The cruellest month?

T.S. Eliot wrote “The Waste Land” influenced by drought and war. But he wasn’t wrong: April is a cruel month, snatching back promises of spring, killing off winter’s frail survivors. This year, however, the cruelty is bleakly evident on news bulletins, and resonates with western observers thankful for their own safety but worried about making ends meet. And governments are scared too, with fragile economies just making it through the winter of a long pandemic to face challenges unfamiliar for decades.

However alarming and unpredictable a pandemic, at least there wasn’t much argument about the proper economic response. What should governments do? Simple (at least in theory): cut taxes and spend cash to prevent household incomes from falling by as much as GDP, and reverse both kinds of fiscal boost as their economies recover. That’s more or less what all developed economies did during “lockdowns”, trying to cut back on “reopening” as the rebound came - quicker than most expected. But now, economies are staggering under the shock of war. And as the effects of Russia’s invasion of Ukraine have blurred with the consequences of Covid, different economies have suffered to different degrees. It’s far less easy for each to say what the best economic response may be.

Start with the obvious: inflation. Prices have leapt, faster and farther than predicted, across Europe, and in the United States. Thirty-year records are being broken. Shortages of some commodities, as well as critical links in manufacturing supply chains (famously, microchips), had emerged before economists began to worry about the impact of the war on supplies of nickel and wheat. Above all, energy prices, having already jumped with the rebound in world demand, have been given another impulse as western governments seek to shift away from Russian supplies of coal, oil and gas. Other sources now command a premium, and the markets remain extremely volatile.

So, short-term inflation forecasts have been raised again. The Bank of England expects over 8% this spring in the UK (and that’s not the end of it), while in March, the increase in the Consumer Price Index was already over 7% in Germany - and the US. Double digits look painfully close. No one wants to repeat that story. But as growth forecasts drop, governments have to judge how much disinflationary medicine the patient can take.

The Covid recession required fiscal action, with monetary policy on an accommodating back foot. Inflation, however, requires monetary policy-makers to wake up and do their job. The problem is: how do you do that without driving the economy back into recession?

As with all monetary policymaking, the first best piece of advice is: don’t start from here. The demand signals arent easy to read. Consumer confidence has fallen sharply, but most developed economies have an overhang of forced savings” ready to be pumped into (say) foreign holidays. On the policy side, interest rates are so low that any imaginable upward course will, at least for a time, leave real rates lower than they have been for decades. On the other hand, quantitative easing has left piles of assets in central bank hands, and reversing that will be venturing into the unknown. If monetary growth slows too quickly, it will be easy to overshoot. There’s no one-policy-fits-all this time, so for each economy, let’s start with a health check.

The continental-sized American economy, with vast natural resources and a fluid labour market, has staged the most impressive recovery from the Covid recession. By the final quarter of 2021, output was already 3 per cent about pre-pandemic levels. And the direct impact of rising world energy prices is far less than in Europe. So with inflation much higher than can be explained by the energy shock and the labour market running hot, the Federal Reserve has had more than enough reason to tighten the screw, changing both the federal funds rate and its asset purchase programme. Too little, too late, say the Fed’s critics, to achieve the desired “soft landing”.

Europe is more - complicated. Take its three biggest economies: Germany, the UK and France. 

Germany, Europe’s manufacturing power-house, was already suffering acutely from post-Covid supply chain problems, and output was still a full point below pre-Covid levels in the last quarter of 2021. Wages have not been rising fast, although a 25% rise in the minimum wage over the course of this year will give a push from the bottom. Now the war in Ukraine has exposed German dependence on Russian energy; recovery is faltering still further in European’s biggest economy. No surprise then that the European Central Bank is still playing with nuances around a wait and see policy.

With an economy dominated by services, the UK’s output is less energy-intensive. And it imports less energy directly from Russia. But with nearly three-quarters of its supply coming from oil and gas, the rise in world prices has had broadly the same inflationary impact as in the rest of Europe. Meanwhile, the UK is now having to adjust to life after Brexit, which has dented exports and tightened its labour market. A post-Covid fall in the “participation rate” (the proportion of the population looking to work) is something all these economies have in common: but in the UK, it has coincided with a reversal of European migration, and there are severe labour shortages not only in the health and care sectors but also in agriculture, hospitality and transport.

Tight labour markets have put upward pressure on wage rates and downward pressure on capacity. The Bank of England clearly needed to dampen demand to match supply constraints. But like the Fed, it has been criticised for following rather than leading the market. We have seen a succession of rate rises, with more to follow. And yet one senior member of its Monetary Policy Committee has said openly that he voted against the latest raise for fear of driving inflation below the desirable 2% over the next couple of years. Under-dose or over-dose? The choice isn’t easy.

By contrast, France has been the best-performer of the three: the only G7 economy other than the US where output had bounced above pre-Covid levels by the end of 2021. Following earlier supply-side reforms fought through by President Macron, investment has recovered. Nuclear power provides about 40 per cent of France’s energy, way beyond even the UK’s latest ambition, and radically different from Germany’s (previous) energy strategy. But oil and gas still account for nearly another 40% of France’s supplies, emptying household pockets here too. And industrial production is flagging. Coupled with his commitment to such further reforms as a rise in France’s extraordinarily low pension age, the “cost of living crisis” is still dogging President Macron on what had at first seemed to be an easy re-election campaign.

No governments relish telling their electorates that they face a choice between; a squeeze on living standards or a wage-price spiral that spins out of control. Demands for governments to ease the squeeze do not resonate with finance ministers trying to recoup Covid spending and seeing a sharp rise in the cost of servicing their debts. (In the UK, the Office of Budget Responsibility has forecast an eye-watering £83 billion this year.) All of them are trying to find ways of protecting the poorest at the lowest public cost: Germany with its minimum wage hike, the UK - with the greatest need to boost spending on health and social care - by tinkering with tax rises to exempt low earners. None of their leaders can expect to win plaudits for presiding over the squeeze: opinion polls consistently show a strong correlation between real personal disposable income and the propensity to vote for the incumbent government.

Most of Europe’s citizens applaud their governments’ stand on the Russian invasion, with strong support for Ukraine, even if they differ on sanctions. But - as French election polls show - the “cost of living crisis” is top of their list of worries. And the fundamental problem remains: inflation and supply-side constraints in combination mean that these economies’ ability to grow their way out of trouble is, for the moment, limited.

So the second-best piece of advice is: hold tight. An inflation shock still isn’t the same as a wage-price spiral. If European governments can get through this year without that, inflationary pressures should ease, and the worst of the real income squeeze be over. That’s less likely to be the effect of monetary policy - a blunt instrument at best - than of the experience of an inflation-free generation. As memories of our inflationary past have faded, so behaviours that kept prices spinning in the past have become less of a guide to future practice. It’s touch and go, and - as in the past - inflation may die harder in some countries than in others. Meanwhile, governments need to protect the most vulnerable without pretending they can sprinkle fairy dust. Some will manage that better than others too, and none will find it makes them popular. But bombed cities and desperate refugees are a reminder that others are suffering worse.



Guest Author: Baroness Sarah Hogg, Former Frontier Economics Chairperson