Japanese inflation accelerates amidst concern about a weak yen

• Japanese inflation is accelerating, although it remains very low compared to levels seen in Europe and North America. Japanese core prices, which excludes the impact of fresh foods, were up 0.8% in March versus a year earlier, the highest level in two years. However, the cost of mobile telephone services fell 52.7%, the result of the introduction of low-cost plans early last year. When this factor is excluded, core consumer prices were up 2.2% in March versus a year earlier, higher than the Bank of Japan’s 2% target and quite high by Japanese standards. The surge was principally due to the sharp rise in energy prices following the Russian invasion of Ukraine. Still, it remains unlikely that the Bank of Japan will adjust monetary policy.

Meanwhile, another factor that might exacerbate Japanese inflation in the months ahead is the sharp decline in the value of the yen. In Japan, where the strength of manufactured exports is critical to economic success, the value of the currency is very important. If the yen rises too much, it reduces the competitiveness of exports by raising export prices and/or diminishing profit margins for exporters. If the yen falls too far, it raises import prices, thereby reducing domestic purchasing power. It also means higher costs of imported commodities and inputs for manufacturers, and potentially higher inflation. Thus, a degree of currency stability is desirable. 

Lately, the yen has fallen sharply, hitting the lowest level against the US dollar since 2002. This is mainly in response to rising interest rates in the United States as well as the negative impact on the external balance stemming from rising commodity prices. The drop in the yen, combined with higher commodity prices, has led to a sharp surge in producer prices in Japan, although consumer prices remain relatively tame. This suggests that margins are being squeezed. Although the government has sought to boost consumer price inflation during the past decade, it is likely wary of a sudden acceleration.

The depreciation of the yen has not gone unnoticed by policymakers. The finance minister, Shunichi Suzuki, said that, when rising commodity prices “can’t be sufficiently passed on through higher prices, or wages don’t grow enough to make up for them, a weak yen can be considered a bad thing.” It is unusual for a finance minister to comment on the value of the yen. Thus, Suzuki’s comments led to speculation that the government may intervene in currency markets to boost the value of the yen. The problem is that, when governments purchase domestic money to boost the value of their currency, this necessarily entails a tightening of monetary policy. It means that the government is selling the central bank’s reserves, thereby reducing the monetary base. The monetary impact can be offset if the central bank purchases government bonds, thereby leaving the monetary base unchanged. This is known as “sterilized” intervention, the principal topic of my own doctoral dissertation many years ago. What I found in my research was that sterilised intervention is rarely effective when there are no capital controls. Thus, if Japanese authorities want to change the direction of the yen, they will most likely have to alter monetary policy.

As for the Bank of Japan, governor Kuroda said that monetary policy will remain accommodative to support a fragile economic recovery and avoid deflation. He said that “the recent falls in the yen, which lost about 10 yen to the dollar in about a month, is quite sharp and could make it hard for companies to set business plans. In that sense, we need to take into account the negative effect” of a depreciating yen. This ambiguous statement, typical of central bankers, will leave traders wondering and, therefore, might help to prop up the yen. Still, the bottom line is that, despite their concerns, there is not much the Japanese authorities can do to reverse the drop in the yen without a tightening of monetary policy. 

Meanwhile, Japanese and US officials have recently discussed the possibility of a joint intervention in currency markets, similar to what happened in the 1980s and 1990s. The US administration likely sees value in a stable exchange rate. However, intervention that boosts the yen means a lowered value US dollar. That, in turn, could be inflationary for the United States. Thus, any joint intervention is likely to be limited in scope. It would likely be meant to create uncertainty on the part of currency traders, thereby causing them to be cautious about further suppressing the value of the yen. Traders don’t want to get caught with their pants down.  

German producer price inflation hits a record high. ECB remains calm.

• After experiencing ruinous hyperinflation after both world wars, Germany (or at least West Germany during the Cold War) became an icon of fiscal and monetary probity, keeping inflation perpetually low for most of the postwar era. Germany’s central bank, the Bundesbank, focused laser-like on steadying prices, thereby maintaining the prestige and stability of the deutschmark. When the creation of the Eurozone was being debated, Germany was wary of giving up the deutschmark, while other European countries saw the euro as a way that they could enjoy the benefits of the deutschmark. This was especially true for long-suffering Italy, which frequently endured relatively high inflation and downward pressure on the lira. 

