Article
26 October 2022

Weekly global economic update

What’s happening this week in economics? Deloitte’s team of economists examines news and trends from around the world.

Ira Kalish

Ira Kalish

United States

Week of October 24, 2022

Supply chain disruption continues to haunt the global economy

  • Last Saturday I went to purchase a new car. There was a terrific car at a local dealership. I was ready to drive it off the lot. Then a problem emerged. The car needed a semiconductor chip that was missing. They said a new chip would most likely arrive in a few days. It did not. So now I don’t have a new car, after having signed all the paperwork and paid a small fortune. The dealer is now trying to find another car for me. He said there is a fully loaded car on a ship headed to Los Angeles that he hopes to grab for me. I’m hopeful but not optimistic. Evidently there are extraordinarily long waits for many models of new cars.

This experience brought home to me one of the key problems in the global economy. As central banks attempt to weaken demand to reduce inflationary pressure, one reason they must do this is that there is a supply constraint that is contributing to a disequilibrium between supply and demand, thereby pushing up prices. There remains an especially severe shortage of chips as well as of other inputs. In addition, there are shortages of labor, stemming from a decline in labor force participation and a sharp decline in migration. 

At a time when many companies worry that imminent recession will hurt demand for their products, they still struggle to meet existing demand because of input and labor shortages. Their struggle contributes to inflation. I cannot recall a similar situation in my many years of observing the global economy. This situation suggests that one potential cure for inflation is an unclogging of supply chains, not simply a decline in demand. Although measures of supply chain stress have improved in recent months, they remain far above prepandemic levels. In my opinion, governments can ease the problem by reversing restrictions on trade and migration, but there are political obstacles to such action. 

Meanwhile, it is not just cars that are in short supply. It is reported that there are not enough airplanes to meet rising demand for air travel. This comes on top of a shortage of skilled pilots. Major airplane manufacturers are said to be far behind their production targets. It is not just a problem of semiconductors. Rather, suppliers to aerospace companies, having taken a hit during the pandemic, are not prepared to meet the surge in demand, because of limited availability of both material and labor. Plus, despite a sharp tightening of monetary policy, demand for air travel shows no sign of abating.

As for materials, there is an interesting situation regarding the market for copper, a key commodity used in telecoms, electric vehicles, solar power, and construction among other industries. Copper prices have fallen sharply due to expectations of a weakening global economy. Yet it is reported that copper inventories are perilously low, creating a risk that a shortage could emerge leading to a sharp rise in prices. It could be that copper traders have paid too much attention to problems in the residential property market in China but not sufficient attention to burgeoning demand for electric vehicles. Indeed, surging sales of electric vehicles have contributed to a sharp rise in the price of lithium.

Britain struggles to recover from financial turmoil

  • Repair work has begun on Britain’s standing in financial markets. Yet with damage having been done to investor confidence in recent weeks, the British economy likely faces headwinds that did not exist prior to the recent crisis and that will continue to generate high bond yields if only owing to perceived risk.

First, the new Chancellor of the Exchequer, Jeremy Hunt, announced a nearly complete reversal of policy on taxes and spending, leading to a sharp decline in bond yields, a rise in equity prices, and a rise in the value of the pound. Yet despite this, bond yields remain quite elevated compared to the precrisis level.

Hunt’s announcement included eliminating about two-third of the tax cuts that his predecessor had proposed. This included cuts in the corporate tax rate and the top tax rate. In addition, the cut in the basic tax rate was shelved. Hunt also scaled back support for households to pay for energy. The “energy price guarantee” will only last until April, after which subsidies will be more closely targeted on lower-income households. The principal goal of these fiscal changes is to reassure investors that the government’s intention is to reduce borrowing and create a stable and credible fiscal path. 

Meanwhile, the Bank of England (BOE) halted the bond purchases that were undertaken to stabilize bond yields. Rather, the BOE will return to its previous policy of bond sales. However, it said it will continue to provide liquidity to pension funds that have been disrupted by troubles in the bond market. The BOE evidently hopes to get its tightening of monetary policy back on track. This will likely include further increases in short-term interest rates.

The investor response to the reversal of policy was as expected. The pound initially surged while bond yields fell sharply. Equity prices rebounded. Yet it is worth noting that bond yields remain quite elevated compared to their precrisis level. Thus, a new risk premium on bonds appears to have developed, signaling investor caution. They say that time heals all wounds. In this case, it will likely take time for investors to recover their confidence in the government’s fiscal probity. 

With the new fiscal policy announced by Hunt, Britain now faces a more significant fiscal contraction than would have been the case absent this crisis. Meanwhile, bond yields and mortgage costs remain higher than before the crisis and will only revert to precrisis levels once confidence is fully restored. Plus, households will now face significantly higher energy bills due to the cutback in planned subsidies. On balance, the British economy is likely now at greater risk of recession than was the case prior to the financial crisis. 

  • British retail sales, adjusted for inflation, fell sharply in September. Sales were down 6.9% in September versus a year earlier, the sharpest annual decline since early in the pandemic. This was the sixth consecutive month of declining sales, driven by surging inflation, especially energy costs. Moreover, wages have not kept pace with inflation and consumer confidence has fallen to a historic low. Meanwhile, real (inflation-adjusted) retail sales were down 1.4% from the previous month. In the past 12 months, real retail sales have grown from the previous month only twice. 

It is widely expected that real retail sales will continue to decline due to a continuing decline in real incomes, rising mortgage interest rates (due to tightening of monetary policy), and a sharp rise in energy prices. It is widely expected that monetary policy will be further tightened. Britain could also face a severe tightening of fiscal policy. The current Chancellor of the Exchequer, Jeremy Hunt, wants such a tightening to convince investors that the government is being responsible about debt. In doing so, he hopes to reduce long-term borrowing costs.  

