Erste Asset Management

For some time valid: Elevated recession risks and restrictive monetary policy

For some time valid: Elevated recession risks and restrictive monetary policy
For some time valid: Elevated recession risks and restrictive monetary policy
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The central banks want to achieve their long-term inflation target of 2%. In order to achieve this goal, they have raised key interest rates and are implementing a restrictive monetary policy. The higher key interest rates will weaken economic growth and also the labour market. Whether this can be achieved without a recession or whether there will be a “soft landing” is currently the subject of heated debate.

Weak economic growth

At the global level, economic indicators point to real GDP growth below potential (subpar growth). Last week, the most important reports were the preliminary Purchasing Managers’ Indices (PMI) for the month of August for selected countries in the developed economies. All countries (US, Eurozone, Japan, UK, Australia) and sectors (manufacturing, services) showed declines. The aggregate output component, with a value of 47.3, points to weak growth. Of particular concern is 1) the falling trend of the aggregate output component and 2) the weak demand components in the manufacturing sector (new orders at 46.7, export orders 45.7). Recession risks thus remain elevated.

Falling inflation – except for Europe

On the positive side, the PMI reports show a further shortening of the delivery period and a further decline in selling prices. Thus, pandemic-related inflationary pressure continues to decrease. In addition, commodity price-induced inflationary pressure has also decreased somewhat. In particular, commodity prices for food, industrial metals and crude oil are well below the levels seen in the first half of the year. For this reason in particular, lower monthly inflation rates are emerging at a global level for the second half of the year compared with the first half.

Very high gas and electricity prices weigh on Europe

However, this positive development is offset by a number of negative factors. In Europe, prices for natural gas and electricity have risen dramatically. The TTF Natural Gas Futures Contract had risen to 339 EUR / MWh by Friday. At the beginning of June, the value was 90 euros. In Germany, the price of electricity has risen to 929 EUR / MHh. At the beginning of June: 240 euros. In Europe, unlike the other regions, inflationary pressure does not fall. On Wednesday, the preliminary consumer price inflation for the month of August will be published. Bloomberg estimate: 9% y/y, up from 8.9% the previous month. These sharp price shocks have raised the recession probability for Europe very sharply. Continued volume restrictions on natural gas would further exacerbate the economic contraction.

Slump of the real estate market in China

In China, a number of adverse developments are weighing on economic activity. Global demand for goods is weakening, the zero tolerance policy toward new infections is hampering recovery after the lockdown-induced slump in Q2, and the real estate market is slumping. For example, housing starts in July were 45 percent below year-ago levels. For this reason, officials are implementing economic support measures. The central bank (People’s Bank of China) has lowered key interest rates and the government has announced stimulus measures. However, the total amount of about 1.5 trillion yuan (1.2% of GDP) since June probably cannot stop the economic downturn, but only slow it down. For this year, real economic growth is estimated to be only around 3%. This is a very low figure for China. Falling import demand is a direct consequence of this. This can already be seen in declining levels of exports and manufacturing in countries such as Taiwan, Singapore and South Korea, as well as falling prices for industrial metals.

Structural Inflation Above the Central Bank Target

Some arguments suggest that inflation rates will remain above the central bank target in the long run. The trend toward fragmentation of supply chains (degloablization) is raising costs, and in an increasing number of countries the working-age population is falling. The latter means a structurally tight labor market and pressure for higher wages. In the long run, a key question is how central banks will deal with structural inflation, which they can do little about. In the baseline scenario, they will accept levels only slightly above the central bank target (2% – 3%). This is because the alternative would be a persistently restrictive monetary policy.

Restrictive interest rate policy for some time

However, the current inflation problem must be distinguished from this. Probably the most important event last week was Fed Chairman Powell’s speech at the annual Jackson Hole Economic Symposium hosted by the Federal Reserve Bank of Kansas City. The main message was that restrictive policy should be expected “for some time.” This means that even if economic growth slows, key interest rate cuts should not be expected as long as the inflation problem remains high.

1970s and 1980s as a reference

This is because the central bank has the responsibility to keep inflation stably low. When inflation becomes an important issue, the inflation regime can easily jump from “low” to “high.” Long-term inflation expectations rise and the relationship between past and current inflation increases (persistence). If persistence becomes entrenched, as in the 1970s, a particularly restrictive policy is needed to break it. Ultimately, the negative effects on the labor market would be greater than if there were an immediate response to the risk of persistently elevated persistence.

In summary, the US Federal Reserve wants to achieve the 2% inflation target by creating an environment “for some time” that can be described as higher (restrictive) policy rates, weaker economic growth (below potential) and a weaker labor market (higher unemployment rate). Whether this can be achieved without a recession (soft landing) is currently the subject of heated debate. In any case, well-known economists like Lawrence Summers expect a Fed-induced rising unemployment rate (and a recession).

PS: home office music: Rolf Kühn, Yellow + Blue

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Prognoses are no reliable indicator for future performance.


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