Thus, it must be disconcerting if not unconscionable for German policymakers to learn last week that producer prices were up in March at the fastest pace since 1949 when data on producer prices began. Specifically, producer prices were up 30.9% in March from a year earlier, up considerably from the 25.9% producer price inflation in the previous month. Moreover, this is quite sudden given that annual producer price inflation was only 5.2% in April of last year. Meanwhile, producer prices were up a stunning 4.9% from February to March, largely reflecting the impact of the Ukraine war on commodity prices. In February, prices were only up 1.4% from the previous month.  

The very high annual number was heavily influenced by energy prices. Natural gas prices were up 144.8% in March from a year earlier while electricity prices were up 85.1%. When energy prices are excluded, producer prices were up a more modest 14% from a year earlier. Still, some nonenergy prices were up substantially. This included metals (up 39.7%), fertiliser (up 87.2%), and wooden containers (up 68.8%). The disruption of the war likely played a big role in these price increases. Ukraine is a major exporter of grain and fertiliser as well as some metals. The war has impeded the efficient production and distribution of these products. 

Meanwhile, the fact that consumer prices are rising at a much slower pace than producer prices likely implies that consumer-facing businesses are taking a hit to their margins by not fully passing on cost increases to consumers. Moreover, the very high producer price inflation in Germany suggests that Germany is uniquely exposed to disruption because of the size and importance of its very energy-intensive manufacturing sector. 

From the perspective of the European Central Bank (ECB), the surge in German inflation is yet another challenge in navigating the crisis. Germany now has some of the highest inflation in Europe, a fact that the ECB cannot ignore. On the other hand, the inflation has been, and is currently being, caused by factors that are not necessarily affected by changes in monetary policy. These are supply chain disruption and politically driven commodity price movements. Moreover, the sharp rise in commodity prices increases the risk of recession by reducing household purchasing power. Thus, it is not surprising that the ECB is being cautious and, for now, retaining a relatively easy monetary policy. Yet there is little doubt that, going forward, it will face considerable pressure to shift gears, especially from the German members of the ECB’s policy committee.

Meanwhile, ECB president Lagarde recently explained why the ECB is not following the Federal Reserve in boosting interest rates. She said that the Eurozone faces greater downside risks to growth than the United States, largely due to the dependence on Russian energy and uncertainty about the future trajectory of the war in Ukraine. She said there will be no action on interest rates until at least after the ECB concludes its programme of asset purchases in June. She said, “That will then lead us to assess whether an interest rate hike is needed. For goodness sake, let’s wait until we have the data and then we move on to decide.”

Navigating China’s challenging path

• China’s economy is in a difficult position. COVID-19 outbreaks in 70 cities have resulted in lockdowns of varying degrees, with production completely shut down in 13 of China’s hundred largest cities, and with the 26 million people of Shanghai in an almost total lockdown. This has seriously disrupted production and distribution of goods and consumer spending. All of this comes at a time of a significant slowdown in the property sector, which is having negative consequences for economic activity. Moreover, China is a commodity-importing country and has been hit by the global surge in commodity prices stemming from the war in Ukraine. Thus, it is not surprising that the government in Beijing is keen to do something that will offset these negative factors.

As such, the People’s Bank of China (PBOC), China’s central bank, recently announced a 25-basis-point reduction in the required reserve ratio (RRR) for commercial banks. This was less than many investors anticipated. It follows 50-basis-point cuts in both July and December. The latest reduction will release the equivalent of roughly US$83 billion of liquidity into the system, enabling banks to boost lending. It is meant to increase credit market activity and, consequently, stimulate economic activity, especially on the part of small and medium-sized businesses. It is an easing of monetary policy. 

On the other hand, it can be argued that easing monetary policy will do little to boost economic activity if it is being suppressed by measures aimed at controlling the spread of the virus. Easing credit conditions assumes that there is demand for credit not being met because of constraints on bank lending. This might not be the case. Economist Lord Keynes suggested that an economy could be afflicted by a liquidity trap in which greater availability of credit makes no difference if participants in the market economy are prone to save excessively. This renders monetary policy ineffective. Keynes suggested the solution to this dilemma is fiscal policy, where the government spends money that would otherwise sit on the sidelines. In fact, China is doing this as well, boosting spending on infrastructure. Meanwhile, it is not clear that banks will want to lend to small businesses in this environment, fearful that they might not get paid back on time.

For China, easing monetary policy could lead to destabilising outflows of capital given that the US Federal Reserve is raising interest rates. In fact, the Institute of International Finance reports that foreign investors are rapidly withdrawing capital from China. This puts downward pressure on the value of the renminbi, compelling the PBOC to sell reserves if it wants to stabilise the exchange rate. 