US midterm elections could have financial and geopolitical consequences

  • I’m often asked about the potential consequences of the upcoming US midterm elections. My answer is that the elections will not likely have a big macroeconomic impact, although they could influence the legislative and regulatory agenda. The main macroeconomic impact would come from a possible conflict over the debt ceiling. Below, are thoughts on this issue from our US economic forecaster Danny Bachman:

Recent press reports on the possible goals of a Republican Congress in 2023 have mentioned the problem of the US debt limit. This is a significant issue that could lead to a global financial crisis. The good news is that this is one crisis that has an easy solution. What’s the problem?

The US Treasury regularly borrows money to cover the Federal deficit, but it must receive authorization from the Congress (a rise or suspension of the debt limit) to do so. In the recent past, this has become a contentious process. Indications are that it will become even more contentious. Kevin McCarthy, the likely future Republican House speaker, has indicated that a Republican-led House would insist on “undoing” some of the recent spending passed in the current Congress. Others have discussed “reforming” Social Security. Would this be symbolic or would it be intended to reverse much of the legislation of the past two years? Much depends on how weak the Republicans in Congress believe the President to be, and the willingness of the administration to accept a period of time when the debt ceiling prevents Federal borrowing.

One key to understanding why the debt ceiling is likely to become a problem is that Democrats have changed their perception of their “payoff matrix,” the expected values of different strategies (compromising or not compromising) since similar battles during the Obama administration. President Biden and Senate Majority Leader Schumer demonstrated a willingness to permit the debt ceiling suspension to expire in 2021. If Republican perceptions of Democrats’ views are still shaped by their previous experience, the Republicans may misjudge how much leverage they have. This makes the possibility that the combined result of both sides’ strategies (in game theory terms) will be letting the current debt ceiling suspension lapse.

Suppose the debt ceiling suspension does lapse, and Treasury can no longer borrow above the statutory level? The US Treasury has determined that it cannot prioritize payments, so its ability to pay bills on any given day would depend on that day’s cash flow. There would almost certainly be days when the Treasury would have to miss interest payments on Treasury securities. Some analysts have described this as “default” although it’s very different from a true default or insolvency. But it’s not just interest payments. Treasury is likely to miss payroll payments for Federal workers and Social Security payments for retirees, depending (noted) on a particular period’s cash flow.

The initial outcome of missing a Treasury payment might be relatively muted. At first, prices of specific Treasuries (those scheduled to pay interest on a date when Treasury would not be expected to have cash) would rise. But a longer period of time when Treasury payments stop might create difficulties for the global financial system, which depends on Treasury securities as its foundation. Nowhere else can financial market players find such a large supply of low-risk assets, so Treasuries will not be easily replaced.

The good news is that, over time, the political pressure to solve the problem will grow. Missed Social Security checks should get the attention of enough members of Congress to allow a bipartisan fix. And Wall Street will certainly be pressuring those members of Congress who are business-friendly. The US has no fundamental inability to make debt payments, like Argentina or Greece. It’s just a matter of passing the law to allow Treasury to do so.

Another potential impact from the midterms could involve Ukraine. The Ukraine government has expressed shock that leading Republican members of the US Congress are talking about cutting assistance to Ukraine should they take control of the House. The Republican leader of the House, Kevin McCarthy, who would become Speaker if the Republicans obtain control of the House, said that “I think people are going to be sitting in a recession and they’re not going to write a blank check to Ukraine.” A senior Ukrainian legislator said, “We were shocked to hear these comments of Mr. McCarthy.” 

The success of Ukraine’s military in fighting Russia is likely due, in part, to the massive quantity of weapons and other aid provided by the United States and its allies. A cutback in such aid would be seen as helpful to Russia and might boost Russia’s confidence and willingness to prolong the war. That is why it has been suggested that the recent Russian decision to join Organization of the Petroleum Exporting Countries (OPEC) in cutting oil production, and thereby boosting the price of oil, was meant to assist Republicans in the midterm elections. If the United States reduces aid to Ukraine, it could drive a wedge between the United States and Europe, possibly increasing the willingness of European nations to ease sanctions or negotiate with Russia on ending the war. This, in turn, could isolate Ukraine.

On the other hand, it should be noted that Republicans in the US Congress are not united on this issue. Although many House Republicans are averse to further aid, many Senate Republicans strongly support aid to Ukraine. In fact, Senate Republican leader Mitch McConnell not only supports aid but has criticized the Biden Administration for not providing sufficient aid. Any new aid to Ukraine will require support in both houses of the US Congress. If the Republicans capture both houses, there could be an intraparty fight over this issue.

Inflation in Eurozone

  • Inflation continued to accelerate in the 19-member Eurozone in September. Consumer prices were up 9.9% from a year earlier, a record high. Prices were up 1.2% from the previous month. When volatile food and energy prices are excluded, core prices were up 4.8% from a year earlier and were up 1% from the previous month. The latter number is alarming in that it suggests that underlying inflation is accelerating. That is, Europe’s inflation is no longer simply driven by food and energy prices. It is becoming entrenched, despite the slowdown in the European economy. This situation was once known as stagflation. The European Central Bank (ECB) is, therefore, evidently justified in its current path of rapid tightening of monetary policy. A recession is likely coming, due to the combined impact of tight monetary policy and the energy crisis.

Indeed, energy prices continued to surge. They were up 40.7% from a year earlier and up 2.9% from the previous month. The price of unprocessed food was up 12.7% from a year earlier and up 1.6% from the previous month. The energy surge remains mostly related to the crisis involving a Russian-engineered shortage of natural gas. How that situation evolves remains uncertain. 

There was considerable variance in inflation by country. From a month earlier, prices were up 2.2% in Germany, up 2.8% in the Netherlands, down 0.5% in France, up 1.6% in Italy, and down 0.2% in Spain. Germany and Italy, two countries with unusually high inflation, are also the two that are likely at greatest risk of recession—especially due to excessive reliance on Russian natural gas.

