Economic policy options now range from the very bad to the truly awful
Europe is spending more on energy as a share of GDP than during the 1980s oil shock, stock markets are melting down and Japan is trying to prop up its yen currency for the first time in two decades.
f economic history is repeating itself, we are stuck in the ‘tragedy’ phase as central banks press harder on the brakes as each inflation print comes in higher than the last.
Departures from orthodoxy are being punished by financial markets as we saw in Britain which is now unmoored from both the EU and economic reality.
Ireland has rock-solid debt fundamentals, even after the Budget. But it will feel cold next year with the domestic economy set to grow just 1.2pc as surging inflation and energy costs have sapped consumer confidence which is at its lowest level since 2008, despite record household savings of €146bnit.
To be sure, there’s always been a trade-off between growth and inflation, but in just over a year we have lurched from an era of zero interest rates to one in which a scramble to hike has pushed borrowing costs to their highest levels since 2008 as inflation hits double digits.
Ireland has rock-solid debt fundamentals, even after the Budget
This rush to raise has coincided with an end to government pandemic supports and killed off a post-Covid recovery that delivered global growth of 5.7pc in 2021 – the strongest rebound in half a century – and has unhinged financial markets to the extent that their dislocations are now stoking the risk of a further crisis.
That blistering recovery from Covid was never going to be maintained, but according to the World Bank the current projected growth path from 2021-23 represents the steepest decline in growth following an initial rebound from global recession since 1970.
The emphasis should be on “current”.
Just last week Deutsche Bank slashed its outlook for the German economy which it now expects to shrink by 3-4pc next year, down from a previous forecast of a 1pc decline. It sees the eurozone as a whole contracting by 2.2pc.
If there’s one certainty about economic forecasting, it is that it lags reality. In January the consensus growth outlook for this year was 4.1pc and for 2023 it was 3.3pc. By August those figures read 2.8pc and 2.3pc respectively.
Yet still those rate hikes keep coming. Last week alone, central banks across the world from Jakarta to Stockholm raised interest rates by a combined 600 basis points. Sweden went for a jaw-dropping full percentage point and Indonesia for half a percent.
The patient has a choice between a quick economic death administered by hefty interest rate rises or a more prolonged agony as inflation spreads through the system.
With central banks led by the Federal Reserve adopting a ‘take no prisoners’ approach to every single inflation print, interest rates are now rising faster in a shorter timespan than anyone thought possible.
The dislocation in financial markets has been severe as the realisation dawned that Jerome Powell, a mild-mannered, Jesuit-educated lawyer, was deadly serious about his mission to tame inflation.
The net worth of American households plunged by a record €6trn in the second quarter of this year as the Fed sharpened its claws. That’s equivalent to 14 Irish economies or two Germanys.
For the European Central Bank and the Bank of England – as well as a host of other central banks around the world – it’s copy-paste the Federal Reserve.
It is clear what the Fed is up to, even if it is wrong. It doesn’t want to see a repeat of the 1970s and 1980s wage-price spiral. That’s because central bank policymakers are incentivised to try and kill inflation, even if that doesn’t always result in the best outcome for most people.
Given that rate rises are a bit like pushing on a piece of string and have an effect 18 months or so down the line, it is hard to know whether the Fed is at the verge of inflicting too much pain.
Monetary policy for the entire world is set in Washington DC
“Given the lags with which monetary policy affects the economy, that risk should not be discounted,” says Bob Schwartz of Oxford Economics.
Monetary policy for the entire world is set in Washington DC. At its most basic, superior US growth numbers and higher interest rates translate into a stronger dollar – up 20pc against the euro since spring of last year – and higher inflation here.
What goes for the Fed also goes for the ECB. Jerome Powell’s pledge to “deliver price stability is unconditional” translates into Isabel Schnabel’s “bring inflation back to target quickly” in Europe.
The ECB pledge comes at the same time as the eurozone has stopped growing. It also faces the prospect of power outages, not only this winter, but possibly next as well, while heavily indebted governments are seeing rising interest bills.
During Covid, debt rose in almost 90pc of countries across the globe and at its fastest pace in at least half a century in around a quarter. Private debt also rose at a record pace to a new high in 2020.
At the end of 2021 the eurozone’s government debt to GDP ratio was 95.6pc, although here in Ireland thanks to the magic of GDP, the State has recorded the biggest decline in its debt ratio of any European country since 2019, according to credit ratings agency Fitch.
That said, economic policy here is set in Frankfurt and in the corporate headquarters of California. With the US, Europe and China – which account for more than half of global output – all in difficulty, it is not the best time to be a small globalised economy.
Good economic fundamentals may not matter that much either if there is prolonged market turmoil.
The surest way to bring down inflation is falling disposable incomes. Yet that is something that governments are finding hard to swallow – the root cause of so much inflation here lies with natural gas shortages which will sustain inflation – and every country is readying some action which will have the effect of sustaining incomes for longer and thus keeping inflation higher
If central bank policymakers see inflation expectations marching still higher, then they are going to press even harder on the brakes. The World Bank estimates in such a case, global real short-term rates would surge, rising by 560 basis points from 2021 to 2023.
That in turn would hammer global markets once again as investors re-price risk. With inflation still too high, central banks would not be able to provide relief for markets and maxed out governments would be in no position to do so either.
The question is not whether recession can be avoided, but rather how big and how damaging will it be?
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