Meanwhile, Shanghai continues to experience a lockdown. Yet the rate of infections in Shanghai, while up significantly, remains far below what has been seen in many other countries. Currently, the infection rate in several European countries is much higher. And yet those countries are easing restrictions and going on with their lives, confident that a high rate of vaccination will mean low rates of hospitalisation and death. 

China’s situation is different. The government is keen to enforce its zero-tolerance policy regardless of the economic cost. Locking down Shanghai means halting most forms of economic activity, with likely reverberations throughout the global economy. People are staying at home, factories are closed, and distribution is disrupted because drivers are locked down as well. 

Thus, the biggest problem for China in the short term is the zero-tolerance policy toward the virus, which includes lockdowns and periodic shutdowns of factories and ports. It suppresses demand and disrupts supply chains. Moreover, it remains unclear whether the government will consider easing this policy. To do so would entail acceptance of a temporary surge in infections and hospitalisations. 

It has been reported that neighbouring Taiwan is now considering easing of COVID-19 restrictions. Taiwan has been successful in suppressing transmission and has retained strong economic growth. Yet, as other countries in the region open up, the government is concerned that Taiwan will get left behind if it does not attempt to live with COVID-19 as other countries have done. 

• As China’s central bank eases monetary policy, it is alone among central banks in the region to do so. Others are tightening monetary policy in response to the US Federal Reserve’s decision to raise interest rates and reverse asset purchases. Specifically, the central banks of South Korea, Singapore, Sri Lanka, and New Zealand have all raised interest rates in recent days. These central banks have not only responded to the moves by the US Federal Reserve, but they are also attempting to quell inflationary pressures. While inflation in most Asia/Pacific countries is far lower than in Europe and North America, it has increased in recent months. For example, the Consumer Price Index in South Korea was up 4.1% in March versus a year earlier, the highest inflation rate in a decade. Meanwhile, inflation in Singapore is the highest in nearly a decade, and in New Zealand it is at a three-decade high.  

US inflation worsens due to war

• The US government reported that, in March, annual inflation hit its highest rate since 1981. And yet, equity prices increased, and bond yields fell following this news. Why? The answer is, although headline inflation was higher than expected, core inflation was surprisingly modest, suggesting that underlying inflation is not accelerating. Rather, inflation in March was driven by the extraordinary circumstances unleashed by the war in Ukraine. Does that mean we can all relax? Hardly. The Federal Reserve is correct to take this inflation seriously and implement a significant tightening of monetary policy. However, if commodity prices either stabilise or reverse, there would be reason to expect a gradual decline in inflation. This will depend on the direction the war takes.

Let’s look at the details. In March, consumer prices were up 8.5% from a year earlier, the highest since 1981 and much higher than the 7.9% rate clocked in the previous month. Prices were up 1.2% from the previous month, a dramatic increase. This was principally driven by energy prices, which were up 32% from a year earlier and up 11% from the previous month. Gasoline prices were up 48% from a year earlier and up 18.3% from the previous month. This was, of course, due to the dramatic surge in oil prices following the Russian invasion of Ukraine. 

When volatile food and energy prices are excluded, core prices were up 6.5% from a year earlier and up 0.3% from the previous month. The latter figure was the lowest since September 2021. In other words, core inflation has decelerated. Still, try telling that to an American consumer who is facing significantly higher prices in many key categories. During my own recent trip to Italy, I left my dog in a kennel for the first time in two years. The cost was 20% higher than the last time. I was shocked. So are many people when they encounter new pricing, which threatens to create an inflationary psychology that could result in a damaging wage-price spiral. That is one reason the Fed is taking dramatic steps. More about that later.

Meanwhile, there are some interesting patterns to the current inflation. For example, from the previous month, used car prices fell 3.8%. Prices of smartphones fell 4.2% and prices of televisions were down 2.4%. On the other hand, airline ticket prices were up 10.7%, the price of renting a car was up 11.7%, and the price of staying at a hotel was up 3.7%. Evidently, people are starting to shift away from goods for the home and starting to travel more, while businesses struggle to satisfy changing demand patterns. Indeed, the price index for durable goods fell 0.9% from February to March while the price index for services was up 0.7%. Prices of nondurable goods, which include gasoline and fuel oil, were up 3.2%.

What are the implications of this inflation report? First, the sharp rise in the prices of essential energy and food goods means that households will have fewer resources available to spend on other goods and services. Although wages have risen, they have not kept up with prices. Effectively, this is a loss of real income. That could have a negative impact on economic activity. On the other hand, the economy is characterised by full employment and strong job growth. In addition, many households possess a vast pool of savings. Thus, a sudden decline in economic activity seems unlikely. 

