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28 April 2022

Monetary Policy: The Imperfect Storm

War in Europe, tight labour markets, not remembering your own salary, these waves are but a few in the storm facing the central bank governors of today. Not long ago the interest rate story seemed simple: the recovery was underway, inflation was rising, and central banks were beginning to tighten policy. The war in Ukraine has intensified the issues, so is tightening still the obvious path?
 
A growing sanctions regime and new legislation from the Kremlin suggesting it is willing to weaponise commodities have lain bare the vulnerability of western supply chains and inflation. Aside from oil and gas, Russia boasts a meaningful share of global industrial metals, producing 35% of the global supply of palladium, 9.2% of nickel, and is the largest producer of aluminium outside of China. These metals have widespread uses in, to name a few, the production of batteries, medical equipment, and cars.
 
Rising input costs are familiar to many having famously been attributed to semiconductor shortages holding global supply chains hostage, but it was widely believed that these shortages were nearing their end. That belief was dispelled upon the discovery that 90% of a critical material in chips, high-grade neon, is produced in Ukraine using a gas-phase laser, the gas for which is sourced from Russian steel manufacturers. The impact on food markets, where Russia and Ukraine account for 25% of global wheat exports, and the former and Belarus for nearly 40% of potash production, a key ingredient in fertilisers, ensure the coming belt tightening will be more than just figurative.
 
United States

Those who blissfully ignore the news may view themselves as impervious to the goings on in the wider world, yet they forget one simple truth – all bow before the petrol pump. Since the shale boom, the US has become a net exporter of fossil fuels to the world, and thus, in theory, harshening sanctions on Russian energy should boost growth in the US economy, though with uneven effects on different sectors. Reality unveils a different picture. With supply chain shortages being so widespread, shale producers face stiff competition for resources, such as steel, that would normally be redirected to increase drilling capacity, while shareholders are enforcing capital discipline, wary of the profligate investment that used to plague the industry. This is exemplified by Pioneer Natural Resources, which is committed to returning 80% of its free cash flow to shareholders. This grim truth is already showing itself in trade figures, where the combined trade deficit of liquid natural gas and crude oil has widened from US$1bn this time last year to US$5bn today.
 
The story for agriculture is more hopeful, though it is true that it could be disrupted by a fall in yields from a shortage of fertilisers. The US has a small trade surplus in agriculture, and disruptions to commodity supplies could create American jobs since wheat is one of its largest exports. Meanwhile, a world beating defence sector looks set to enjoy a renewed European commitment to defence spending. The US economy appears strong on most measures: an impressive package of fiscal stimulus is still taking effect, jobs growth is continuing apace, and commercial banks have resilient balance sheets which are being turned into a fast pace of credit growth. In this environment, it seems likely the Federal Reserve will continue with its policy tightening programme.

Europe
Europe is decidedly less insulated from soaring energy prices. It has long been a net energy importer, importing 40% of its gas and a quarter of its oil from Russia, and has limited production capacity to make up the difference. All else being equal, rising energy prices resultantly deteriorate Europe’s current account (the net value of trade in goods and services), which acts as a drag on growth. As oil is a commodity with reaching uses, an increase in its price broadly increases input costs, and its rapid price gains do not bode well for inflation, which tracks oil prices.
 
The EU’s Common Agricultural Policy (CAP) targets food security by subsidising farmers with the intention of shielding production capacity from volatile food prices. This has granted the bloc a steady agricultural base with which to increase supply in times of shortage, and a sizeable surplus in the trade of foodstuffs, meaning it stands to gain from gummed-up supply in international food markets. Such supply shocks spell trouble for the continent’s fragile recovery, however, raising the spectre of ‘stagflation’, or stagnant growth and high inflation, while a rate rise could simply plunge Europe into recession.
 
A concern unique to the ECB is trying to balance inflation and growth while staving off a sovereign debt and currency crisis. Upon adopting the Euro, countries relinquished control of monetary policy to Brussels, which must set rates in consideration of all its members – raising rates to tame German growth and inflation, for example, could axe a tentative recovery in Spain. The rate the ECB sets also determines the cost of borrowing for Euro adopters, and six countries, including Italy, Spain and France, all have national debts over 100% of GDP. Italy alone struggles with its debt burden and, when the prospect of an economy as small as Greece defaulting nearly caused a collapse of the Euro, the risks of debt troubles, or speculation of them, in one of the bloc’s larger economies are self-evident. Though European inflation is on the rise, much of its root is from the supply side which is not something higher rates can hope to solve save by reversing a weak recovery, while monetary policy decisions are heavily politicised from their impact on indebted member states.

United Kingdom
For Britons, lower dependence on Russian energy is a point of pride, with the government being able to commit to winding down oil imports, which consist of 11% of the total, by the end of this year. Such a number appears manageable by European standards but is made deceptive by British energy being heavily integrated into international markets, which in reality makes its economy susceptible to higher prices from reduced supply. A gas squeeze has already bitten and looks set to continue with a 50% increase in the energy price cap due in April and another large increase expected in October. Combining this with announced hikes in national insurance, student debt repayments, and an annual inflation rate of 5.5% in January, consumers are facing an unprecedented rise in the cost of living and are saving in anticipation of hardship.
 
The British Chamber of Commerce has halved its UK growth forecast for the year, expecting consumer spending to be one third lower than predicted, and business investment to be weaker than previously thought. On the income side, the 0.25% increase in interest rates already undertaken is projected to depress incomes by 2%, and real wages shrunk in 2021. Sanctions are turning off the taps not just for Russian oil, but money too, with the impact of reduced demand for the financial, legal, PR, and hospitality services required by any budding oligarch yet to be seen. In spite of these troubles, the Monetary Policy Committee struck a hawkish tone when raising rates, with a significant plurality of members advocating an interest rate of 0.75%. For good or ill, do not be surprised by further rate rises.

Please note that this communication is for information only and does not constitute a recommendation to buy or sell the shares of the investments mentioned. The value of investments and any income derived from them may go down as well as up and you could get back less than you invested.
Monetary Policy: The Imperfect Storm
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