Inflation in the United Kingdom

  • The British government also reported on inflation and the news was not seen as favorable. In September, consumer prices were up 10.1% from a year earlier, a 40-year high. The good news is that inflation stopped accelerating. Inflation has been roughly steady for the past three months. In addition, consumer prices were up 0.5% from the previous month, the same as in August. This was the lowest rate of monthly inflation since January. When volatile food and energy prices are excluded, core prices were up 6.5% from a year earlier, a record high. Core prices were up 0.6% from the previous month. Thus, underlying inflation is not getting better even as headline inflation stabilizes. This report reinforces the likelihood that the BOE will further tighten monetary policy significantly, setting the stage for a likely recession.

Given the inflationary situation, outgoing Prime Minister Truss promised to adhere to the so-called “triple lock” regarding pensions. The triple lock means that the government will increase pensions either in line with inflation, average earnings, or 2.5%—whichever is larger. Inflation is the largest of the three, implying that pensions will rise 10.1% in the coming year.

Week of October 17, 2022

Global inflation and recession risk

  • Many economists and central bankers believe that the primary reasons for recent surge in inflation included a shift in global consumer demand toward durable goods, disruption of supply chains due to the pandemic, and the surge in commodity prices following the start of the war in Ukraine. Monetary and fiscal expansion played a role as well. In response to inflation, central banks around the world have been tightening monetary policy, creating the risk of recession.

Yet now, the fundamental causes of inflation have started to reverse, thereby auguring a deceleration in inflation. This raises the question as to whether central banks are going too far in raising interest rates. This question is especially pertinent when it comes to the United States given the global impact of Federal Reserve policy. The sharp rise in US interest rates has generated capital outflows from emerging markets, compelling many emerging-market central banks to raise their policy rates, thereby stifling economic activity and boosting the risk of recession. The relative rise in US rates has boosted the value of the US dollar, creating concerns in other developed nations. They face depreciating currencies, which can be inflationary.

Meanwhile, there are things taking place that can lead to lower inflation. In the United States and Europe, consumers have shifted spending back toward services, thereby alleviating the massive inflationary pressure in the market for goods. In addition, measures of supply chain disruption have eased, with fewer shortages and delays and a considerable decline in the cost of shipping containers and commodities. In part, this easing reflects weakening global demand. Although the war in Ukraine continues, prices of many key commodities have fallen, including oil, food, and key metals—although all remain relatively elevated. In the United States, fiscal policy has become contractionary. All these factors are reducing inflationary pressure. Indeed, the United States has seen a notable deceleration in inflation, although the number remains very high. 

Fearful that an inflationary psychology could become entrenched in the market economy, central banks have sought to fight inflation by raising interest rates to not only directly lessen inflationary pressure, but also to anchor expectations of future inflation. The latter has been a success as indicated by very low inflationary expectations on the part of investors. The question, then, is how far central banks must go to fight inflation if other factors are already causing an easing of inflation. And is there a risk that central banks will overshoot (as they often do), thereby leading to recessions that might otherwise have been avoided. 

On the other hand, central banks recognize that, if they fail to stifle inflation before it becomes entrenched, then it will become more difficult and costly to suppress. Moreover, if investors lose faith in central banks’ determination to fight inflation, then borrowing costs are likely to rise sharply in line with expectations. Thus, central banks are in a difficult position. For now, it appears that the major central banks (other than those of Japan and China) are attempting to err on the side of fighting inflation. Recession risk remains. 

Of course, the inflation/recession risk dynamics differ by region. In the United States, the economy evidently continues to grow, with monetary policy mainly affecting the housing market. Recession might or might not be avoided. If it comes, it will likely be modest and short-lived. In Europe, on the other hand, the war-driven energy crisis means a high probability of recession due to energy shortages and tightening monetary policy. In China and Japan, inflation remains muted as does economic growth. Thus, the central banks of these countries continue to maintain an easy monetary policy, thereby putting downward pressure on currency values. Finally, emerging markets are caught in the middle, struggling to balance avoidance of currency depreciation with concerns about recession.

US inflation and Fed sentiment

  • In the United States, inflation is easing, but far more slowly than anticipated or hoped for, according to today’s report on the consumer price index. Moreover, while headline inflation is easing due to a decline in energy prices, core inflation is accelerating. The problem is that the economy remains stronger than expected, despite repeated interest-rate increases on the part of the Federal Reserve. And although the housing market is already in a recession, other parts of the economy continue to perform well, evidently not sufficiently influenced by higher borrowing costs. This suggests that the Fed will have to tighten a good deal more to suppress inflation more forcefully. The expectation of this led to a sharp drop in equities and a rise in bond yields. 

The irony, however, is that popular perceptions of the economy sometimes differ from reality. Although some business leaders talk about recession, the evidence suggests that most are more concerned about inflation than recession risk. Deloitte’s latest survey of CFOs found that 73% of respondents are more concerned about inflation while only 27% are more concerned about recession. On the other hand, 46% of respondents expect the US economy to be in recession in 2023. 

In any event, here is what the inflation data revealed. In September, consumer prices were up 8.2% from a year earlier, down from 8.3% in August and 8.5% in July. Prices were up 0.4% from the previous month, up from 0.1% in August. The rate of deceleration in annual inflation is much lower than had been expected. It reflects the fact that, even as energy prices have dropped, underlying inflation has accelerated. When volatile food and energy prices are excluded, core prices were up 6.6% from a year earlier, higher than in August. Moreover, core prices were up 0.6% from the previous month. 

Part of the problem in September was a sharp acceleration in the price index for shelter. This reflects the impact of rising house prices and rents. Yet the index for shelter rises gradually and tends to lag actual prices of homes. This means that, even as house prices now start to decline, the price index for shelter will likely continue accelerating in the coming months before reversing. This implies that inflation will be exacerbated for a while, especially given that shelter accounts for 32.5% of the overall price index. If shelter as well as food and energy are excluded, prices were up 6.7% from a year earlier and up 0.5% from the previous month. 