Second, the Federal Reserve has already begun a significant reversal of monetary policy, with the aim of quelling inflation. Yet the fact that the current surge is largely related to the war in Ukraine means that the Fed must be cautious lest it engineer a recession. The experience of 1974 is likely top of mind. At that time, a quadrupling of global oil prices set off a sharp rise in inflation combined with a loss of real income. This “stagflation” was greeted by a tightening of monetary policy by the Fed, which led to a deep recession. 

Finally, the biggest unknowns right now are the trajectories the war in Ukraine and the recent COVID-19 outbreak in China take. The latter has led to lockdowns and severe disruption of supply chains. How these events unfold will likely have a significant impact on the future of inflation. 

The US Federal Reserve reverses course

• The US Federal Reserve is shifting dramatically to a fairly tight monetary policy. Consider the last few months: First, the Fed started to wind down the pace of asset purchases. Then it started to raise short-term interest rates, and subsequently, it signaled that the next rate increase will be of 50 basis points. Now the Fed tells us that it will soon start to sell the assets it has accumulated. Recall that, when the pandemic began in March 2020, the Fed massively purchased government bonds and mortgage-backed securities, with the goal of keeping credit markets open at a time when a seizing up of markets was considered a risk. Over the course of nearly two years, the Fed accumulated an additional US$4.5 trillion in assets. Now, based on the latest minutes of the Fed’s policy committee, the Fed is set to start selling these assets at a rate of US$95 billion per month. The goal is to reduce pressure on an over-inflated economy. The mechanism by which this happens is an increase in borrowing costs. 

As the Fed has shifted policy, and as expectations of inflation have increased, bond yields have surged. The yield on the US Treasury’s ten-year bond increased from roughly 1.75% at the start of March to roughly 2.77% by mid-April. In addition, bond yields in other major countries increased commensurately. There are two principal components to a bond yield: an expectation of inflation over the life of the bond, and the real yield that is affected by supply and demand conditions in the bond market. The so-called breakeven rate measures the inflation expectations component. It has only risen modestly (about 20 basis points) since the start of March. Thus, the main factor driving increased bond yields in the past month is supply and demand. With the Fed first halting purchases, and then announcing the sale of bonds, markets are pricing in a flood of bonds into the market.  

The surge in bond yields is already having an impact on markets. Mortgage interest rates have risen sharply, up about 100 basis points since the start of March. With home prices continuing to rise, this means a significant reduction in affordability. This augurs a slowdown in housing market activity. Meanwhile, the yield on so-called junk bonds has increased about 60 basis points in the past month. The volume of M&A transactions has fallen sharply. Thus, the Fed is clearly already having an impact. The challenge for the Fed will be to avoid tightening too much given the negative economic consequences of the sharp rise in commodity prices. 

• In the past, US recessions were preceded by a widening of credit spreads. That is, the gap between the yields on risky assets and safe assets widened as investors perceived greater risk. Often this widening of spreads followed a tightening of monetary policy. Yet this has not happened lately. The Fed has started to tighten monetary policy by raising short-term interest rates but yield spreads have remained very low. Why? One possibility is that companies are flush with cash having substantially deleveraged during the pandemic. Thus, the risk of not being able to service debts appears to be historically low. Why is this important? The answer is, if borrowing costs for companies remain low, there is less likelihood of a contraction of credit activity and, consequently, recessionary pressure. 

On the other hand, the sharp rise in mortgage interest rates could ultimately lead to a downturn in housing market activity, thereby hurting economic growth. In addition, heightened perception of risk has hurt the volume of M&A transactions on Wall Street. Still, a wide range of indicators still point to continued economic growth. These include healthy consumer balance sheets, continued growth of consumer spending, and strong job growth.

The ECB bucks the trend of major central banks

• With inflation having accelerated sharply in the 19-member Eurozone, there was expectation that the European Central Bank (ECB) might choose to speed up the process of monetary policy normalisation. So far, this has not happened. The ECB’s policy committee met this week and decided to retain its plans for gradual ending of asset purchases and delayed increases in the benchmark interest rate. The ECB committed to ending asset purchases later this year. This is in contrast to the US Federal Reserve, which will soon start to sell assets at a brisk pace.

ECB president Lagarde said that “downside risks to the growth outlook have increased substantially as a result of the war in Ukraine.” She noted, however, that “the upside risks surrounding the inflation outlook have also intensified, especially in the near term.” Yet she evidently believes that a balanced approach is needed in order to avoid recession. She said that “we’ll deal with interest rates when we get there.” Regarding comparisons with monetary policy in the United States, Lagarde said that “comparing our respective monetary policies is comparing apples and oranges. Our economies do not compare and this is likely to be accentuated by the fact that the euro area is probably going to be more exposed and will suffer more consequences as a result of the war by Russia against Ukraine.”

