William De Vijlder

Group Chief Economist BNP Paribas

Economic cycle

How are growth, inflation and employment trends evolving in a given country or region? William De Vijlder examines the cyclical fluctuations of an economy in crisis, expansion, recession and recovery phases as part of a cyclical analysis.

Incertitude

Europe: the reaction of uncertainty to Covid-19 and the war in Ukraine

Uncertainty matters greatly for households and businesses when taking decisions. It can have many causes: economic, economic policy, political or even geopolitical. Survey data of the European Commission show that the Covid-19 pandemic has caused a huge jump in uncertainty, followed by a gradual decline. The war in Ukraine has triggered another, albeit more limited, increase. It will be important to monitor the development of uncertainty in the coming months at the level of consumers, businesses and individual countries. In the absence of a decline, one should expect that the negative impact shows up in spending and activity data.

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Inflation

Multiple dilemmas on the horizon

In most developed countries inflation is exceptionally high. It is widespread – it affects the vast majority of the components of the consumer price index – and, what’s more, it is persistent, as statistical analysis shows. It should therefore take time to return to a level in line with central banks’ objectives.

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Inflation

Inflation and the sustainability of public sector debt

At first glance, higher inflation seems like good news for governments. After all, inflation erodes the real value of debt and lowers the public debt/GDP ratio through a higher nominal GDP. However, the impact of inflation on public finances depends on whether higher inflation was anticipated by financial markets and on its expected persistence. Both factors would influence the borrowing cost and hence the dynamics of the debt ratio through the difference between this cost and nominal GDP growth. Public finances should benefit from having a central bank that is credible in its ability to keep inflation expectations well anchored and is not afraid of tightening policy when inflation has moved well above target. In the euro area, higher Bund yields cause higher sovereign spreads, reflecting a higher risk premium, which in the longer run will worsen the dynamics of the debt ratio. It implies that fiscal policy also has a role to play by keeping the debt ratio under control.

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Dollar vs euro

ECB: the weaker euro, a blessing or a headache?

At first glance, the significant depreciation of the euro looks like a blessing for the ECB. Via its mechanical effect on import prices, it should remove any remaining doubt about the necessity of hiking the deposit rate. However, upon closer inspection, there is concern that the weaker euro, through its effect on inflation and hence households’ purchasing power, will weigh on growth. This would warrant a cautious approach in terms of policy tightening. On balance, a deposit rate hike in the second half of the year looks like a certainty, but the real question is about the scale and timing of subsequent rate increases. This will depend on how the inflation outlook develops.  

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Inflation

Global: inflation persistence and why it matters

Elevated inflation has become widespread. It raises the risk of further price increases because companies may be more inclined to raise prices when most others are doing the same. This would make high  inflation more persistent, implying that it would take more time for inflation to converge back to target.  Persistently high inflation could weaken the credibility of the central bank and cause an un-anchoring of long-term inflation expectations. To pre-empt such a development, monetary authorities could decide to tighten policy aggressively. Research by the Federal Reserve shows that US inflation has become more persistent. This helps to understand the increasingly hawkish rhetoric of Federal Reserve officials and their insistence on the need to frontload monetary tightening. The ECB is also monitoring inflation persistence closely. This could mean that, depending on the data, the first rate hike could come sooner after all, even as early as July.

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US yield curve

US: should we worry about the flattening of the yield curve? Not yet.

 The US yield curve has flattened, giving rise to comments that, given the historical experience, risk of a recession is increasing. Yet, when drawing conclusions, caution is warranted. Market-based inflation expectations, which are very high, should decline after a number of rate hikes. This could pull down long-term nominal bond yields, leading to a further flattening or even an inversion of the curve. However, a decline in inflation is growth-supportive. Another reason for caution is that due to past central bank asset purchases, the slope of the yield curve is less steep. Past QE may thus reduce its quality as a leading indicator of economic growth. For these reasons, an alternative indicator has been developed. The near-term forward spread compares market-based expectations for short-term interest in 18 months’ time with current short-term rates. Its record as leading indicator is better and, what’s more, the current spread is very large. This implies that we should not yet be concerned about the flattening of the yield curve.

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Eurozone: what drives companies’ elevated selling price expectations?

An exceptionally high number of Eurozone companies plan to raise selling prices. It is unlikely that, at this stage, unit labour cost growth would already be a key driver. Rising input costs and strong demand are playing a crucial role, whereby well-filled order books make it easier for companies to increase their prices. Selling price expectations of euro area companies are much higher than what would be expected based on their historical relationship with input prices and order book levels. It seems that when more companies are raising prices, others will be inclined to do the same. This broad-based nature of the increase of inflation could slow down the reaction of inflation to slower demand growth.

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Consommation inflation

Eurozone: household spending under pressure from inflation

A priori, rising inflation and inflation expectations, reflecting robust growth in demand and economic activity, should boost household spending by reducing real interest rates. Today’s situation is different. In many advanced economies, inflation is exceptionally high and to a considerable degree explained by negative supply shocks. In the EU and the euro area, household confidence recorded a big drop in March. Although unemployment expectations have increased, the main reason seems to be concern about high and rising inflation. Eurozone consumer confidence measures provide information about spending up to three quarters into the future. Given their recent decline, one should expect below-average consumer spending growth over the coming months. However, unemployment expectations that are still below their long-term average should provide some support to spending.  

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Cyclical outlook dominated by a shock to expectations

The latest cyclical surveys show the impact of the war in Ukraine. Confidence of households and companies has dropped, although, concerning the latter, significant differences exist between countries and sectors. In Germany, the IFO business climate has plummeted whereas in France, the decline is more limited. Services tend to be doing better than manufacturing. Importantly, employment expectations of companies remain at an elevated level. It is a key factor to monitor in view of what it signals about companies’ confidence in the medium outlook as well as for its influence on households’ sentiment about their future personal situation. This last point is particularly important given the plunge in household confidence, which is largely related to concern about the general economic outlook. Undoubtedly, the jump in energy prices and rising inflation play an important role in this respect.