Meanwhile, many other price categories are rising rapidly. For example, airline fares were up 42.9% from a year earlier, food prices were up 11.2%, and new car prices were up 10.5%. On the other hand, appliances were up a modest 1.7% while apparel prices were up 5.5%. Going forward, it remains likely that inflation will decelerate. Yet if this happens slowly, the Federal Reserve will feel compelled to speed up the pace of monetary tightening. 

  • The Federal Reserve released the minutes of its policy meeting from late September. The minutes indicate that Fed officials are worried about the persistence of inflation and the possibility that, so far, they are not doing enough. Meanwhile, the rest of the world worries that the Fed might do too much and thereby drive the global economy into recession.

The minutes indicate that Fed policymakers see the war in Ukraine and the resulting disruption of supply chains in multiple industries as contributing to higher inflation than otherwise. In addition, they note that the US economy shows greater resilience than many people have expected. For example, consumer spending and business investment continue to grow. Consumer spending has been boosted by strong job growth and access to a large pool of savings that was accumulated during the pandemic. As for business investment, although it continues to grow, it has slowed, and in some cases, companies are constrained by higher borrowing costs.

In addition, the job market remains tight while businesses continue to hire. Fed policymakers believe that the labor market needs to loosen for inflationary pressure to abate. Yet if this is not happening, it may be necessary to tighten monetary policy further. It has been suggested that many companies are hoarding labor. That is, in anticipation of the next economic rebound, and given the unusual shortage of labor, companies are keen on obtaining and retaining the labor they will need during the recovery. This might mean fewer job dismissals than would normally take place during a downturn. This explains why the Fed now expects to require more severe tightening in the months ahead than previously expected. Indeed, the minutes state that policymakers see doing too little as more costly than doing too much.

Russian war goals and the potential for disruption

  • British intelligence says Russia is running out of sophisticated weapons. Russia is also running out of manpower. The head of British cyber intelligence said that “we know—and Russian commanders on the ground know—that their supplies and munitions are running out. Russia’s forces are exhausted. The use of prisoners to reinforce, and now the mobilization of tens of thousands of inexperienced conscripts, speaks of a desperate situation.” Hence, Russia’s recent activation of reservists, which led to protests and a surge in emigration of young men. In fact, Russia has now said that it will reverse course and end the draft. With the war going badly for Russia, with Ukraine making progress against Russian forces occupying parts of eastern Ukraine, Russia has responded with missile attacks on civilian targets in Kyiv and elsewhere. 

In addition, President Putin hinted at the use of nuclear weapons to protect Russia’s existence. He said that “I want to remind you that our country also has various means of destruction, and when the territorial integrity of our country is threatened, to protect Russia and our people, we will certainly use all means at our disposal. This is not a bluff.”

Traditionally, the nuclear doctrine of the Russian military was that nuclear weapons would be considered if the country’s existence is threatened. Although Russia’s existence is not currently threatened, discussing it in these terms is seen as providing an excuse for the use or threat of tactical nuclear weapons in Ukraine. US President Biden has publicly stated that Putin is not “joking when he talks about potential use of tactical nuclear weapons or biological or chemical weapons” and that the danger of a nuclear holocaust is now greater than at any time since the Cuban Missile Crisis in 1962. 

Meanwhile, the United States and its allies are said to be in talks about how to deter Russia or how to respond should Russia take radical action. The United States is sending more weapons to Ukraine and is seeking to hold the coalition together. The goal is to make the cost of Russian use of nuclear weapons intolerable. The G7 issued a statement saying that “we are undeterred and steadfast in our commitment to providing the support Ukraine needs to uphold its sovereignty and territorial integrity. We will continue to provide financial, humanitarian, military, diplomatic and legal support and will stand firmly with Ukraine for as long as it takes.” Also, Russia might be hoping that Republican success in the upcoming US midterm elections will undermine US support for Ukraine, given that many Republican members of Congress have expressed aversion to spending more money on support for Ukraine. 

Finally, what is Russia’s end game? I suspect that the main goal is to avoid regime change. If Russia were to end its invasion of Ukraine without having gained anything, the position of the current regime might be at risk.

While supporters of Ukraine can cheer the evident success of Ukraine’s military operations, the more Russia is forced to retreat, the greater the risk that Russia will create new problems for the West. Investors are well aware of this. Recent market volatility is likely at least partially related to fears about what Russia might do next.

Invitation to attend an exciting webcast:

Dear subscribers, given the impact the latest developments with respect to the ongoing war in Ukraine has had on global markets, I’d like to draw your attention to a timely upcoming webinar hosted by the Deloitte Global Boardroom Program on geopolitics and related company challenges. The webinar will be held on October 20 with the former director of the CIA, a former foreign secretary of the United Kingdom, together with the CFO of Tata Steel (see below for full details).

All board members and C-suite executives are kindly invited to register to hear from this outstanding group of speakers.

Best regards,

Ira

Week of October 10, 2022

Of OPEC, Russia, and Europe

  • After peaking in early June of this year, oil prices have been steadily declining as the global economy weakened. Prices fell roughly 26% from early June to late September. This helped to ease inflationary pressures as well as boosting the purchasing power of consumers. It offered hope that the global economy might have a soft landing in which inflation eases and a deep recession is avoided. However, last week, OPEC+ (which is a combination of OPEC members and Russia) announced it has agreed to cut production by two million barrels per day, or about 2% of global output. This led to a sharp rise in prices. This was a surprise and indicated that Saudi Arabia and other Gulf oil exporters are effectively siding with Russia in its dispute with Western oil-consuming nations.

This comes at the same time that the G7 industrial nations are attempting to place a cap on the price that they pay for Russian oil. This would entail creating a monopsony, in which the buyers, by colluding, have leverage over the supplier and can set the price below what the market would bear. Of course, many non-G7 nations such as India and China are unlikely to participate in this cap. Still, a cap would lead to a loss of revenue for Russia, which would not likely be offset by increased sales to other nations at higher prices. 