Investors reacted to Lagarde’s comments by pushing down the value of the euro. It fell to its lowest level against the US dollar in nearly two years. Bond yields in Germany, France, and Italy all increased on expectations of higher inflation. Equity prices increased modestly, perhaps on the belief that the risk of recession is lower than previously expected. The ECB is now one of the few major central banks not to quickly tighten monetary policy. Rates have risen in the United States, the United Kingdom, Canada, Singapore, South Korea, and other countries. Only Japan, where inflation remains very low, have rates not been increased.

The deglobalisation debate continues

• I have recently written about the debate on the future of globalisation. Some observers say that we are entering a new age of deglobalisation, driven by trade wars, disruption of global supply chains, fear of further tension between China and the West, and populist sentiment against the free movement of goods, capital, and people. Others think that disruptions caused by the pandemic and the war in Ukraine are the nails in the coffin of globalisation.

And yet, global trade continues to thrive. If deglobalisation is coming, it is not yet evident in the statistics. The volume of global trade in early 2022 was roughly 9% higher than just prior to the pandemic, despite a slowdown in trade in China in early 2022. In fact, trade accelerated in recent months. Recent indicators of supply chain stress demonstrate that global business continues to struggle to satisfy strong global demand for traded goods. If there were deglobalisation, supply chains would be turning inward.

Still, the hallmark of globalisation has been the constant search for the lowest cost and fastest speed of producing and transporting goods. In the last two years, however, costs have risen and transport has slowed. This reflected the disruptive impact of the pandemic. The war in Ukraine and the recent lockdowns in China simply add to the disruption. But this does not necessarily mean that globalisation is being reversed. Rather, it means that globalisation has hit a roadblock and turns out to be more vulnerable than previously believed. If global businesses move to boost the resilience of supply chains through diversification, it does not imply a reversal of globalisation. 

Perhaps the pessimists are concerned less about the economic issues than the geopolitical issues. That is, there is fear that the economic relationship between China and the West will fall apart, especially if global companies fear that China might become subject to the kinds of sanctions that the West recently imposed on Russia. Such fear will likely cause supply chain diversification to accelerate. Yet this does not imply that supply chains will not be global or that companies will bring most processes back home.

Meanwhile, the debate continues. It is often said that “saying it’s so makes it so.” If true, then all the talk about deglobalisation could turn out to be a self-fulfilling prophesy. Companies might act in ways that undermine globalisation due to fear of being left behind. 

Strong US labour market, but worried financial markets

• Earlier this month, the US government released yet another favourable jobs report, signaling that the economy continues to grow at a healthy pace, despite growing sentiment that a recession is nearing. The report found strong growth in the number of people employed, rising participation, and a decline in the unemployment rate. The US government releases two reports: one based on a survey of establishments; the other based on a survey of households.

The establishment survey found that there were 431,000 jobs created in March, a strong number but the lowest since September. Among the industries that experienced strong job growth were manufacturing (up 38,000), retailing (up 49,000), professional and business services (up 102,000), and leisure and hospitality (up 112,000). The establishment survey also revealed that average hourly earnings of workers were up 5.6% in March versus a year earlier. This was an acceleration from recent months, but not dramatically so. Wages are rising more slowly than prices, rendering consumers with less real spending power. That, in turn, could threaten the economic recovery. On the other hand, the modest pace of wage gains means that we are not yet seeing the kind of wage-price spiral that could lead to sustained and prolonged inflation. 

The household survey found that the labour force continued to grow faster than the working-age population, thereby boosting the rate of labour force participation. Employment grew even faster, causing the unemployment rate to decline to 3.6%, the lowest since February 2020. It should be noted that the job market is often a lagging rather than a leading indicator of economic performance. Thus, some observers fear an imminent recession despite current strong job market indicators.

• Recently, the spread between the US Treasury’s 10-year bond yield and the yield on two-year bonds became negative. This inversion of the yield curve worried investors. Almost every time there has been a sustained inversion of this yield spread a recession soon followed. However, the spread between the yield on the 10-year bond and the three-month Treasury bill did not invert. In modern times, all recessions were preceded by such an inversion. Thus, there was reason to believe that a recession was not in the cards. Meanwhile, the 10-year two-year spread has since reversed and is no longer inverted. How can we interpret this?

