Run, rabbit, run

Run, rabbit, run

Chinese astrology ascribes “patience” and “luck” to the Rabbit, whose year we are entering this January - and the world plainly needs both.

In this first Newsletter of 2023, our specialists look at some of the exceptional economic challenges.

For the past couple of years, we’ve turned the calendar to January with at least the private hope that the new year couldn’t be worse than the old. Pestilence, war and a threat of the third of the biblical trio of disasters - famine - soon doused our hopes in both 2021 and 2022.

But while 2023 looks a poor year for the world economy as a whole, as it struggles to absorb higher energy prices without embedding inflation, there’s hopes that parts of it may already have seen the worst. Countries whose governments have done most to damp down energy prices on the way up will see them fall more slowly, and so will inflation - but it should not out-run expectations as spectacularly as in 2022.

Hopes are sprouting most vigorously in the United States, where the inflation rate slowed from 9.1 to 7.1 between July and November, and natural gas prices have dropped; while the Fed has warned off those hoping for early interest rate cuts, the pace of increase is slowing. There’s talk of a soft landing again, which is probably wishful thinking, since the Fed, still smarting from criticism of its failure to raise rates soon enough, won’t abandon its hawkish pose in a hurry. But any improvement in the glide path is good news for Europe, since the dollar is acutely sensitive to US interest rates, and its strength has been adding to inflation headaches on the other side of the pond.

Where things don’t look quite so good.

Despite the slowdown in global growth, the Organisation for Economic Co-operation and Development expects only three of its 38 members to see output fall year-on year - apart from Russia, engaged in a protracted exercise in self-harm, the two are Germany and the UK. Germany is paying the price for its dependence on Russian energy, as well as the other pressures that have slowed down the whole of Europe. Britain, meanwhile, is still suffering the the long-term effects of withdrawal from the European single market: not only on trade but on the labour market.

In the the US, the labour market has been hot because the economy has rebounded strongly from Covid; in the UK, the weakest recovery from the Covid recession of all the major economies has still left the labour market tight because the safety valve of free movement of labour from Europe has been lost, and the economy has become less reliably dependent on immigration from farther afield, with the effects most acutely seen in the National Health Service.

Although all European economies are suffering from the “cost of living crisis”, a tight labour market, poor public finances and a real pay squeeze have led to particularly widespread industrial action in the UK. So although the government looks more stable than it did in 2022, it entered the New Year mired in confrontation.

One of our specialist articles looks at the cost of policy uncertainty, and the data that clearly demonstrated how this has increased. The long textbook years in which central banks maintained very low inflation almost in their sleep, the prevailing orthodoxies of competition and free trade drove national and international policies, climate change drove energy policies (even if too slowly), and governments found it cheap and easy to borrow, are clearly over. Regulators, including competition authorities (as another of our specialist articles discusses) are feeling obliged to focus on the cost of living rather than competition per se, protectionism is rising, security of energy supply is rivalling climate change as a policy objective and interest on public debt has risen sharply.

As inflation declines, all eyes will again be on central banks. How much will they continue to tighten as inflation slows and output falters? Some forecasts suggest inflation may fall so rapidly that the main risk is of overshooting, others that it will get stuck at perhaps twice the general target of about 2 per cent, and central banks and their political masters will have to decide whether to forfeit credibility or kill off recovery. Wage inflation is likely to be the key indicator, which of course explains why governments are digging in their heels on public sector pay; but where vacancies rates are high and the workforce demoralised (the National Health Service again), the problem isn’t going to go away.

On the private sector side of all major economies, however, there are some grounds for optimism. Non-unionised firms are adjusting more quickly to the complex problem of a higher cost of living, squeezed margins and the competition for labour. Energy-dependent industries, notably those in Germany, are facing the loss of some capacity that is no longer economic, but seem to be working the problem through with less damage than originally feared. And - with two big ifs - there is bad news leading to good in the country that brings us the year of the Rabbit.

China is suffering a heavy death toll from the removal of Covid restrictions from a poorly-vaccinated population. But once through that ghastly re-entry, the economy will begin to operate much more efficiently again, and although that will put further upward pressure on commodity prices it will also unblock supply chains and take some uncertainty out of globally-distributed industrial production.

The first big if, of course, is that it does get through this period without embedding a persistently high level of Covid sickness or unleashing a new, dangerous variant on the world. The second is that this alarming period does not cause a domestic political reaction that the Chinese Government does not seek to deflect with external actions, notably with respect to Taiwan.

At the moment, however, it is two governments farther west which are vying for the 2023 rogue state title: Russia and Iran. With no end in sight to the war in Ukraine, and Iran lashing out unpredictably, it’s impossible to feel very sanguine about global politics in 2023. Patience, yes, rabbit xiānshēng, but we’ll need a lot of that good luck too.

Guest Author: Baroness Sarah Hogg, Former Frontier Economics Chairman