The economy is booming. However, the big policy question for 2022 is whether policy-makers will return to accommodation if inflation remains high, but growth falters significantly. There are a few risks on the horizon. This fifth wave of contagion comes on top of disruptions leftover from previous waves.
Supply bottlenecks are lingering and may worsen from worker shortages. Energy prices have been rising due to colder weather and geopolitical supply restrictions. European liquid natural gas prices have quintupled, to the equivalent of crude at an exorbitant $250 per barrel. These supply-side issues are adding pressures to inflation from strong demand, fuelled by previous fiscal largesse and consumer frustration with missing the freedom of ‘before.’ For now, the Federal Reserve and the European Central Bank are tapering, though to different extents.
The good thing is that inflation expectations have been falling since mid-November, revealing that markets perceive the Omicron variant to reduce demand enthusiasm more than aggravate supply disruptions. In Europe, gas prices will almost certainly moderate from their extreme levels once winter has passed.
Fiscal spending will fall relative to 2020-21, reducing pressure on prices but with less of a headwind to growth because households saved much of the stimulus. In Europe, Union-financed fiscal transfers will top up public spending this year, by around 1% of gross domestic product in Italy and Spain. Japan, where inflation is a non-issue, is set to benefit from a sizable fiscal spending plan this year, at 10% of GDP.
This could well make for a lasting expansion at this stage of the recovery. Pent-up demand is amplified by some unusual ingredients.
High savings buffers translate to buoyant consumption and capital expenditure plans when the pandemic allows. Because firms and households are cash-rich, demand for credit has been very low. This is not the usual expansion boosted by leverage that central banks need to slow by hiking financing conditions. In the US, firms are deleveraging and, in Europe, corporate credit growth has been quasi-null. In both regions, consumers are borrowing mostly to buy a house. Banks are well capitalised and ready to lend, providing an additional buffer that the private sector can access when needed.
Any rate hike will, at worst, affect financial markets and morale – and temporarily. The credit channel is weaker and the recovery will be strong. The key word in the Fed’s hawkish message in December was ‘optionality’ in case the growth outlook disappointed –policy forward guidance in uncertain times requires new concepts. While policy must adjust to the continued recovery, financial conditions will likely stay accommodative in 2022. The Fed showed it cared: it accelerated the pace of tightening – also to be able to do less later.
The end of the European Central Bank’s pandemic bond purchase programme should not be understood as an impulsive tightening. It should be viewed as the end of emergency – the same way the exceptional fiscal impulse will wane around the world, bar Japan battling a different predicament. Markets will come to realise that the policy buffer remains. Small increases in rates will support growth in an unusual way – there will be a larger appetite for banks to lend.
The central scenario for 2022 is one in which inflation jitters will not cut short the recovery. Growth in Europe and the US will remain above trend, and be slightly faster in the former than the latter. Beyond its lag in catching up with pre-crisis trends relative to the US, Europe faces a more manageable growth-inflation mix. Supply disruptions and labour shortages are less intense, and policy remains accommodative. Policy support and medical progress in both places will extend the economic cycle into expansion – despite temporary slowdowns – without passing through a recession, as in a standard business cycle.
Politics remains a key risk. Besides the usual hard-to-predict geopolitical events that may rattle the world this year, there are presidential elections in Europe and mid-term elections in the US. In France and Italy, there are a number of divisive figures who could push incumbents to make foolish announcements. Viral fears will continue to resurface as long as vaccinations are not complete globally.
The sequence of slowdowns and recoveries could give a feeling of Groundhog Day, switching the reopening trade on and off again in an unpleasant déjà vu. As Albert Camus said, one must imagine Sisyphus happy.
Agnès Belaisch is Chief European Strategist, Barings Investment Institute.