The inversion of a yield curve is often seen as signaling investor expectations that future short-term interest rates will be lower than currently, likely due to the central bank easing of monetary policy in the face of recession. Thus, an inverted yield curve is often seen as predicting a recession. And, indeed, it is often correct—but not always. The fact that the 10-year three-month spread did not invert suggests that investors are not convinced that a recession is imminent. Meanwhile, there is plenty of discussion about the risk of recession in the business community, a discussion that did not seem to be present prior to the war in Ukraine. The shock of a big increase in commodity prices and uncertainty about which way the war will go have clearly frightened many people in the business community. Indeed, the volume of M&A transactions dropped sharply since the war began.

Eurozone inflation accelerates

• Inflation in Europe appears to be converging with the high rate of inflation in the United States. The European Union reported that, in March, consumer prices in the 19-member Eurozone were up 7.5% from a year earlier, the highest since the creation of the Eurozone. US inflation was 7.9%. In the Eurozone, prices were up 2.5% from the previous month. The principal culprit was the war-related surge in energy prices. The European Union reports that energy prices were up 44.7% in March versus a year earlier and were up a stunning 12.5% from the previous month. When volatile food and energy prices are excluded, core prices were up a more modest 3% from a year earlier and up 1.2% from the previous month. 

By country, the 12-month increase in consumer prices was 7.6% in Germany, 5.1% in France, 7% in Italy, 9.8% in Spain, 11.9% in the Netherlands, 9.3% in Belgium, 8% in Greece, and 5.5% in Portugal. 

The European Central Bank (ECB) now faces a conundrum. On the one hand, it will likely tighten monetary policy in order to assure investors that it has inflation under control. On the other hand, Europe is at most risk of a recession emanating from the war in Ukraine. The risk is particularly acute given the possibility that the European Union, or at least some members, will halt purchases of Russian oil and/or gas. Thus, even higher prices and a shortage of energy could ensue. For the ECB, this means tightening monetary policy further creates a risk of recession. 

Chinese manufacturing activity weakens

• In March, there was a sharp decline in activity in China’s manufacturing industry according to the latest Purchasing Manager’s Index (PMI) from IHS Markit. PMIs are forward-looking indicators meant to signal the direction of activity in the manufacturing sector. They are based on subindices such as output, new orders, export orders, employment, pricing, pipelines, and sentiment. A reading above 50 indicates growing activity. The higher the number above 50, the faster the growth—and vice versa.

Markit reports that the PMI for Chinese manufacturing fell from 50.4 in February to 48.1 in March. This was the lowest PMI since the start of the pandemic and indicates a significant decline in activity. The latest PMI included a sharp decline in output, new orders, and export orders. In addition, there was a sizable increase in both input and output pricing. China’s manufacturing sector was hit by two headwinds. First, government efforts to suppress the virus led to disruption of production, distribution, and consumer demand. Second, the war in Ukraine boosted input prices and created uncertainty that likely sapped consumer sentiment. Going forward, the outlook for manufacturing in China will depend on how the government addresses COVID-19. As of now, a lockdown in Shanghai continues. In addition, the resolution of the war in Ukraine will also have an impact.

The future of dollar dominance

• As discussed previously in these pages, the war in Ukraine and the resulting sanctions on Russia’s central bank have led to questions about the future of the dominant role of the US dollar. Many observers wonder if sanctioning Russia’s central bank opens a pandora’s box. That is, although the current sanctions were imposed by numerous governments, one can imagine a scenario in which the United States acts alone in sanctioning the central bank of another country. If there is a risk of this happening, then it would make sense for various central banks to diversify their portfolio of foreign currency reserves away from the dollar. If they worry that European states might act in line with the United States, then diversifying away from euros and toward currencies of smaller economies might make sense. 

In fact, this has already been happening during the past decade. Economist Barry Eichengreen has found that the dollar share of global reserves fell from 70% at the start of this century to roughly 59% now. Moreover, this was not offset by increased holdings of traditional reserve currencies such as the euro, pound, and yen. Instead, the share held in other currencies increased. The Chinese renminbi only accounted for 25% of that increase. The rest went into currencies issued by smaller market economies such as Canada, South Korea, Australia, Singapore, and Sweden. Evidently, central banks like holding reserves issued by stable countries with open capital accounts and the rule of law.  

Going forward, there will likely be some further diversification of reserves away from traditional reserve currencies, if only as an insurance policy against geopolitical disruption. In that sense, the sanctions on Russia have created a greater sense of risk that warrants diversification. The sanctioning of Russia’s central bank was a landmark event, given the large size of Russia’s economy. Moreover, there will not likely be a significant surge in reserves held in renminbi so long as China retains capital controls and a lack of financial transparency. Thus, the world of reserves is gradually becoming more multipolar rather than unipolar. 