Meanwhile, the OPEC+ action comes at a time when the global market for oil is already tight, when global inflation has surged, and when many key nations are facing significant recession risk. This action is likely to exacerbate both inflation and recession risk. Moreover, it comes despite heavy lobbying of Saudi Arabia by the US government. This suggests that the Saudi-US relationship has been damaged. US criticism of Saudi responsibility for the death of a US journalist has evidently not sat well with Saudi authorities. For its part, Saudi Arabia defended the production cut by pointing to the need for more investment in oil production. Higher prices are likely to stimulate more risk-taking by energy producers, not just in OPEC countries but in the United States as well. 

What makes last week’s action so surprising is that it is hard to see how it is in Saudi Arabia’s interest. The Kingdom would surely suffer from a global recession. Plus, the Saudis might be calculating that Iran is not as much of a threat as previously believed. Otherwise, it would not take action that enriches Iran and weakens its alliance with the United States, which effectively protects Saudi Arabia from potential Iranian aggression. In any event, Russia’s leaders are likely hoping that the G7 will fail to implement a price cap and that, consequently, Russia will benefit from higher oil prices—as has already been the case. 

  • Meanwhile, with the energy crisis in Europe having exacerbated inflation and reduced real consumer incomes, governments in the region have been acting to varying degrees to limit the inflationary impact and to limit the impact on consumer and business purchasing power. The most impactful government intervention so far has come from the United Kingdom, which has allocated 150 billion pounds, or 6.5% of GDP, to energy subsidies. 

The largest expenditures within the Eurozone are coming from Germany, France, and Italy, the three largest economies in the region. As discussed below, Germany intends to vastly increase its subsidies. However, the largest share of GDP so far has been allocated by Croatia, Greece, Italy, Latvia, and Spain in that order. The smallest share is being allocated by Ireland, Finland, Sweden, and Estonia.

European governments are using a variety of policy tools to deal with the energy crisis. The most common are reductions in value-added tax (VAT) and direct transfers to households. Other interventions include direct government controls on the retail price of energy, taxes on windfall profits, direct subsidies to business, and credit loans or bailouts for utility companies. As for the latter, the countries that have done the most such lending as a share of GDP are Sweden, Finland, and Germany.

Energy subsidies as well as price controls are likely to temporarily suppress inflation. On the other hand, additional expenditures at a time of high inflation and tight labor markets will stimulate economies, thereby adding to longer-term inflationary pressure. Central banks might be compelled to accelerate the tightening of monetary policy in response. This is certainly likely in the United Kingdom. Thus, energy subsidies are a double-edged sword. Still, it is hard to see how governments can avoid them given the huge shock to consumer purchasing power that has been unleashed by the war in Ukraine. 

  • In any event, subsidies are causing conflict within Europe, particularly due to Germany’s latest policy initiative. In order to offset the inflationary and recessionary impact of the sharp rise in energy prices, the German government intends to offer a 200-billion-euro plan of subsidies for German consumers and businesses. This two-year plan comes on top of a previous allocation of 100 billion euros for subsidies. Thus, Germany is set to spend more than twice the combined spending by France and Italy. In fact, Germany is now set to spend far more than any European government, either in absolute terms or as a share of GDP, on energy-related subsidies. 

The German plan has been sharply criticized by other European governments who prefer that European countries take a united approach to dealing with subsidies. Moreover, some European leaders have said the German plan violates EU rules on support for business. These rules are meant to create a level playing field for companies within Europe. Germany defends its decision by pointing to the large size of its economy, the especially large size of its manufacturing sector, which depends on natural gas, and its disproportionate vulnerability to Russian action. 

Germany’s unfunded subsidies will mean more government borrowing. Yet due to the expectation that German inflation will decline because of subsidies, borrowing costs have declined. This partly reflects investor confidence in Germany’s fiscal probity. Meanwhile, other countries in Europe, forced to also offer subsidies, will likely face higher borrowing costs due to greater investor concern about their fiscal probity. This could exacerbate interest-rate differentials, leading to difficult choices for the European Central Bank (ECB). In addition, eastern European governments that offer subsidies could face fiscal problems. The disagreement about subsidies between Germany and others is clearly the kind of discord that Russia has hoped to create by weaponizing energy. It is likely that Russia hopes to undermine European resolve and unity on sanctions, especially potential new sanctions.  

Understanding why Britain had a financial crisis

Ian Stewart, chief economist of Deloitte UK, discusses the reasons for the recent action by the Bank of England (BOE) and what it says about financial crises in general.

  • Last week’s action by the BOE to support UK government bonds, or gilts, was its biggest intervention in financial markets since the pandemic. Action was needed to prevent a sell-off in gilts developing into a wave of contract defaults across UK pension funds.

An arcane part of the financial plumbing of the UK economy, liability-driven investment (LDI), was at the heart of the crisis. LDI uses derivatives to match the cost of future pension pay-outs with the value of the pension fund’s assets. The linkages are complex, but the sell-off in 30-year UK gilts forced pension funds to sell down their own holdings of gilts to cover costs associated with LDI strategies. That reinforced the gilt sell-off, threatening a downward spiral of plummeting gilt prices.

Without the BOE’s pledge last Wednesday to buy gilts on “whatever scale is necessary” the sell-off could have turned into a financial crisis. The episode illustrates how financial systems, subject to rapid falls in asset prices and soaring volatility, can buckle, risking a cascade of effects across the real economy. In a crisis, the network of connections that enables financial systems to operate can spread and amplify damage far beyond the site of the crisis.

The collapse of Lehman Brothers in 2008 was just such a systemwide failure. It spread panic across the financial markets, triggering sharp declines in asset prices and causing liquidity to dry up. The scale and breadth of the fallout took policymakers by surprise and turned a downturn into America’s deepest US recession since the 1930s. Four years later, in the euro crisis, sharp falls in the bond prices of indebted governments threatened the solvency of banks that held the bonds. Fears about excessive government debt threatened to morph into a banking crisis. Only the ECB’s commitment to buy the government bonds of at-risk countries without limit saved the day.

