Will We Sacrifice Economic Development to Halt Inflation?

  • 2022-09-09
  • Simona Striževska, Economist at Citadele subsidiary CBL Asset Management

In the global economy, autumn has begun with a certain feeling of doom. You don’t have to look far to find reasons for this pessimism: overall price increases are forcing consumers in Western countries to be more selective in their spending; business outlooks are weakening globally; and, while Europe continues to prepare for a harsh winter, central banks are using any opportunity to highlight their rigidity when it comes to fighting inflation, even if this results in slower growth or even recession.

The many faces of a global economic downturn 

Although the current weakening of the global economy seems synchronised, the global downturn has many different faces. Worries surrounding the U.S. generally come down to one of the fastest cycles of interest rate increases in the history of the Federal Reserve System (FRS), which aims to cool down an economy which has become overheated with pandemic stimulus policies. In China, the government’s zero Covid policy continues to disrupt state economic processes, and this is being worsened by structural setback in the Chinese real estate market. Unlike the U.S. and China, Europe’s downturn is largely triggered by external factors that are more difficult to control: under the influence of the shock in energy prices, a recession scenario in in the monetary union and other European countries is becoming increasingly realistic.

If several indicators in Europe are already signalling a reduction in economic output, the U.S. is currently only showing distinct signals of a recession in its real estate market. Higher prices and interest rates are stopping buyers in the U.S. from purchasing property, resulting in reduced activity and investments in the sector. The healthy employment market figures have so far dismissed fears of a recession in the U.S. economy. 

For some time now, the global manufacturing market has been pivoting away from the goods deficit and overconsumption, and the number of new orders is falling on a global scale. The European manufacturing market is also being complicated by the energy crisis in the fragmented gas and electricity markets. Some energy-intensive plants in Europe, including fertiliser and metal manufacturers, have already announced production limits or temporary stoppages due to the rise in gas and electricity prices. It is no surprise that, of the Eurozone superpowers, one of the largest impacts is being felt by the German economy. Historically, it has been dependent on Russian gas imports, and the lack of other alternatives makes Germany particularly vulnerable. In the autumn, European consumers will also start to feel the negative effects of the increase in gas and electricity prices. 

Uncertainty in the energy resource market forces governments to open their purses 

The recent pause in Russian gas imports to Europe through the Nord Stream pipeline poses even greater risks to inflation and economic development in the Eurozone. At the end of August, two months faster than planned, Europe reached its 80% gas storage capacity goals. This will partly help European countries to get through the winter, but competition for gas deliveries with Asian countries among others will keep gas prices and market uncertainty high, particularly if Russian gas disappears completely from Europe.    

According to International Monetary Fund estimates, the impact of completely cutting off Russian gas supplies on the European Union and German economies could range between 0.4% — if it can be replaced with imports of liquified gas — and almost 3%, if gas deliveries to businesses are limited to help households. 

To reduce negative effects, European governments are currently working on support programs for new businesses and consumers. For example, the German government announced a support program of almost 2% of GDP, which is twice as large as the measures introduced last September. In other European Union countries, support programs comprising 1-3% of GDP have been implemented over the past year. However, unlike pandemic stimulus packages, governments will have to pay more for larger budget deficits, as government borrowing costs rise in tandem with Central bank rate rises.

Balancing the fight against inflation with slowing growth

There are currently too many unknowns to speculate how long and deep Europe’s economic downturn could end up being in reality. It will depend not only on events in the energy markets, government action and the resilience of global demand, but also on such an unpredictable factor as weather this winter. Analysts are already predicting that economic growth next year in the U.S. and Eurozone will not exceed 1%, and there is a large possibility that the real figures in the Eurozone will be lower or even negative.  

Worsening economic figures in Europe as inflation remains at a high level will make life even more complicated for the European Central Bank (ECB). In September, the ECB sped up rate raises and increased the main refinancing rate to 1.25% from July’s 0.50% and a round 0 at the start of the summer. Bearing in mind the record speed of inflation, the ECB plans to continue increasing rates over the next several meetings. At the same time, standing at the crossroads of high inflation and slower economic growth, the ECB may have to pause the process of raising interest rates. 

About CBL Asset Management 

Citadele Bank’s subsidiary, IPAS CBL Asset Management, is one of the leading and most experienced financial asset management companies in the Baltics, employing globally-recognised fund managers. It has managed investment portfolios since 2002. Meanwhile, in 2003, it became one of the first in Latvia to manage level 2 pension savings. CBL Asset Management has the largest team of managers in Latvia, which regularly analyses the financial and capital market and macroeconomic trends using their experience and the latest technologies, investing pension savings in both large international and local Latvian businesses, as well as in the bonds of various countries.