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Uncertainty

Radical geopolitical uncertainty

The war in Ukraine influences the euro area economy through different channels: increased uncertainty, financial market volatility, reduced exports, higher prices for oil, gas and certain other commodities. Although the economic channels of transmission are clear, the size of the impact is not. Counterfactual analysis of last year’s jump in oil and gas prices provides a reference point but the geopolitical nature of the economic shock reduces the reliability of model-based estimates. Moreover, the other transmission channels should also have an impact on growth. Finally, there is a genuine concern that, the longer the crisis lasts, the bigger the economic consequences because eventually, months of elevated uncertainty would end up weighing heavily on household and business confidence.

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Companies’ pricing power and the inflation outlook

The question of the persistence of high inflation matters because it will determine the extent of monetary tightening necessary to bring inflation under control. Key factors are growth of unit labour costs, the price elasticity of demand and its mirror image, the pricing power of companies.

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William De Vijlder

Inflation: a cycle in three phases

Over the past two years, the world economy has suddenly moved from too little to too much inflation. Three phases can be distinguished. The first phase concerns the inflation impulse, which was driven by four factors: an increase in demand, a reallocation of demand, supply bottlenecks and a shift in the sector preferences of the labour force. These factors caused important changes in relative prices as well as a jump in inflation. In phase two, second-round effects enter into force. Wage growth increases and elevated inflation becomes broad-based. Key conditioning factors are negotiation power of the labour force and pricing power of companies. Both depend on the growth environment. In phase three, ‘natural’ forces such as slower growth can weigh on inflation but the prominent role is taken by central banks. They prefer to tread carefully, seeking to avoid premature or excessive tightening. Their task is complicated because at the current juncture inflation is to a considerable degree caused by a shock in energy prices. More than anything, they hold the key for the future development of inflation.

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Global: supply side disruption, some hopeful signs

The current business cycle is atypical and this influences the analytical approach, with a focus on the supply side and whether it will be able to meet the level of demand in the economy, rather than on the demand side. Supply side disruption has been a key issue but recent PMI data suggest that we may have seen the worst. In the euro area and the US, the percentage of companies that are confronted with rising input prices and are contemplating to increase their output prices has started to decline and delivery lags are shortening. The Federal Reserve of New York’s global supply chain pressures index seems to have peaked. However, anecdotal evidence suggests visibility remains very low. Given the importance of supply disruption for the growth and inflation outlook, it implies that forecast uncertainty will remain very high. 

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Illustration ECOTVWeek Jan 2021

Euros in our pockets: looking back, looking ahead

20 years ago, on 1 January 2002, the biggest cash changeover in history took place when 12 EU countries introduced euro banknotes and coins. Today, the euro is the currency of 19 EU countries and more than 340 million people. It benefits from a high degree of popular support. Since its launch, the euro has gone through different phases: a first decade with good growth but increasing imbalances; the sovereign debt crisis; the years of disinflation and finally the Covid-19 pandemic. Looking ahead, important challenges remain: the project of launching a digital euro, finalising banking union and making significant progress towards a capital markets union. In addition there is the need to reform economic governance, which is big challenge. In the nineties, huge adjustment efforts were undertaken under external pressure, the argument being that they were necessary to be able to join the euro. Now, the euro area countries find it hard to agree on what pressure is needed to steer national policies in a direction that would benefit all.

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2022

2022: assessing upside and downside risks

Judging by the latest forecasts, the outlook for growth in 2022 is positive and, at some point during the year, inflation should start to decline. Uncertainty remains elevated however so there is a risk that key economic variables evolve differently than anticipated. The biggest ‘known unknown’ concerns the future development of the pandemic. Real GDP growth could surprise to the upside should inflation decline faster than expected. A tightening of financial conditions, more supply disruptions and inflation staying high for longer are the key sources of downside risk to growth.  

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Year 2022

2022: towards the big normalisation

After last year’s sudden, deep and a-typical recession, caused by the Covid-19 pandemic, this year has also been a-typical in several respects. Supply bottlenecks and supply disruption have been dominant themes throughout the year, acting as a headwind to growth, both directly but also indirectly, by causing a pick-up in inflation to levels not seen in decades. Under the assumption that the pandemic is gradually becoming less of an issue thanks to the vaccination levels, 2022 should see a normalisation in terms of growth, inflation and monetary policy.

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Ciel menaçant

Three headwinds to growth

In his testimony to a commission of the US Senate, Jerome Powell has acknowledged that inflation is less transitory than considered hitherto, adding that, as a consequence, a faster tapering seems warranted. Despite this hawkish tone, the reaction of US Treasuries was muted. This may, amongst other things, reflect concern about how the pandemic might evolve. The new Omicron variant undeniably represents an uncertainty shock for households and companies. It comes on top of a negative supply shock that is already a clear headwind to demand. It clearly makes the task of central banks more complicated than ever when deciding how much of a monetary headwind they can create.

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Emploi

European area labour market bottlenecks: structural aspects

Companies in the euro area report record-high levels of labour shortages. These are partly cyclical in nature but structural factors also play a role. Last year’s annual investment survey of the European Investment Bank shows that the availability of staff with the right skills is the second most important factor weighing on long-term investment decisions in the EU. Structural labour shortages can weigh on potential GDP growth through its impact on capital formation, innovation and productivity. Economic and in particular education policy including vocational training and lifelong learning schemes will have to make sure that, going forward, the available skills, both in quantity and quality, fit the evolving needs.

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