Growing concern about the UK public finances and expectations that interest rates would need to rise sharply were at the heart of last week’s gilt sell-off. Central banks work hard to identify and monitor risk across economies. Most major central banks publish regular financial stability reports. The BOE’s Financial Policy Committee is tasked with monitoring and taking “action to remove or reduce systemic risks to the UK’s financial system.”

But economies are complex, evolving systems. Threats are often idiosyncratic and obscure. Averages can conceal extremes. Before the 2008–09 financial crisis, the Federal Reserve did not see the US housing market posing a particular risk to stability. That generalization missed the accumulation of debt and risk in the subprime mortgage sector, which was a precipitating factor in the financial meltdown. The persistence of financial crises over time, and the unexpected nature of most shocks, testify to the difficulties policymakers face.

A recessionary, higher interest rate environment will create new pressures across the economy and in financial markets. Last week’s gilt market turmoil is a timely reminder of the risks—and of the likelihood of stresses and surprises ahead.

Mixed picture from US job market

  • The latest jobs report from the US government indicates that, in September, job growth decelerated to the lowest level since April. However, growth remained relatively strong while the unemployment rate declined. Consequently, financial markets interpreted this data to mean that the economy is stronger than previously believed. Investors pushed down equity prices and pushed up bond yields on expectations that the Federal Reserve will be compelled to reinforce the tight direction of monetary policy.

The US government publishes two reports on the job market: one report based on a survey of establishments; the other based on a survey of households. The establishment survey found that 264,000 new jobs were created in September, a sharp deceleration from recent months but a number that, historically, was considered quite strong. 

The industries that saw relatively strong job growth included construction, manufacturing, professional and business services, health care, and restaurants. The industries that experienced a decline in employment included retailing, transportation and warehousing, financial services, and state and local government. 

The separate survey of households found that the labor force contracted slightly in September as participation in the labor force fell modestly. Meanwhile, employment grew. The result was that the unemployment rate fell from 3.7% in August to 3.5% in September. 

In addition, the government also reported that average hourly earnings of workers in the United States were up 5% from a year earlier, the slowest rate of increase since December of 2021. Earnings were up 0.3% from the previous month, the same as in August. This means that workers continue to lose ground as wages fail to keep pace with inflation. It also means that, with wages relatively tame, the United States is not yet seeing the kind of wage-price spiral that could prolong and exacerbate inflation. It remains a surprise that, in a tight labor market, wages are so restrained.

  • Meanwhile, another report from the US government offered evidence of a weakening of the job market. Specifically, the number of job vacancies fell sharply in August, hitting the lowest level since June 2021. There were 10.1 million vacancies in August, down from a record level of 11.9 million in March. On the other hand, it is worth noting that the number of vacancies remains vastly greater than the prepandemic level, which was close to 7 million. Moreover, the number of vacancies remains almost double the number of unemployed. Thus, the job market remains relatively healthy.

This data comes from the US government’s Job Openings and Labor Turnover Survey (JOLTS), which assesses the tightness of the job market. The survey found that the overall job openings rate (the share of available jobs unfilled) fell from 6.8% in July to 6.2% in August. The industries that saw big declines included nondurable manufacturing, transportation, financial services, and health care. On the other hand, some industries saw an increase in the vacancy rate, including construction, wholesale trade, and real estate. The industries with the highest vacancy rate were leisure and hospitality (10.6%) as well as professional and business services. The latter, which includes Deloitte, was 7.7% in August. There were low vacancy rates in retailing and education. 

Last week’s report signals a possible weakening of the job market. Still, this is one data point that hardly makes a trend. Thus, the overall trajectory of the US job market remains uncertain.

Planning for the US recovery

  • When clients in the United States ask me about how to prepare for a potential recession, I often tell them that they ought to prepare for the recovery that will follow a recession or downturn. There are two important reasons for this. First, any recession is likely to be short-lived and moderate. The recovery will come sooner than companies realize. Second, many companies have strong balance sheets with plenty of cash. And many are in industries that are not especially vulnerable to economic cycles. As such, a recession won’t necessarily hurt such companies grievously. 

When the recovery comes, as it always does, the economy will grow, but not necessarily at a rapid pace. After all, unemployment is currently very low and is likely to rise only modestly in a recession. Thus, a recovery will likely be characterized by modest growth in employment and a continued tight labor market with a shortage of labor. Companies would do well to avoid substantial job dismissals during recession if only to avoid facing a shortage of labor when the rebound comes. In addition, given a likely labor shortage, now might be a good time to invest in technologies that boost the productivity of existing workers. 

Meanwhile, companies that want to achieve a postrecession competitive edge might consider acquiring relatively cheap assets now or during the recession. They might also consider disposing of noncritical assets in order to be focused and lean in the aftermath of recession. 

Finally, when the recession/downturn ends, companies will face a new postpandemic world. Now is a good time to prepare for that world. It will likely entail continued shortages of labor; a strong desire by workers to avoid prepandemic work patterns such as daily trips to the office; a more fraught relationship between China and the West, involving more restrictions on cross-border trade and capital flows and more geopolitical uncertainty; greater economic impact from climate change and from government policies aimed at mitigating climate change; and less fiscal space for highly indebted governments to engage in flexible policy.

Plus, there remains uncertainty as to whether or not we will face a world of higher inflation, although my view is that inflation will come down quickly toward a less onerous level. All these issues require that companies make strategic investments and choices. Moreover, such decisions should not wait for the recovery. They should be made now, especially when assets are relatively cheap.

Week of October 3, 2022

Bank of England intervenes to restore financial stability

  • The British government’s shift toward fiscal stimulus recently upended British financial markets. The combination of massive energy subsidies and tax cuts alarmed investors who worried that the British budget deficit would become unsustainable. The result was a very sharp rise in bond yields, a decline in equity prices, and an historic drop in the value of the pound.  