That said, the US dollar and the euro are likely to remain substantially dominant, not only as reserve currencies but also, and more importantly, as principal trading currencies. Indeed, the dollar and euro together account for about 80% of all international transactions. The dollar and euro have some important attributes that make them highly attractive. These include a transparent financial system, rule of law, and in the case of the United States a vast and liquid market for government-issued securities. I believe if you asked a farmer in an emerging country how they would like to be paid for his wheat exports, they would likely say dollars rather than renminbi. As long as that is his answer, the dominant role of the dollar will remain.  

Reaction to Russian request for payment in rubles

• Recall that Russia recently attempted to change the conversation by insisting that, going forward, it be paid in rubles for its energy exports to “unfriendly” countries. The idea was that European powers, especially Germany, would be forced to violate their own sanctions, thereby undermining the credibility of the sanctions. Moreover, by being paid in rubles, Russia would obtain funds needed to wage war, without having to fuel inflation by printing money. Yet Russia’s demand was risky in that, if it were rejected, Russia might be stuck with a sharp drop in energy exports. 

Now comes word that the energy ministers of the G7 countries unanimously rejected Russia’s demand. Germany’s energy minister said that, to abide by Russia’s demand would violate existing contracts. He said that the G7 countries were prepared for “all scenarios” including the loss of access to Russian energy. If Russia now rejects payment in euros, it will experience a sharp drop in revenue. If Russia allows payment in euros, it will continue to receive revenue but will suffer a loss of credibility. Europe’s leaders likely hope that Russia will concede. 

Meanwhile, European gas prices were relatively stable after the G7 announcement. Analysts said that, absent the G7 statement, prices would likely have fallen after reports that European gas storage was substantially replenished in the last few days, hitting levels not seen since 2018. European nations are actively attempting to boost access to alternative sources of energy. Germany last week said it intends to wean itself from Russian energy within the next two years. And the United States pledged a substantial increase in exports of liquid natural gas to Europe. 

• Meanwhile, the German government is taking steps to ration natural gas, now that it has refused to pay for gas using rubles. The government indicated that, if rationing is not successful in dealing with potential supply shortages, then the government is prepared to cut gas from industry in some parts of the country and give preference to households. Currently, gas storage facilities in Germany are only about one-quarter full, leaving little wiggle room.   
  

The risk, of course, is that a substantial reduction in gas supplied to Germany could lead to a dramatic rise in prices (and, therefore, inflation) as well as reduced economic activity—perhaps a recession. Yet Germany has lately been quite firm in its aversion to engaging Russia. It said it will not meet Russia’s demand to be paid in rubles, and it has pledged to quickly wean itself from both Russian gas and oil. The goal, however, is to bring Russia’s economy to its knees to limit its ability to wage war. 

Ruble returns to precrisis value

• The value of the Russian ruble is roughly back to where it was prior to the imposition of sanctions. In part, that is because the Russian government imposed severe capital controls, thereby limiting the ability of Russians to take money out of the country. It also means that foreign investors are restricted in disposing of assets in Russia. In addition, the doubling of the central bank’s benchmark interest rate provided savers with an incentive to hold onto their Russian bank deposits. Plus, higher oil and other commodity prices have enabled Russia to continue generating foreign currency revenues, despite obstacles. Finally, Russia imposed a rule that exporters of energy must convert 80% of their foreign currency revenues into rubles, thus boosting demand for rubles. 

Still, the highly intrusive sanctions, especially those aimed at Russia’s banking system, mean that the market for trading rubles has shrunk dramatically. Thus, although the exchange rate is back to the precrisis level, the volume of trading suggests illiquidity. While the Russian government might point to the exchange rate as evidence that the sanctions are not working, the reality is that the sanctions are having a big negative impact on economic activity. Real GDP is likely to shrink significantly this year.  

Ukraine’s economic performance

• Ukraine’s troubles began in 2014 when, after a popular uprising that overthrew a pro-Russian government, Russia invaded Crimea and provided support to rebels in eastern provinces. Crimea, where 58% of the population are Russian speakers, had been part of Russia until then Soviet leader Nikita Khrushchev essentially gave Crimea to Ukraine in the 1950s. In the eastern provinces such as Donbass, just under 40% of the population are Russian speakers. Russia’s actions were met with limited sanctions on the part of the United States and the European Union. Russia was unhappy about the Western tilt of Ukraine policy and wanted to weaken Ukraine and prevent it from becoming more closely tied to the West. The evidence, however, suggests that Russia failed.

