was 22.9% above the level in February 2020 just prior to the start of the pandemic. In other words, while demand for durables is receding, it remains far higher than prepandemic levels, even after accounting for rising prices. It was the surge in such demand that made a major contribution to the inflation we’ve seen in the past year.
Meanwhile, real spending on nondurable goods fell 1.9% from January to February. Although real spending on nondurables has been relatively flat for the past year, it remains 11.9% above the prepandemic level. Finally, real spending on services increased 0.6% from January to February. Although real spending on services has been steadily rising since collapsing at the start of the pandemic, it remains 0.3% below the prepandemic level. Thus, the sharp shift by consumers away from services and toward goods during the pandemic remains with us, although it is clearly abating. That shift played a big role in generating high inflation. After all, a disproportionate share of the rise in prices was attributable to goods rather than services.
Meanwhile, the government also published the Federal Reserve’s favorite measure of inflation, the Personal Consumption Expenditure Deflator, or PCE-deflator. This is not as well known as the Consumer Price Index (CPI), which is highly reported in the press. The data on the PCE-deflator indicates that, in February, consumer prices were up 0.6% from January to February, the same as in three of the last five months. Prices were up 6.4% from a year earlier, a 40-year high. When volatile food and energy prices are excluded, core prices were up 0.4% from January to February, the smallest increase since September. Core prices were up 5.4% from a year earlier.
Notably, prices of durable goods were unchanged from January to February while prices of nondurables were up 1.8%, largely due to rising energy prices. Prices of services were up 0.3%. One can make the argument that the February data shows some promising signs. Yet the reality is that the war in Ukraine has led to dramatic increases in the prices of energy, food, and some key minerals. This will show up in the inflation data in the months to come, exacerbating and prolonging inflation in the United States and elsewhere. How bad this gets and how long it lasts will depend on the war, the sanctions, and the reaction of policymakers. The Federal Reserve has initiated a tightening of monetary policy meant to suppress inflation.
Cover image by: Sofia Sergi