One month into 2022 was enough to upset long-held convictions about the path of inflation, the cost of money, the state of employment, the future of work, the safety of investments and the best ways to a prosperous future, or at least, how to avoid utter destitution on pension day.
People like me, who had hoped that the post-pandemic inflationary push will somewhat ease with supply chains untangling and the resumption of more balanced economic activity, seem to have been proved wrong.
The prevailing view among economists is now that central banks were too optimistic believing that inflation will come down by itself once the economy settles on a normal, post-pandemic path. The will have now to hike the cost of borrowing more aggressively to bring inflation down, thereby possibly disrupting growth.
I still think that hopes for normalisation were not misplaced. A lot of impressive growth in December was inventory building, which will go into reverse once the excess demand for goods, which have reached 120 per cent in the US year on year, will abate.
The problem, alas, which central banks now face is that COVID-related transport and component bottlenecks, as well as labour shortages and a steep rise in energy costs, have started to permeate everything, even those parts of the economy which were deemed immune to shock shortages. Some of these inflationary effects could persist even when transport bottlenecks have eased, supply is catching up and energy costs will normalise.
Hence the announcement by central banks in the US, the UK and the eurozone to hike rates, to wind down their bond- buying programmes and to start to reduce their holdings of bonds by letting them expire or even by selling them off. After 12 years of ‘quantitative easing’, central banks will dabble in ‘tightening’. Governments of the world’s most prosperous nations will have to raise debt in the markets, without the generous and unquestioning help of their money printing department.
Private, financial institutions and investors will decide how debt should be priced from now on, not central banks, and they will demand financial incentives. As a result, US treasuries are already yielding close to two per cent per annum, the yield of Greek and Italian debt is inching upwards and Germany, for the first time in three years, has to actually pay if it wants to borrow beyond 2027. And this is before any of the big central banks bar the UK (0.25 per cent hike) have actually done anything.
The epicentre of inflation is the United States, where consumer prices have risen 7.5 per cent year on year (January 2022). This is reflecting on all of us no matter how much restraint we would demand from manufacturers and employees, as the US goods demand has global inflationary effects.
Eurozone inflation has reached 5.1 per cent in January and even in Malta, seemingly an island without inflation worries (I would like to get your views on this), prices have increased by 1.5 per cent in 2021 according to the National Statistics Office, more than double the reading of 2020 (0.64 per cent).
Energy costs are by far the largest contributor in most countries’ inflation readings, and there’s not much what monetary tightening can achieve to bring them down, bar of suffocating the economy. Oil companies and oil producing sovereigns have been hesitant to invest in future production after the slump of 2020, and publicly quoted companies feel also the pressure of environmental campaigners to divest from fossil fuels.
The epicentre of inflation is the United States, where consumer prices have risen 7.5 per cent year on year- Andreas Weitzer
The standoff with Russia over the Ukraine and threats of pipeline and payment embargoes has quintupled gas prices in Europe. This feels almost like normalisation when compared to December spot prices which were up tenfold but have more than halved since.
The UK and most European governments are willing to counter the resulting ‘heating poverty’ by subsidising energy bills for households, forcing energy providers to take losses, imposing windfall taxes on oil companies or to scrap VAT on electricity.
This is misguided, of course. There is no heating poverty. There is poverty. And poor households deserve to be supported in a meaningful way, regardless of gas prices. To subsidise fuel use is neither green, nor alleviating income disparity. To tax the very corporations which we’d wish to invest in gas and renewables is counterproductive.
No matter how fast and how resolutely central banks will tighten the screws, we should not hope for our savings accounts to eventually bolster our income. Central bankers aim to reach a ‘neutral’ interest rate, a foggy concept which envisages monetary conditions which neither stimulate nor throttle the economy. Currently, it is broadly assumed to be around two per cent, meaning deeply negative, real rates to persist, once five per cent inflation is subtracted.
What will eventually tame inflation is either a gradual normalisation of the current demand distortions and the easing of supply bottlenecks, or persistently high inflation without real wage rises as it will dampen consumption, or interest rates high enough to stop economic activity altogether.
The latter is a distant worry for me. Apparently, 50 per cent of household wealth in rich countries (McKinsey Global Institute, The rise and rise of the global balance sheet) is tied to real estate. If this is a correct estimate, a rise of US dollar interest rates to merely three per cent – with interest rates in other countries having to follow suit – would deeply damage real-estate wealth, with painful consequences for banks, pension insurers and private households suffering foreclosure or higher rents.
Many sovereign borrowers could be junk-rated. The eurozone might need another rescue. So either short-term inflation stabilises by itself any time soon, or interest rates will rise sufficiently to destroy everything in its wake. Central banks, faced with this the state of affairs, are seeing their hands tied.
The long-term forces of inflation are hard to predict. The disinflationary forces of outsourcing to South East Asia have run its course, neutralised by higher domestic wages and the costly detangling of politically and economically ever-more fragile supply changes. Wealth inequality and an ageing population, on the other hand, will continue to cause a savings overhang over new investment, depressing yields and returns.
Climate change will increase the cost of farming and housing, with new inflationary consequences. The green investment needed to wean the world from fossil fuels – if it ever gets serious about it – will demand infrastructure investment of estimated $60 trillion in the next three decades, creating new impetus for higher interest rates, growth and inflation.
Yet any threat of tightening financial conditions now has already shaken markets. Investors are scrutinising revenue growth, discounting future income streams, and willing to sell at the slightest sign of disappointment. Facebook, its shares losing $ 230 billion in a single day, was a telling example. We will see a lot of volatility this year.
The edifices of leverage will start to crack. As the tide of free money will abate, corporate fraud will be revealed, all these shortcuts to shiny balance sheets. Corporations will suffer weaker revenues and stock valuations will hectically wobble Facebook-style. My old portfolio laggards, European banks and Big Oil, started to work as a fine hedge.
The purpose of this column is to broaden readers’ general financial knowledge and it should not be interpreted as presenting investment advice, or advice on the buying and selling of financial products.
andreas.weitzer@timesofmalta.com