A study conducted at Harvard found that, following 2014, Ukraine’s exports shifted dramatically away from Russia. In 2012, 25% of Ukraine’s exports went to Russia. Today that figure is roughly 7%. The difference was mainly made up by increased exports to the European Union. One result of this is that Ukraine has become more integrated into European supply chains. For example, Ukrainian exports of electronics to Germany increased significantly in recent years. Moreover, EU direct investment in Ukraine increased commensurately. Roughly 128,000 Ukrainians are employed by EU companies. However, less than 2% of Ukrainian workers are employed by foreign companies—a much smaller share than in many neighbouring countries. Notably, Ukraine’s increased economic engagement with the European Union mostly took place in the western provinces of Ukraine, leaving the eastern, Russian-speaking areas behind. 

What can we infer from these statistics? First, Russia’s attempt to pull Ukraine away from Europe failed. Second, Russia’s actions led to weaker economies for the Russian-speaking areas of Ukraine. Third, it seems likely that the war was launched, at least in part, to halt any further Ukraine integration with Europe, especially a potential membership in the European Union. Finally, the evident failure of Russia’s invasion offers hope that Ukraine’s path toward greater economic integration with the West might resume. 

US consumer spending pattern continues to shift

• In the United States, consumer spending on goods continued to decline in February while spending on services increased. Meanwhile, prices of durable goods were unchanged from the previous month, raising the possibility that inflationary pressures had started to abate in February. Nevertheless, all assumptions based on February data must now go out the window because of the war that began a month ago. When the numbers come in, it is likely that inflation in March will have accelerated sharply, mainly due to the very sharp rise in energy prices.

This commentary is based on the latest US government data on consumer income and spending and prices in February. The data shows that, in February, real disposable household income declined 0.2% from the previous month. While nominal income rose, the increase was more than offset by high inflation. Notably, real (inflation-adjusted) consumer spending fell even more, mainly a result of rising savings rates. Specifically, the share of income that households save increased from 6.1% in January to 6.3% in February. 

As for consumer spending, real spending on durable goods fell 2.5% from January to February. Spending on durables was 8.5% below the peak reached in March 2021 but was 22.9% above the level in February 2020 just prior to the start of the pandemic. In other words, while demand for durables is receding, it remains far higher than prepandemic levels, even after accounting for rising prices. It was the surge in such demand that made a major contribution to the inflation we’ve seen in the past year. 

Meanwhile, real spending on nondurable goods fell 1.9% from January to February. Although real spending on nondurables has been relatively flat for the past year, it remains 11.9% above the prepandemic level. Finally, real spending on services increased 0.6% from January to February. Although real spending on services has been steadily rising since collapsing at the start of the pandemic, it remains 0.3% below the prepandemic level. Thus, the sharp shift by consumers away from services and toward goods during the pandemic remains with us, although it is clearly abating. That shift played a big role in generating high inflation. After all, a disproportionate share of the rise in prices was attributable to goods rather than services.

Meanwhile, the government also published the Federal Reserve’s favourite measure of inflation, the Personal Consumption Expenditure Deflator, or PCE-deflator. This is not as well known as the Consumer Price Index (CPI), which is highly reported in the press. The data on the PCE-deflator indicates that, in February, consumer prices were up 0.6% from January to February, the same as in three of the last five months. Prices were up 6.4% from a year earlier, a 40-year high. When volatile food and energy prices are excluded, core prices were up 0.4% from January to February, the smallest increase since September. Core prices were up 5.4% from a year earlier.

Notably, prices of durable goods were unchanged from January to February while prices of nondurables were up 1.8%, largely due to rising energy prices. Prices of services were up 0.3%. One can make the argument that the February data shows some promising signs. Yet the reality is that the war in Ukraine has led to dramatic increases in the prices of energy, food, and some key minerals. This will show up in the inflation data in the months to come, exacerbating and prolonging inflation in the United States and elsewhere. How bad this gets and how long it lasts will depend on the war, the sanctions, and the reaction of policymakers. The Federal Reserve has initiated a tightening of monetary policy meant to suppress inflation.

Deloitte Global Economist Network

The Deloitte Global Economist Network is a diverse group of economists that produce relevant, interesting and thought-provoking content for external and internal audiences. The Network’s industry and economics expertise allows us to bring sophisticated analysis to complex industry-based questions. Publications range from in-depth reports and thought leadership examining critical issues to executive briefs aimed at keeping Deloitte’s top management and partners abreast of topical issues.

Learn more