William De Vijlder

Since the start of this year, the European Commission’s industry sentiment survey has seen a significant decline, yet companies continue to report that labour remains a key factor limiting production. This is probably due to order books that remain at record high levels in terms of duration of assured production. Through their impact on the growth of employment and wages, labour market bottlenecks should provide some resilience to consumer spending when the economy is turning down. This support will probably not last however. Hiring intentions of companies have started to  decline, which should ease the bottlenecks through a slowdown of employment growth.

Household wealth -the difference between assets (property, financial) and financial liabilities- matters because in the longer run, it should allow to finance expenditures post retirement. During the pandemic, we have seen in the euro area a big jump in the savings rate as well as an above-trend increase in property prices whereas financial assets suffered from negative valuation effects. The European Commission estimates that, on balance, between the onset of the pandemic and the end of 2021, households accumulated around EUR 2.7 trillion of new wealth in excess of the normal trend. This was considered as a factor of resilience for household spending. Households could save less than normal in case of a weaker economic environment because they had saved more than normal during the pandemic. However, according to the European Commission, by mid-2022 elevated inflation had already eroded the real value of additional wealth by almost 50%, implying a much thinner cushion to absorb shocks.

The US consumer price data for October have reinforced the view that disinflation -the narrowing of the gap between observed inflation and the central bank’s inflation target- has started. That conclusion seems clear as far as headline inflation is concerned -it has peaked in June- but we need confirmation that the decline in core inflation from the September peak is not a one-off. Core goods inflation has been moving down but core services inflation  remains stubbornly high on the back of transportation services and shelter. What matters now for the economy and financial markets is the speed of disinflation because this will influence Fed policy, the level of the terminal rate and how long the federal funds rate will stay there. All this influences the perceived downside risks to growth.

The latest ECB survey of professional forecasters (SPF) shows a downward revision of the growth outlook and an upward adjustment of the inflation forecast. For next year, the real question is not about the direction of inflation but about the speed and extent of its decline. Slower than expected progress could convince the ECB of the need for more rate hikes than currently priced by markets, implying a bigger output cost of bringing down inflation. Disinflation could indeed take longer than expected. Over the past two years, a variety of factors have led to an exceptionally elevated but also broad-based inflation. Not all shocks have occurred simultaneously and it often takes time for them to work their way through the system, from the producer to the wholesaler to the retailer. This creates an inertia in the inflation dynamics.

When growth is slowing, risks tend to be tilted to the downside because households and companies adopt a more cautious attitude in their spending and investment decisions. At the present juncture, it is also difficult to see what could create an upside surprise. To the contrary, according to the IMF, there are several downside risks: the cost of energy, the problems in Chinese real estate, persistent disruptions in the labour market. Financial conditions could deteriorate. Already today they create a discomforting environment, with the risk of a non-linear impact on growth. It illustrates the challenge of central banks with growth-at-risk being at the low end of historical ranges and inflation at the other extreme.

Due to the recent significant increase in interest rates, Eurozone countries now have a borrowing cost on newly issued debt that, for an equivalent maturity, is higher than that of the existing debt. From a debt sustainability perspective, this necessitates a smaller primary deficit or a larger surplus, depending on whether the average interest cost is, respectively, lower or higher than the long-term nominal GDP growth rate. However, this effect will only be fully operational when the entire debt has been refinanced at the higher interest rate. Given the long average maturity of existing debt, the annual adjustment effort is small for the time being but it will grow over time. However, debt sustainability is about more than keeping the debt ratio stable under certain circumstances. It is also about the resilience to interest rate and growth shocks. The higher the debt ratio, the more important it is to do more than simply trying to stabilize it.

Usually, during a period of sluggish growth and rising official rates, bad news about business activity and demand is often welcomed by the stock market, as it often causes central banks to take a more cautious approach during their monetary-tightening cycle.

 Recent economic data paint a picture of increasing concerns about the economic outlook. In the US, high inflation and rising interest rates play a key role. In the euro area, the same factors play a role -although interest rates are still below those in the US- but skyrocketing energy prices and gas supply disruption are additional forces that should drag down growth. Easing price pressures in business surveys are a hopeful development but selling price expectations remain nevertheless exceptionally high given the weakening of order books. This could point to input price pressures that force businesses to charge higher prices to protect their margins. It is to be feared that slowing demand will make this increasingly difficult, forcing companies to cut back on investments and new hirings.

Recent data send conflicting signals about the outlook for the US economy. A survey of chief financial officers shows they have become gloomier and the nowcast of the Federal Reserve Bank of Atlanta is forecasting a contraction of real GDP in the second quarter. This would mean two successive quarters of negative GDP growth, which corresponds to the popular definition of a recession. However, the labour market continues to be strong and the majority of indicators used by the NBER Business Cycle Dating Committee are still in an uptrend. This suggests there is no imminent risk of recession yet.

The chief financial officers of US companies have become gloomier about the outlook for the US economy. The latest Duke University CFO survey shows that 20.8% of the participants expect negative GDP growth over the next 12 months. The assessment about the own-company prospects has declined far less, leading to a record high gap with the outlook for the economy as a whole. This is a source of concern: how long can own-company confidence remain high if the overall environment continues to deteriorate? Interest rate developments will play a key role in this respect. Of those US companies that plan to borrow, two-thirds would reduce their investments in case of an increase of borrowing costs of 3 percent. It is a sobering message considering the expected tightening of monetary policy.