Three different economies and threat of stagflation

2022-05-20 at 11:50 Timo Löyttyniemi

The world economy and financial markets are in a state of amazement. Just as we in the West are leaving Covid-19 constraints behind, we are exposed to pressures from three different economies and three strict policies. These pressures are felt in everyone's wallet through price increases, availability of goods and the growing uncertainty about the future. These three different economies and policies are the tightening interest rate policy in the US, the geopolitics weighing on Europe and the strict Covid-19 policy pursued by China. Common threat is stagflation.

US economy in the overdrive

When the economy is doing well, it’s not always such a good thing. At the moment, the US economy is thriving, may be too much so. This has translated into extremely low unemployment and, for a variety of reasons, rapid price rises, i.e., inflation. Low unemployment is a good thing and should be welcomed. However, a shortage of labour means that fears of a wage inflation are running high.

There are several drivers fuelling the inflation. During the Covid-19 pandemic, prices were driven up by global supply constraints as a result of a shortage of goods and problems with supply chains. Moreover, raw material prices are rising across the board.

The US Federal Reserve increased its policy rate by 0.25% in March, followed by 0,5% hike in May. Central banks have been compelled to perform a balancing act between inaction in response to temporary inflation and measures to combat a potentially permanent inflation. The latter means interest rate hikes. Markets expect monetary policy to tighten by a further this year. A lot of things could still happen as the central bank seeks to prevent the inflation from accelerating by resorting to steep interest rate hikes.

As a result of the rate increases, the technology stocks have fallen sharply in value. Netflix, Amazon and many other companies that have benefited from the Covid-19 restrictions have suffered, and stock prices have fallen as economies return to normal and people resume their pre-pandemic behaviour patterns.

Geopolitics in Europe

Europe is gradually feeling the cruelty of geopolitics. Russia has curtailed the import of natural gas, which has kept its price record high for no real reason. At the same time, the price of oil has peaked as a result of Russia’s war of aggression. Consequently, Russia has been able to maximise its energy export revenues in the short term.

Energy has a major impact on inflation. Europe's inflation figures have risen on the back of energy, forcing the European Central Bank to adopt a hawkish rhetoric. It may be followed by hawkish action to tighten the monetary policy, despite the fact that Europe's economic growth is not as rapid as in the US and unemployment still remains high in many countries.

The return of Covid-19 restrictions in China

Small things can have a great impact, especially if those small things involve a potential pandemic.  A small epidemic may quickly turn into a pandemic. Shanghai and many other cities are adopting strict policies to stop the outbreak of a Covid-19 pandemic and its spread. Now that we’ve been watching the behaviour of the coronavirus for two years, it appears extremely difficult to find ways to suppress it completely. Nevertheless, China is trying to stop the virus by closing down cities.

China’s Covid-19 restrictions have raised new concerns about the performance of production and supply chains. Goods delivery times are growing longer and the prices of many products have gone up. Moreover, it is next to impossible to assess the success of China's policy or the timetable for restrictions.

Two effects and one threat

The three economies and policies outlined above have two effects that are similar. First, what they have in common is the current inflation. Second, both entail weaker economic growth. And when these two things are combined, we are faced with the magic word ‘stagflation’. While it is not yet present, it is an imminent threat. Stagflation would mean a combination of rapid inflation and weak economic growth, or rather economic decline. So far we only have inflation.

”Déjà vu”

Are we returning to the 1970s? Probably not, because energy – and oil in particular – played a much bigger role in the economy back then. The oil price shock was severe, the inflation rate reached over 10% and economic growth stalled. It was a bad time for equity investors, as share prices fell sharply. Of course, this is a concern shared by many. Now, in the short term, this concern has been justified as stock prices have fallen in the first half of this year.

But as consolation based on the experiences from the 1970s, it should be pointed out that continued inflation was good for real assets. They held their value until the US Federal Reserve decided to get rid of inflation once and for all by tightening monetary policy vigorously. However, action was not taken until six years had passed from the oil price shocks that triggered off the inflation.

The writer is VER’s CEO Timo Löyttyniemi.

TLö blogi 2020

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