In recent months, the Bank of England (BOE) has been engaged in monetary tightening, involving raising short-term interest rates as well as selling government bonds (the latter being a reversal of quantitative easing). The sale of government bonds was meant to withdraw liquidity from the economy. Selling bonds means that bond yields are likely to go up—which is what has happened. Yet the recent fiscal announcement by the government caused a dramatic surge in bond yields that alarmed the BOE. Consequently, last week it completely reversed course, saying that it will purchase bonds and that it will do so at “whatever scale is necessary.” Indeed, it said that, initially, it will purchase 65 billion pounds worth of bonds. It justified its action by saying that the current situation creates a “material risk to UK financial stability.” 

The BOE action was met with relief by investors. Bond yields plummeted, not only in the United Kingdom but in the United States as well. The yield on the British 10-year bond fell by almost 50 basis points (bps) in one day while the yield on the US bond fell by 22 bps. In addition, equity prices increased sharply, the price of oil increased, and the value of the US dollar fell against the pound, the euro, and other currencies. 

Although investors were pleased that the BOE stepped in to repair the perceived damage done by the government, this is hardly a long-term solution. After all, the new BOE approach is effectively an expansionary monetary policy at a time when Britain continues to face high inflation and requires monetary tightening. It is possible that the government could find a way to reverse course. Perhaps it can indefinitely postpone tax cuts, at least until inflation has been brought under control. 

Meanwhile, despite the BOE intervention in the bond market, the BOE’s chief economist said that there might be big interest-rate hikes at the next policy meeting in November. In other words, the BOE has not completely reversed monetary policy. Instead, it is attempting to stop the mass sell-off of bonds. That sell-off threatened to dramatically increase the cost of servicing government debt. It also threatened to boost capital costs to an unsustainable level. 

As for government’s fiscal policy, the fiscal expansion could disrupt the BOE’s ability to address inflation. Cutting taxes stimulates the economy and likely adds to inflationary pressure, thereby requiring a greater degree of monetary tightening. On the other hand, the energy subsidies will likely stifle inflation temporarily by halting the rise in prices paid by consumers.

The International Monetary Fund (IMF) urged the British government to “re-evaluate” its fiscal program and suggested that the new policy could intensify inflation. The IMF also said that “given elevated inflation pressures in many countries, including the UK, we do not recommend large and untargeted fiscal packages at this juncture. It is important that fiscal policy does not work at cross purposes to monetary policy.”

Aside from the IMF, there were direct or veiled criticisms of British fiscal policy from the US government, credit rating agencies, and private sector economists. Outside of the British government itself, it is difficult to find support for the current policy. The bigger issue, however, is what happens next. If the government reverses or eases its policy stance, then markets will likely calm down. If not, then the crisis could continue, with further downward pressure on the pound. 

Is there any precedent for a British government roiling financial markets soon after taking office? Yes. In 1955, Anthony Eden, long-serving foreign minister under Winston Churchill, finally became prime minister and was seen as a steady hand who was likely to serve for many years. In 1956, however, his decision to participate in an invasion of the Sinai Peninsula, with the goal of restoring British control of the Suez Canal, led to a run on the pound. The US government only offered to help stabilize the pound if Britain would reverse course. It did, and by the end of 1956, Eden was ousted by his own party. 

In the current crisis, an economic policy shift has led to a sell-off of government bonds and the pound, leading the BOE to step in. Yet unlike during the Suez Crisis, the intervention is not conditional. The United States only helped stabilize the pound after Britain agreed to remove troops from the Suez Canal. In this case, the BOE did not require the government to reverse course on its fiscal policy before it chose to purchase bonds. The risk, then, is that the government might feel that it can continue with an expansive fiscal policy because the BOE will effectively fund its largesse. Yet if the bank had failed to act, the crisis would likely have gotten worse. 

So far, the government has been publicly unrepentant. As for the BOE, if investors start to believe that it will fund future government deficits, then the decision to purchase bonds could ultimately backfire, leading to renewed crisis. Thus, it is likely that the bank could only do this one time. 

Investors evidently fear that a permanent increase in the budget deficit will likely crowd out private investment, reduce future fiscal flexibility, and undermine Britain’s competitiveness. Even those supportive of the notion that lower marginal tax rates are good for competitiveness suggest that tax cuts ought to be offset by other revenue enhancers or spending cuts, especially at a time of ruinously high inflation. Going forward, stability in British financial markets will depend on perceptions about the government’s commitment to fiscal probity.

The latest on the US economy

  • The National Bureau of Economic Analysis (NBER) is tasked with determining when a recession in the United States has begun. To do so, it examines a variety of monthly economic data including consumer spending. Last week the US government reported that real (inflation-adjusted) consumer spending increased modestly in August, suggesting that a recession has not yet begun. The report offered some interesting bits of information. First, real disposable household income increased from July to August, despite a decline in real wages. This means that employment growth more than offset the loss of purchasing power from declining wages. Second, consumer savings remained muted but stable in August. Third, real consumer spending on goods declined, but this was more than offset by an increase in spending on services. Evidently, US consumers continue to return to prepandemic spending patterns. Moreover, although real disposable income declined from a year earlier, real consumer spending increased from a year earlier, largely due to consumers dipping into their vast pool of accumulated savings.

Finally, the report found that the Federal Reserve’s favorite measure of inflation, the personal consumption expenditure deflator (PCE-deflator), remained high in August and that core inflation (which excludes the impact of volatile food and energy prices) actually accelerated in August. From the Fed’s perspective, this signals that inflation remains a serious problem and aligns with its evident determination to continue tightening monetary policy.

