William De Vijlder

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.

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.

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.

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.

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. 

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.

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.  

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.

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.