  • One indication of the slowing of the US economy came last week from a new report on orders for durable goods. The report showed that, in August, new orders for durable goods fell modestly from the previous month. However, when defense equipment is excluded, new orders were down sharply in August after having grown strongly in the two previous months. This suggests a decline in business activity. Meanwhile, new orders for nondefense, nonaerospace capital goods increased strongly in August after having grown strongly in the two previous months. This bodes well for increased business investment. The conflicting nature of this report suggests that there is not yet unambiguous evidence that a recession is imminent, but there is evidence that the economy is slowing.
  • Another indicator of economic health (or otherwise) concerns housing. The US government reported that, in August, sales of new homes surged from the previous month and were roughly unchanged from a year earlier. This is interesting because, in recent months, sales of new homes had been weak as have other housing indicators. This was one of the negative consequences of a tightening of monetary policy. Why sales suddenly rebounded is hard to say. Moreover, one month does not make a trend. Still, this was an especially interesting data point and one that is inconsistent with the notion that housing will soon contribute to a recession.

Meanwhile, home prices in the United States fell from June to July, according to the latest S&P Case Shiller report on home prices in 20 large US cities. Prices were down 0.8% from the previous month while still up 16.1% from a year earlier. The monthly decline was the first since 2019 and the biggest decline since 2012. This comes alongside other data indicating weakness in the US housing market, mainly due to a surge in mortgage interest rates. It also comes after a two-year period of stunning increases in US home prices.

  • Recently, as expected, the US Federal Reserve significantly boosted interest rates again, increasing the Federal Funds rate by another 75 bps. Unlike previously, markets reacted violently—not so much to the Fed’s action as to the words of its leaders. Fed Chair Powell offered a prediction as to the likely path of the Federal Funds rate and it was steeper than investors had expected. Powell expects the Fed Funds rate to hit 4.6% in 2023 before declining. Powell said that “we have got to get inflation behind us. I wish there was a painless way to do that. There is not.”

Since Powell spoke, bond yields have gone way up, equities way down, and oil prices fell to the lowest since January. Evidently, investors have reassessed the risk of recession due to Powell’s words. Indeed, Powell no longer speaks about a soft landing for the US economy. Rather, he acknowledged that ending inflation might entail significant pain, including a significant rise in unemployment. Powell’s words were the first major statement since the last inflation report. That report had disappointed investors as it signaled more persistent inflation than had been expected.

Also, although bond yields are up sharply, breakeven rates (which measure bond investor expectations of inflation) have remained steady or are declining. This suggests that investors believe that the Fed will be successful in stifling inflation. Interestingly, the 10-year breakeven rate is now roughly the same as the five-year breakeven rate for first time since January 2021. This signals that investors now expect inflation to come down quite quickly and stay down, a measure of confidence in the Fed.

The belief that the likelihood of a US recession is higher than previously believed not only led to lower equity prices. It also led to a sharp decline in oil and other commodity prices. This will be helpful in suppressing global inflationary pressure. In addition, the rise in the interest rate gap between the United States and other countries led to a further sharp rise in the value of the dollar.

Inflation continues to accelerate in Europe

  • Inflation in the 19-member Eurozone continues to accelerate, largely due to the energy crisis. In September, consumer prices were up 10% from a year earlier (the first double-digit increase ever) and were up 1.2% from the previous month. Energy, and to a lesser extent food, played the dominant role in driving inflation. Energy prices were up 40.8% from a year earlier and up 3% from the previous month. Food prices were up 11.8% from a year earlier and up 1% from the previous month. When volatile food and energy prices are excluded, core prices were up 4.8% from a year earlier and up 1% from the previous month. This is historically high, but still relatively low compared to other countries. 

By country, consumer prices were up from a year earlier by 10.9% in Germany, 6.2% in France, 9.5% in Italy, 9.3% in Spain, 17.1% in the Netherlands, and 12% in Belgium. The highest inflation rate in the Eurozone was in Estonia at 24.2%. All three Baltic states had inflation in excess of 20%. The lowest inflation rate in the Eurozone was in France. 

The ECB continues to tighten monetary policy. Its main policy tools are the short-term interest rate and the sale of bonds (which raises long-term bond yields). Both tools are meant to stifle credit market activity, thereby slowing the economy and removing inflationary pressure. Moreover, the goal is to anchor expectations of inflation to prevent a wage-price spiral. The inflation is mostly being driven by the political tug of war between Russia and the EU regarding the flow of natural gas. As such, the ECB lacks adequate tools to deal with the underlying cause of inflation. Thus, the possibility remains that the ECB will simply succeed in slowing an already at-risk economy while not necessarily having a big impact on inflation.

On the other hand, if natural gas prices peak and stabilize, or even fall, then the inflationary impetus from the energy crisis will abate and inflation should come down, especially if the economy weakens due to monetary policy. Regardless of the causes, ECB president Lagarde said that “we will do what we have to do, which is to continue hiking interest rates in the next several meetings.” Investors now expect a 75-bps increase in December.

Meanwhile, the natural gas crisis is getting more complicated. The Nord Stream pipeline was damaged in what NATO leaders are calling sabotage by Russia, although Russia denies complicity. For Europe, there is already substantial angst regarding the likely shortage of gas during the upcoming cold winter months. Russia likely wants to undermine European unity. This is starting to happen. Slovakia warned that the surge in gas prices could wreak havoc with its economy and called for help from the EU. How to fund such support, in turn, could become a controversial issue within the EU. The chief economist of the ECB suggested that member states boost taxes on the rich to fund energy subsidies for everyone else. He said that this would be a fair way to deal with the problem of high energy prices without causing a sharp increase in government debt.

Cover image by: Sylvia Chang

Deloitte Global Economist Network

The Deloitte Global Economist Network is a diverse group of economists that produce relevant, interesting and thought-provoking content for external and internal audiences. The Network’s industry and economics expertise allows us to bring sophisticated analysis to complex industry-based questions. Publications range from in-depth reports and thought leadership examining critical issues to executive briefs aimed at keeping Deloitte’s top management and partners abreast of topical issues.

Ira Kalish

Ira Kalish

Chief Global Economist, Deloitte Touche Tohmatsu

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